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[Fed Tapering:Part1 of 2] Meaning of Fed Tapering, its Negative Impact on Indian Economy, Worst case scenarios, Balance of Payment Crisis, explained
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Prologue What is Fed tapering Why is it called Fed Tapering? How can Fed Tapering affect India? Worst case scenario [WCS] by Fed Tapering 1. WCS1: Hot money gone / Flight of Capital 2. WCS2: Weaker Rupee= bigger CAD + bigger inflation 3. WCS3: Exports may not increase 1. Dushmani 4DEVYANI= less EXPORTs 2. Special 301 report & Priority status= less EXPORTs 6. BoP crisis: How can that happen? 7. Can Fed Tapering really cause BoP crisis?

Prologue
1. you already know about Quantitative easing and its impact on Indian economy. Click me. So far we know that: 2. in this article, well learn the basics of Fed tapering and its (possible) negative impacts on Indian Economy. 3. in the next article= Steps taken by RBI +Government to immunize Indian economy against the negative impacts of Fed Tapering (currency swap agreements etc.) click
me

What is Fed tapering

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In the first article, we saw that: Subprime crisis: Investors money stuck in mortgage backed securities and other toxic assets. You may visualize this as a Draught of dollars. Quantitative Easing American RBI (US Feds) launched a program to buy toxic assets and government securities from market. Result? Dollar supply increased. (Because central bank is buying stuff from someone and paying them in dollars.) You may visualize this as American RBI opened all gates of the dam to send maximum quantity of water (dollars) to American farmers. Although lot of that water- went to Chinese and Indian farmers as well! QE was carried out in three phases. Finally in Dec 2012, Chairman Ben Bernanke announced that hell stop this water-supply when EITHER unemployment rate is <6.5% OR inflation is >2.5%. Because each condition implies that American farmers are booming, hence no need to give them lot of irrigation water (dollars) under Rajiv Gandhi Sinchaai yojana Quantitative Easing.
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Dec 2013: Finally Chairman Ben Bernanke sees American farms are booming, there is no need to release lot of water from dam (dollar supply). [in reality unemployment rate became lower than 6.5%] So, he starts closing dam-gates one after another. Result? water supply (dollar) reduced. This is fed tapering. Observe Time Dec 2013 Jan 2014 Feb 2014 March 2014 Bond Buying Program (Billion USD) 85 75 65 55

At this rate, canal doors should completely shut down @October 2014. (Because now the new Chairman Jenet Yellen is reducing the water supply (dollars) by 10 billion USD per month.)

Why is it called Fed Tapering?

In above graph, observe that the Width of canal / graph is decreasing constantly. (in other words, Dollar supply is decreasing). Tapering is a mechanical term, to describe such constant decrease in width. And since this is being done by US Federal Reserve, so we call it Fed Tapering. Formal definition: Fed tapering is the gradual reduction in the bond buying program of the US Federal Reserves.

How can Fed Tapering affect India?

From Mexican drugloards to Hongkong smugglers to Russian arms dealers to Italian Mafias to Indian Bookies n Match fixers- everyone uses dollars. So any increase OR decrease in dollar supply affects all economies. In last article, we saw the effect of Quantitative Easing (=increased dollar supply) on Indian Economy.

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Let me summarize that in a table: Indian point of view Dollar Supply FDI-FII ExchangeRate Rs. becomes Strong Quant. Easing HIGH Increase 09=50 10=44 Down due to Subprime + Greece/Eurozone crisis. Export

Since QE = increase dollar supply and Fed tapering= decrease in dollar supply, so by common sense, every effect should become reverse, right? Indian point of view Dollar Supply

FDI-FII ExchangeRate Rs. Becomes Strong

Export

Quant. Easing

HIGH

Increase

2009: $1=50 rupees. 2010: $1=44 rupees. Rs. Becomes Weak

Down due toSubprime + Greece/Eurozone crisis.

Fed Tapering

Medium

Decrease

March13: $1=55 Not as high as expected. May 13(rumor of (more given in later Fed tapering paragraphs) starts) Sep 13: $1=66 Rs.

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Lets not waste more time in ball by ball commentary and jump directly to:

Worst case scenario [WCS] by Fed Tapering

Every once in a while, Rajan and Chindu make press statements that Indian economy is strong enough to survive the negative effects of Fed tapering. Meaning, atleast one expert in the whole world -believes that Indian economy is bogus and well be thoroughly devastated by Fed Tapering. (otherwise

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Rajan/Chindu did not have to keep giving such explanations to media.) So lets check the possible worst case scenarios. How can Fed tapering hurt Indian economy?

WCS1: Hot money gone / Flight of Capital

FIIs takeout their money from India to reinvest in USA (Because Fed tapering implies that US economy is recovering. So, American investors may want to re-invest in USA.) Result? Sharemarket may go down (may even crash- if there is largescale exit of FIIs)=> desi investors money lost. Rupee will weaken further. How? Suppose an American FII (say Morgan Stanley) invested in Reliance infra.shares. But now he wants to exit. Morgan sells those shares= get gets paid in rupees But he wants to re-invest money in USA = he needs dollars. Not rupees. Therefore, hell sell those rupees to get dollars (onion). Supply of onion Decreased because of fed tapering. (recall those dam gates are being (dollars) closed one by one) Demand of onion Increased because FII is exiting from Indian market. (dollars) Onion (dollar) gets more expensive. $1=65=>$1=70.. In other Result? words, dollar strengthens and rupee weakens.

