Millennium Post

Fed decision and capital inflows

The American economy on an expanding phase is welcome for global growth and India’s exports if our exchange rates are not over-valued, but the ending of Federal Reserve’s asset purchases (QE3) opens way for US interest rates’ to rise in the near future with costs to other economies.

This is likely to trigger some capital outflows from emerging market economies including India, which is in dire need of foreign capital to build infrastructure. For some time, India had been building its defences against spillovers from the termination of Fed monetary stimulus, which had left the world awash with cheap money.

But now, as the Fed begins sometime in the New Year  to normalise its monetary accommodation by revising its current net zero policy lending rate, following the October 29 announcement of end of bond-buying programme (which had pushed its balance-sheet to 4 trillion dollars), there will be a rise in global interest rates. And the dollar’s dominance is set to continue.

In terminating Q3, the Fed statement took note of ‘the underlying strength’ of US economy and substantial improvement in the labour market - with the unemployment rate down to 5.9 per cent, near long-term average - and also retained its language of ‘considerable time’ before rate revision takes effect. There is bound to be some uncertainty for the markets and possible volatility in speculation over rate rise timing.

But the Fed also makes it clear that before a gradual rate rise begins, its assessment will take into account a wide range of information, including labour market conditions, indicators of inflation pressures and expectations, and readings on financial developments. The Fed could also hold its hand if projected inflation continues to run below the Committee’s 2 percent longer-run goal.

According to Fed statement, if incoming data shows faster progress toward Fed’s twin mandated objectives of ‘maximum employment and price stability’ than it expects, ‘the increases in the target range for the federal funds rate (now zero to 0.25 per cent) are likely to occur sooner than currently anticipated’. Conversely, if progress proves slower, the increases are likely to occur ‘later than currently anticipated’. Though the Fed has never indicated any possible date, it had been assumed by the market so far it would be in mid-2015. But the day after the Federal Open Market Committee meeting concluded, US Commerce Department announced the economy grew at an annual rate of 3.5 per cent in the July-September quarter, driven by solid gains in business investment, export sales and the biggest jump in military spending in five years.

This third quarter rise, though first of three estimates, followed the 4.6 per cent rebound in second quarter, after the harsh winter had led to a 2.1 per cent contraction in the first quarter. The pace of recovery momentum suggests possible advancing of Fed’s timing of the first rate revision, even if too modest, well ahead of current mid-2015 projections. Keeping up the suspense, the Fed has also not ruled out keeping rates ‘below levels’ if economic conditions may warrant, despite employment and inflation being near ‘mandate-consistent levels’. Federal spending, especially defence, business fixed investment, export sales and residential construction all contributed to the third quarter growth, which point to US economy on course to the projected 2 to 2.2 per cent growth in 2014 and rising to 3.1 per cent in 2015 (IMF). There is a visible bounce-back in USA and the Fed is given greater credit for US recovery than what the stringent fiscal mechanism could do subsequent to President Obama’s inadequate stimulus of 2009.

The emerging global scenario, whatever the negative impact from slowdown in the other major 
advanced economies, notably EU and Japan, presents for India both risks and opportunities, at a time when the Modi Government at last had begun to make some incremental reforms and business sentiment is strengthening, though investment yet to take off and macro-economic stability needs more attention.

Yet the risks could outweigh on external side with a possible widening of trade deficit and its effect on current account (even if CA gap is held within tolerable level) while there is also lingering uncertainty on holding fiscal deficit to target, the way Finance Ministry is putting pressure on tax authorities to get hold of ‘internal stashing’ after NDA failures so far on exposure of hidden treasures abroad.

Secondly, the launch of another ‘austerity drive’- which was assumed to be in-built in the structure of the Modi Government - on the Chidambaram model of 2013, may be as before, a cover for cuts in budgeted allocations to balance the books, unless there is a major effort is mounted over the next three months to realise the budgeted disinvestment receipts. No doubt, a sustained fall in oil prices came as a windfall for the Modi Government to demonstrate its reform credentials with deregulation of diesel prices, fixation of gas price and other related changes to help bring down subsides under non-plan expenditure.  But there would be a step-up in defence and security expenditure which may not yield the ‘savings’ (non-utilisation of allocations)as in previous years.

Not much new expenditure is likely to be incurred on most of the much-trumpeted welfare ‘yojanas’, including some provided for the Budget for fiscal2015. All these are positives for Finance Minister Mr Arun Jaitley to prove as much credibility as his predecessor had established for holding down fiscal deficit, having embraced the 4.1 per cent of GDP target set by Mr Chidambaram in the interim budget of Feb.2014.

Even if we are now setting our sights for the next fiscal year for better economic prospects and a stronger growth rebound,  with further progress on major reforms including GST, and a further fall in inflation, the next five months is no less a critical period in economic management. Though India has gained greater clout abroad, all our FDI liberalizations and procedural quick-fixes are yet to make an impact for lifting the country’s abysmally low ranking in ‘Doing Business Easier’ of the World Bank.

The process of creating conditions for investments and growth and jobs – the high hopes of those who voted for Mr Modi – is not proving as easy as it was imagined to be while seeking votes. Industry is still to recover from the slump of last two years and banks are in no sound position as before to contain bad debts. But Mr Jaitley, like Mr Chidambaram before, sees an early ‘breakthrough’ with a rate cut by RBI, if Governor Rajan will go along with him on factor assessment. The Fed announcement makes RBI’s task a bit more challenging at this time. It is to be seen how the RBI Governor is able to turn the present uncertainty into new opportunities for Indian economy. 
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