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.