WCS2: Weaker Rupee= bigger CAD + bigger inflation

FII gone = Rupee weakens While weak rupee = good news for Exporters. But bad news for importers. Weaker rupee = weve to pay more amount of rupees, to get same amount of crude oil = Current Account deficit (CAD) gets Higher. Rupee weakens further. As crude oil gets more expensive =petrol diesel gets more expensive= transport charges increase= milk, veggies everything gets more expensive. (Including raw material.) Raw material gets expensive= input cost of exporters increased = they cannot fully take advantage of the new demand created by USA customers/US importers.

WCS3: Exports may not increase

Fed tapering = US feds has started decreasing water supply (dollar) from their canal (Bond-buying program). This implies that USA economy is recovering. So, If US economy is recovering = American juntaa will buy more = Indian exporters will see more demand. (This is the positive thinking assumption.) but there are two errors in this positive thinking. 1. Weak rupee = expensive crude oil =Cost of raw material increases. Hence our export prices may not get that competitive yet, (compared to China, Thailand etc.)

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2. Dushmani 4 DEVYANI (Explained below)

Dushmani 4DEVYANI= less EXPORTs

American MNCs love India only as long as we are their call center guys and allow them to open malls and e-commerce sites in India. But as soon as our companies compete in their hometurf @USA, these American MNCs will use every trick in the book to prevent our entry. Indian government mishandled Devyani case- annoyed the Obama administration, creating some bitterness in relations. Now, American business lobbyists are using this negative-sentiment to get American regulatory bodies to teach us a lesson and get tit-for-tat. Observe: US body Lesson taught to Indians during Feb 2014 Federal Aviation administration. In Feb 2014, They reduced Indias airline safety ratings from level I to level II. When Indian flights go to USA, their officers will do more safety checking = more time will be wasted, inconvenience to Desi passengers. Jet airways share prices fell down. Domino effect: Singapores aviation authority also started inspecting Indian aircrafts. The aviation regulators of EU, Japan, UAE will also reduce our rating. Consequences: Indian aviation will not bring *that much* dollars as expected. Theyve Have cancelled licenses of Ranbaxys Punjab and Gujarat factories.Feb 2014: USFDA commissioner came to India to inspect our USFDA pharma companies. USFDAs activism = hurts our pharma companies, negative publicity = less export orders (From US customers, as well as EU, Japan- everwhere.)= less export = higher CAD. United States Trade Representative. They lodged complaint against India, for giving solar subsidies to desi companies. (Since Indian government gives USTR subsides to local companies under national solar mission program= American solar systems automatically become expensive in India= cannot compete. Thus India is violating the non-tariff barriers principle of WTO. USITC Given below US International Trade Commission (USITC) It is a quasi-judicial body. US government uses their report to decide trade policy. Hence, if USITC writes negative report about India, then well suffer indirectly in future (if Obama imposes tariff and non-tariff barriers on Indian goods and services). At present USITC is conducting a hearing about How Indian trade policies affect US jobs.

USFAA

Special 301 report & Priority status= less EXPORTs

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United States Trade Representative (USTR) writes this report. Deals with IPR (intellectual property rights) related matters. US government also uses this report to decide future trade policy. Experts believe, India will also get negative review in this 301 report. Because Indian authorities have hurt the IP-interests of Pharma MNCs. For example Novartis Bayers pharma SC rejected patent claim over their blood cancer drug (Glivec) Indian Patent office allowed NATCO to product the same blood cancer drug (NEXAVAR).

If we get negative review in Special 301 report = USTR can classify India as Priority foreign country Priority tag sounds VIP right? Nope infact it is bad news. Because USTR has powers to penalize priority countries e.g they can to impose higher duty/taxes and quota restrictions on Indian exports to USA. (and WTO may not help India in this case.) Since USA accounts for ~12% Indian exports. So imagine the negative consequences on Balance of Trade (Because export will decline). Ofcourse, one can argue that Indian drugs are bad quality or that Indian IPR/Patent law sucks. Therefore, USAs actions are justified. But we are the same country since last three years- yet until now American regulatory bodies did not take any action. BUT ONLY after Devyani case and within just one month (February 2014) , they suddenly start all this regulatory activism=> something fishy, revenge mindset, will hurt Indian exporters.

BoP crisis: how can that happen?

In the worst-of-the-worst-case scenario, Fed tapering may cause Balance of Payment (BoP) crisis in India. How? First lets understand some background theory: when and how can BoP crisis happen? 1. Balance of Payment is a systematic record of all economic transactions between residents and non-residents of a country. 2. BoP is divided into two parts. Current vs Capital. (and incoming vs outgoing money in each of them). click on following chart.

