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Day 25 – Q 3. What do you understand by Fed tapering? How does it affect the economy of developing countries? What measures are usually adopted to lessen the impact of Fed tapering on the domestic economy? Discuss. (15 Marks)

  • IASbaba
  • February 24, 2022
  • 0
Current Affairs, GS 3, Indian Economy, TLP-UPSC Mains Answer Writing
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3. What do you understand by Fed tapering? How does it affect the economy of developing countries? What measures are usually adopted to lessen the impact of Fed tapering on the domestic economy? Discuss. (15 Marks)

फेड टेपरिंग से आप क्या समझते हैं? यह विकासशील देशों की अर्थव्यवस्था को कैसे प्रभावित करता है? घरेलू अर्थव्यवस्था पर फेड टेपरिंग के प्रभाव को कम करने के लिए आमतौर पर कौन से उपाय अपनाए जाते हैं? चर्चा करें।

Approach-

Candidates need to write about the Fed tapering and then explain how it affect the economy of developing countries. Also discuss measures adopted to lessen the impact of Fed tapering on the domestic economy.

Introduction

Tapering refers to the Federal Reserve policy of unwinding the massive purchases of Treasury bonds and mortgage-backed securities it’s been making to shore up the economy during the pandemic. The reason the Fed has decided to accelerate the process is likely because it now believes inflation may be less transitory than it had hoped, at the same time that the labor market appears strong.

How does Fed tapering affect the economy of developing countries:

  • An aggressive financial tightening would raise US yields and strengthen the US dollar against EM currencies. As a result, portfolio flows would abruptly reverse. 
  • The sudden stops and reversal of capital flows will lead to depreciation pressures on EM currencies. When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. If the EM currency depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds.
  • The Fed’s policy guidance that it would raise borrowing costs more quickly did not cause a substantial market reassessment of the economic outlook. 
  • Should policy rates rise and inflation moderate as expected, history shows that the effects for emerging markets are likely benign if tightening is gradual, well telegraphed, and in response to a strengthening recovery. 
  • Emerging-market currencies may still depreciate, but foreign demand would offset the impact from rising financing costs.
  • Even so, spill overs to emerging markets could also be less benign. Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. 
  • Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally. 

What measures are usually adopted to lessen the impact of Fed tapering on the domestic economy:

  • A depreciated currency would undoubtedly help boost exports, benefiting countries like Saudi Arabia and Iran that export energy, but would hurt countries like India, Indonesia and Turkey that import oil and gas.
  • Secondly, EMDEs and LICs with a large stock of foreign currency debt and low forex reserves will be particularly vulnerable to tightening global financial conditions. This group of countries includes Argentina, Colombia, Indonesia, Turkey and Sri Lanka.
  • Thirdly, a rising US dollar would increase the debt-servicing costs (in local currencies) of EM non-financial corporates (NFC) with unhedged currency exposure, thereby exacerbating liquidity and solvency concerns. 
  • Fourthly, in response to faster rate hikes by the Fed, EME central banks would have to raise interest rates to maintain interest rate differentials, prevent capital outflows and domestic currency depreciation, despite sluggish recovery and growth risks.
  • Indeed, tighter monetary policy by the US and other advanced economies presents dilemmas for policymakers in EMEs. 
  • If EM central banks continue the current loose monetary policy with low-interest rates, it will lead to capital outflows and domestic currency depreciation. 
  • On the other hand, if EM central banks pursue tighter monetary policy by increasing interest rates too early, it would derail a fragile domestic economic recovery. Hence, both options risks undermining the economic recovery process. Only those EMEs that actively manage capital accounts can pursue some degree of monetary autonomy.
  • As the US Federal Reserve gears up to taper its huge asset purchases, the impact on Indian market is likely to be limited and there is unlikely to be a repeat of 2013 when it caused huge volatility across markets.

Conclusion

While the global recovery is projected to continue this year and next, risks to growth remain elevated by the stubbornly resurgent pandemic. Given the risk that this could coincide with faster Fed tightening, emerging economies should prepare for potential bouts of economic turbulence.

 

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