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  • Writer's pictureGalactic Advisors

Taper Tantrum and It's Effects On Emerging Markets

Investors started panicking, bond yields shot up, stock prices plummeted in the US in the middle of the year 2013. And not just this, the financial conditions of the months that ensued also tightened. We have set the stage for you, now let us take you through what exactly caused panic among the investors.

We are all well aware of the Global Financial crisis that happened in 2008, people lost their jobs, investors started losing confidence and it later led to the recession. In response to curb the impact of the financial crisis on the economy, the Federal Reserve (equivalent to the Reserve Bank of India in the US) executed something called Quantitative Easing (QE). Well, what exactly is QE? Central banks use various monetary policy measures to pump liquidity into the economy, QE is one such unconventional monetary policy tool wherein a Central banks purchases longer-term securities like the Government securities and other securities from the open market to increase the supply of money while also encouraging lending and investments.

Okay back to the Fed, in its QE, the Fed started purchasing close to $85 billion in the open market every month. And Fed’s balance sheet grew by close to a whopping $2 Trillion by 2013. And then here’s what happened, the then chairman of Federal Reserve, Ben Bernanke, believed that the economy was in a much better place than it was in 2008. Housing was recovering, State and local governments were on a firmer foot than they had been for a while and all in all, it was stronger. So in the policy meeting of May 22, 2013, Ben stated that considering the economic situation of the US the Fed was considering to now dial back those cash injections. But investors did not believe that the economy was in a strong position to carry on without Fed pumping in money. A lot of that money had also found a home in the stock markets, a reason why indexes were at record highs. So now if the Fed starts to dial back those cash injections (a.k.a started tapering), will the high stock prices be supported? Most investors believed that they wouldn’t be and hence started selling. This lead to a huge decline in stock markets. And why did bond yields go up? (a measure that paradoxically sees a rise when economic confidence is low) With the reduction in bond purchases by the Fed, the demand for bonds in the general market would go down and hence the purchase of bonds. Bond investors immediately started selling the bonds, because of the prospect of a decline in prices, pushing the price further down. Bond prices and yields are inversely correlated to each other, and hence the yields shot up.

The effect of Taper tantrum was not just seen in the US, but also emerging markets. A potential important side effect of QE by the Fed was the expansion of global liquidity, some of which flowed into emerging markets. And hence, when the Fed decided that it will now unwind its quantitative easing program, the capital inflows into the emerging markets then reversed themselves. This lead to a tangible effect on the financial stability of financial markets. The currencies of the emerging market saw high depreciation. The financial market turmoil was felt most in India and Indonesia, which experienced rising current account deficits (imports more than exports) and also other macroeconomic imbalances. This turbulence, which was termed as taper tantrum, destabilized virtually all emerging markets and provoked fears of crisis.

Well, here we are again in the time where global markets have sold off due to fears surrounding the spread of Covid-19. But times have changed, this time the Indian Rupee has outperformed against major emerging market currencies, in stark contrast to the 2013 period when emerging market currencies plummeted due to (we know why) taper tantrum.

The major reason for its out performance can be attributed to the gross external financing requirement of India as a share of its forex reserves, which is at a decade low level. The external debt of India has also been trending downwards in the past couple of years, external debt now stands at 19.4 % of GDP. At 19.4%, it is much lower than other emerging market countries. India’s Net International liabilities at 15.7% of GDP as of 2019 also favoured the rupee to stand out against its peers. Meanwhile, the lower crude oil prices can help the country to reduce the current account deficit.

Maybe a gradual exit from the infusion of liquidity would have not caused the taper tantrum & along with that, careful communication should rule out the risk of another taper tantrum that could disrupt financial markets this time (since due to Covid-19 FED is again supporting markets by infusing money. More than ever this time!) — at least that is what central banks and most investors expect.

Disclaimer: This post originally appeared on Forexonomics written by Sakshi Jain and has been reproduced here (with certain minor edits) with her kind permission.


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