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In each of them, further weve incoming money (credit) and outgoing money (Debit). For the sake of understanding, lets observe a BoP data from 2012-13 (USD million dollars).

[Table] BoP Current Account [2012-13]

Current Account, Million dollars Visible Goods services Invisible Income (Profit, Interest, Dividend) Transfers (Remittance) Balance of Current Account Credit + 300000 150000 10000 68000 528000 Debit 500000 80000 30000 4000 614000 Net -200000 +70000 -20000 +64000 -88,000

In other words, we had Current Account deficit of 88 billion $ in 2012-13.

[Table] BoP: Capital account

capital account Credit + FDI 215000 investment FII 175000 Borrowing Government +private 150000 Bank Capital Non-resident bank accounts 83000 Total Capital acct. Debit 170000 150000 120000 67000 Net 45000 25000 30000 16000 +89300

In otherwords, we had Current account surplus of ~90 billion $ in 2012-13. Now lets do total 2012-13 Current Capital Error Omission Overall Million USD -88000 +89300 +2689 +4000 (Approx.)

What happens to this overall surplus 4 billion USD? Three things can happen Then +4 billion USD = more supply of onions (dollarS) in the Desi Forex market. This will change in rupee-dollar exchange rate, because of laws of supply n demand. Balance of payment will become zero.

1. Do nothing.

2. Give them to IMF 3. RBI should put them in forex reserve.

Same as above.

We took the third option. Observe. 2012-13 Million USD

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A.Current account B.Capital account C.Error Omission Overall (from A+B+C) Overall surplus sent to RBIs forex reserve Balance of Payment

-88000 89300 2689 +4000 (Approx.) -4000 0

Meaning, as long as Capital account has more money than Current account, well have surplus. But what happens IF we dont have surplus (i.e. capital account has less money than current account)? It happened in 1991s BoP crisis. Observe the data 1991 (Apr-Sep) Current Capital Overall Balance Million $$ -6634 +4808 -1826

In above table, We dont have any surplus! See we had deficit of ~2 billion USD. (=pothole is created). IF we want to get final Balance of payment ZERO then someone (Rajan, Mohan, Chindu, Rajesh Khanna or Shakti Kapoor) must pour in +2 billion US dollars to fillup this pothole. But in the 1991, RBI did not have sufficient forex reserve to fillup this pothole with dollars. (RBI had barely ~730 million USD, while pothole was ~2 billion). If this pothole is not filled up, then what will happen? 1. Extreme shortage of onions (dollars) in Indian forex market. => price of 1 onion(dollar) will go as high as 500 Rupees or even more! 2. Then, We wont have dollars to pay for our crude oil imports= economy collapses. This is called Balance of Payment (BoP) crisis. Solution? We had to pledge ~65 tonnes of gold to IMF to borrow ~2.3 billion USD. That money was used to fillup the BoP pothole. We also initiated LPG reforms, to ensure that in future we have sufficient capital surplus so BoP crisis doesnt happen again. Enough flashback of 91, Back to original moving:

Can Fed Tapering *REALLY* cause BoP crisis?

There are three pre-conditions for BoP crisis to happen: 1. Huge current account deficit. (i.e. lot money outgoing in crude oil / gold / xyz imports while exports dont bring enough dollars) 2. Capital account surplus is not big enough to fill that Current Account deficit. (i.e. less money coming via FDI, FII, ECB, NRI-bank deposits.) 3. RBI doesnt have enough forex reserve to fill up the pothole created by #2 MINUS #1. Preconditions 4BoP Crisis? Worst case scenario under Fed Tapering Precondition met?

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#1: Huge current account deficit

Dushmani 4Devyani angle, + weak rupee=input cost high. So export may not bring that much dollar. Yes, definitely Outgoing dollars high because of crude oil + gold imports = CAD will be huge. Fed tapering= dollar supply decreased = less FII than earlier era (under Quantitative easing era) FII may pullout existing money from Indian market, to re-invest in USA or elsewhere. Not correct. RBI has sufficient backup RBIs own Forex reserve: ~300 billion USD BRICS bank backup: 100 billion Japan Currency swap backup: 50 billion = total atleast 450 billion USD backup. (more details after few paras.)

#2: Capital inflow not big enough.

Yes, may be

#3: RBI doesnt have forex reserve.

Hell NO!

Meaning, 1. Fed Tapering unlikely to cause BoP Crisis v2.0 in India 2. because THIRD pre-condition is not met. (And thats because RBI DOES have large forex reserve + backup to fillup the pothole.) Nonetheless, prevention is better than cure. In the next article, well see the steps taken by RBI +Government ot immunize Indian economy against the negative impact of Fed Tapering. Courtesy: Mr.Shivaram G. for inputs. Visit Mrunal.org/Economy For more on Money, Banking, Finance, Taxation and Economy.

URL to article: http://mrunal.org/2014/03/fed-taperingpart1-2-meaning-fed-taperingnegative-impact-indian-economy-worst-case-scenarios-balance-payment-crisisexplained.html Posted By Mrunal On 27/03/2014 @ 22:47 In the category Economy

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