Bernanke was one of the influential economists and his work on the Great Depression of the 1930s placed him in a special position to handle the situation post the 2008 global financial meltdown. Faced with a situation in which the central bankers were at a loss to use monetary policy instruments like interest rate variation to influence the economy's behaviour, the leading central bankers had introduced what came to be known as“Quantitative Easing”.
This involved releasing more liquidity into the system by purchase of financial assets and thus pumping in fresh funds. Well after the situation had stabilised, QE had continued and then came the time when these have to be stopped - a regime of policy reversal. Bernanke had started that process from the US Federal Reserve's end which had led to global financial turmoil of the 2012-13.
What had happened then was that the reversal of policy stance led to a flight of funds from the emerging market economies and back into the US. As a result, the currencies of the EMEs faced a sort of run and exchange stability hurt the EMEs severely. The most affected were even given a name, the Fragile Five.
That phase had come to be known, among finance experts, as taper tantrums, because of the tapering of bond purchases by the US Federal Reserve system.
With the new US incoming president Donald Trump suggesting a battery of economic actions, a similar volatility is being manifested by the financial markets. It is nervousness, plain and simple. Donald Trump is threatening to impose tariffs across the board on countries which have export markets in the USA. Thus, Trump is saying he would impose tariffs on Canada, Mexico and above all, China on their products entering the US market.
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Trump has not spared India either. He has often described India as the tariff King, pointing out that India often imposed tariffs on imports, including those from the United States.
The Trump tariffs are meant to limit imports from outside. An obscurantist autarkic regime in USA will obviously restrict imports and instead direct American demands for home produced items than from outside. This should hopefully restore or achieve what Trump protagonists and his acolytes have professed and hoped to achieve -Make America Great Again- the so-called MAGA action plan.
However, given the ground level economic situation in America and its trade partners, the tariffs restricting imports would create supply pressures inside America. As Barry Eichengreen, one of the well known professors of economics, has argued, because of the rigidities of manufacturing within USA, the American consumers would have to turn to imported items to overcome the domestic shortages. For this to happen, the US dollar will have to appreciate to make foreign products still cheaper to buy.
Thus, it appears that in the short term, the US dollar would come under heavy pressures for appreciation. The trading partners would face greater challenges in stabilising their economies. Already, many of the competing currencies, and most importantly the Chinese currency has shown lower levels against the dollar.
In a situation of such global readjustment to the new realities of USA with Trump presidency, it will be prudent to adopt a very cautious approach to calibrating the Indian financial sector to the new realties. What are the new realities and trends against which the Indian central bank should fashion its policies for the foreseeable future?
First, it is nearly impossible to really control the exchange rate of a currency against market forces. What happens is that the central banks blow up a massive amounts of funds to intervene in the market to stabilise rates. The attacks on the currencies recur immediately after intervention is over. This had happened time and again.
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Secondly, the currency rates reflect in general the domestic strengths and weaknesses over a period. Thus, the trends in overall trade, the domestic price levels, interest rates and similar factors influence the long term prospects. These are almost given.
As for the Indian foreign exchange market, the rates are almost directly linked to the behaviour of the foreign institutional investors. If the FPIs sell in the domestic market and then withdraw their funds, rupee comes under pressure. This has been seen and written about in a paper published in the latest issue of the Reserve Bank of India bulletin. This trend is nothing new. It was observed during the post 2008 financial meltdown period.
RBI intervening heavily in the market to stabilise against such background is somewhat futile. Of course, these interventions do achieve its immediate goal -stabilising the rates for the time being.
But there is another aspect of the foreign exchange market - the strictly technical factors which often tend to get accentuated and needs a little fine tuning. One such factor is the overseas non-deliverable rupee trade trends. These are purely speculative and no really deliverable. It had taken some excessive importance when Raghuram Rajan had just assumed office of the governor of the Reserve Bank. Being a finial economist, he had moved very successfully to contain the overseas non-deliverable market.
The lessons of those days may be worth a re-look and some of the lessons could be instructive. However, a pronged and sustained programme for intervention for containing gyrations in the rupee exchange rate could be counter-productive and we might end up blowing up a good part of the foreign exchange reserve.
Trump regime promises to be turbulent for the global economy with his plans for America first. There ill for sure be volatile financial markets and large movements of capital across borders, which will leave many other parameters, let alone, exchange rates in uncharted territories. We should not let our guards down.
At any rate, the Reserve bank has very vital and useful institutional memory of handling exchange market in times of turbulence. The RBI knows how to to move in such a situation. (IPA Service )
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