The return of the tantrum

India has seen improvements in its macroeconomic fundamentals since 2013, and is better suited to face the global financial market tantrum predicted later this year.

Every macroeconomist worth his salt has an opinion on when the Federal Reserve is going to increase the interest rates. Speculations about rate hikes have intensified in 2015, making it the most anticipated and feared event in the financial calendar. The ramifications of a rate hike in the US are huge. This article will not focus on the possible timing of the change in monetary policy stance; instead it will focus on the possible consequences for the various global stakeholders.


With increasing interconnectedness of financial markets and the real economy, global economic performance has been reactive to the US interest rates. Back in 2013, indications from Ben Bernanke, former Fed chairman, that the monetary policy in the US is going to tighten resulted in currencies and equity markets across emerging markets to go into a tailspin.  In early 2015, Janet Yellen, present chairperson of the Fed, announced that there could be an increase in US interest rates later in the year. A US rate hike will result in investors exiting from emerging markets and depositing it in the US dollar. As a consequence, emerging market currencies will depreciate and the equity markets will fall. The extent of the damage will depend on the health of the economy. India has improved its macroeconomic fundamentals and growth prospects look better since the previous episode, which will help in averting a crisis.

To get a better understanding of the possible outcomes of such an event in 2015 due to Fed rate hike, it is imperative to revisit and analyse the taper tantrum of 2013.

Taper Tantrum: Episode One
After a period of extraordinarily low interest rates between 2001 and 2003 (about 1 percent), the Fed started tightening in gradual steps by June 2004, apprehensive that the loose monetary policy had led to an enormous asset (housing) bubble in the US. However, it was a case of “too little, too late”, as the subprime crisis that rocked the global economy in 2007-08 was  gathering momentum. In order to tackle the crisis and avoid repeating the mistakes during the Great Depression of 1929, the Fed immediately lowered and maintained rates at near zero levels (as portrayed in the chart below). However, it was found that even zero rate of interest (negative real rates) was not enough to stimulate the economy and thus, the Fed started various large-scale asset purchases, commonly known as Quantitative Easing (QE), to inject liquidity in the system.

Chart 1: The Effective Federal Funds Rate has been zero bound for a long time

Chart1 Effective Federal Funds Rate(Withoutcaption)

Source: Federal Reserve Economic Database (FRED), St. Louis Fed.

In May 2013, following some encouraging economic data, Ben Bernanke announced that it was an opportune moment for the Fed to reduce its rate of purchasing these assets, i.e., taper the rate of QE. Following the announcement, the global financial markets got caught in an irrational frenzy, triggering massive sell-offs in emerging markets. The subsequent string of global events was collectively called as “taper tantrum”.

These episodes of high market pressures were marked by a sudden aversion to risk with sharp corrections in the Emerging Markets (EM) such as rapid currency depreciations, increases in external financing premia sell-offs in equity, sharp increases in bond prices, and  reverses in capital flows. Between May 22 and the end of June, on average, currencies across EMs depreciated 3 percent, spreads rose 1 percentage points, and equities fell 7 percent. This episode of broad selloff was then followed by greater differentiation during the second half of 2013. Countries, which have larger external financing needs and poorer macroeconomic fundamentals, faced the worst of the financial market tantrum. Brazil, India, Indonesia, Turkey and South Africa were the pick of the investors. These five countries witnessed, on average, bond yields rise by 2½ percentage points, equity market fall by 13¾ percent, exchange rates depreciate by 13½ percent while reserves declined by 4.1 percent during May 22–(end of) August 2013.

Chart 2: Emerging market currencies against the US$ during the first taper tantrum

Chart2 EM Currency depreciation

Source: Exchange Rates from IMF database.
Note: Currencies have been indexed with 20th May values =100. A number above 100 denotes depreciation.

As can be seen in the chart above, the Indian rupee fared the worst amongst the group, falling from Rs.55/$ to about Rs.66/$, a 21 percent depreciation in its value. The BSE-Sensex lost about 1600 points in two months. There was net FII outflow during this period, worsening the balance of payments situation.

The key take away from the 2013 episode is that after the initial frenzy that affected almost all emerging markets uniformly, there were differentiated effects on different countries. There has been literature on why countries reacted differently after the initial uniformity. An IMF working paper finds that “countries with stronger macroeconomic fundamentals, deeper financial markets, and a tighter macro prudential policy stance in the run-up to the tapering announcements experienced smaller currency depreciations and smaller increases in government bond yields”. The taper tantrum lasted through most of 2013 and half of 2014. QE in US has officially come to a close.

The Return of the Tantrum
What is in store for the global financial market in 2015? The Global Financial Stability Report by the IMF casts a rather gloomy forecast by saying that global financial risks have increased. The main risk comes from loose monetary policy as a response to deflationary trends – especially from the Bank of Japan and European Central Bank. Emerging markets also pose a financial stability risk, due to falling commodity prices and higher corporate foreign indebtedness. Further, Chinese economy has been slowing considerably and its growth outlook is skewed heavily downside.  The foreign exchange market also looks quite volatile. The Euro and Yen have been depreciating, while the dollar has appreciated considerably.

Add to this mix of financial instability the prospect of US rate hike and we are potentially seeing a bumpy ride ahead. It can be taken for granted that most emerging markets will witness currency depreciation due to an outflow of funds. A few of the emerging markets have overvalued currencies as measured by theReal Effective Exchange Rate (REER). REER is the weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation. It can be seen from the table below that China, India and Indonesia have overvalued currencies by 41, 19 and 8 percent respectively. In May 2013, almost all currencies (except South Africa) were overvalued and then, duly depreciated. China is due for a depreciation of its currency, not merely because it is overvalued, but also because that is the last resort to increase growth rates and reduce the burden of foreign denominated loans, as this article by Anantha Nageshwaran suggests.

Table 1: The Real Effective Exchange Rates of Emerging Markets

Table1 REER EMSource: Real Effective Exchange Rate for 178 Countries: A New Database, Bruegel

Though India has recently depreciated against the dollar, it has significantly appreciated against other currencies (euro and yen), which has pushed the trade weighted REER well above 100. This means that the rupee will face a significant devaluation when the tantrum returns. Normally, this could be seen as a good fillip to a sluggish export and manufacturing sector. However, given that most other competitors (China, Indonesia, Philippines) are due for depreciation as well, it might not have much effect at all.

Equity markets are much harder to predict. The first few days after the rate hike will see large movements in equity markets across the globe, as “hot money” recedes. There have been 16 times that the Fed has raised interest rates after the economy has started recovering from a downturn and in 80 percent of these events, the stock markets have been negatively hit.

The lessons from 2013 discussed above will hold in 2015 as well. Countries with strong macroeconomic fundamentals such as low inflation, potential for growth, low current account deficit, low budget deficit, etc. will be in a much better position to stabilise quickly after the initial storm. Holding significant foreign exchange reserves by the central bank will also empower it to intervene in the forex market, when necessary. India is in a better position this time as compared to 2013, when it was the worst performing of the fragile five.

Table 2: Significant improvements in India’s macro fundamental since June 2013

Table2 Macro Performance India
Source: Database on Indian Economy, RBI

India has seen an improvement in its fundamentals since 2013. This will mean that India has done just about enough to weather the storm due later this year. Moreover, performing comparatively better than the trouble ridden emerging markets, it still remains the preferred destination for investors.

Photo: Tax credits