QE Tapering and India

The most pertinent question lying in front of the financial world is life post the unprecedented Quantitative Easing (QE). Just the thought about tapering has brought about a 100 bps rise and an upheaval in the currency markets. So we would like to present our thoughts on how the economic scenario shall pan out following the complete wind down of the US QE program.

Background: The US Fed since Alan Greenspan has constantly tackled economic problems by perpetrating another one. This began with the crash of LTCM and Internet bubble when the Fed went for loose monetary policies which in turn lead to a housing boom, mainly because the benchmark interest rates fell from 6% to below 2% from 2000 to 2002.  As the housing boom attained bubble proportions along with heightened economic growth, interest rates went back to 5.5% by January 2007, following this came a crash in mid-2007 due to excessive and complex derivative built-up in the system, the Fed tried to overcome this scenario once again by reducing interest rates to near zero levels and QE. Now we are faced with another bubble being formed in the Fixed Income securities market. So by the time the QE is wound up, the US Fed might have to propagate another bubble in another asset class.

Rise in Interest rates: Interest rates will surely get firm once we see the end of the QE program, we have already seen a glimpse of this in the recent past. Another factor would be the raising of the US debt ceiling; this could also perk up the rates further. Currently US is considering increasing the debt ceiling, any increase in the debt ceiling will go towards meeting the welfare obligations like Obamacare and unemployment benefits. This will is surely contrary to Keynesian economic thinking of increasing spending to perk up employment in the economy. However, if the commercial banks in the US start begin purchasing treasury bills instead of holding cash or reserves, then interest rates could be capped.

India will be placed in a precarious situation in case of withdrawal of QE as one of the foremost beneficiaries of QE, with Foreign Institutional Investors (FII) pumping in a lot of money in the Equity and Debt market. India has in the recent past relaxed FII investment norms for Indian debt, and due to capitalize on the high interest rates as compared to the US, we have seen good inflows. However, with the rising interest rates in the US, risk premiums for holding Indian debt would also rise and hence we saw a concomitant rise in the interest rates and the dollar. India will have to change its strategy of attracting FIIs from interest rate arbitrage to better growth potential opportunities.

With flawed economic policies being followed in the US and India; greater risks lie ahead for the Indian economy as the US will manage to float as its status not only as the reserve currency of the world but also a huge consumer of products. But India will have to put its house in order to raise the living standards and the per capita income; with elections looming ahead and chances of another weak coalition government prospects look extremely dim.