It was supposed to be the Damocles’s sword hanging over global markets, including that of India’s, over the last few months. Ultimately, when the U.S. Federal Reserve did announce the start of a tapering of its $85 billion monthly bond-buying programme on December 18, the event set off nothing more than minor ripples across global equity and currency markets. Does the credit go to the Fed for preparing the markets for the winding down of quantitative easing? Probably yes, because it has been talking about the tapering process for the last six months. Yet, the absence of turbulence can be attributed to two main reasons. One, of course, is that the markets had already discounted the fact that a wind-down of the bond-purchase programme was imminent and factored that into their valuations. Second, and more important, is that the start of the tapering process is a clear signal that the health of the U.S. economy, which is the global economic engine, is getting closer to normal. To be sure, Fed Chairman Ben Bernanke, who is retiring next month, has started with a modest $10 billion scale-back in bond purchases and has resolved to maintain short-term interest rates at near-zero levels to stimulate growth. His clear guidance that the stimulus will be gradually wound down over the next one year has also been a factor in calming the markets.
The Indian markets reacted to the news with minor turbulence on December 19. The Sensex declined and the rupee wobbled a bit but they both regained their balance on December 20. This is in sharp contrast to the turmoil that they experienced when the T-word was first mentioned by Mr. Bernanke in May. That is because the intervening period has seen a smart turnaround in India’s external account. The current account deficit fell to 1.2 per cent of GDP in the second quarter from a high of 4.9 per cent in the first; it is projected to be 3 per cent or less for fiscal 2013-14, which is a vast improvement over the last year. GDP growth has rebounded in the second quarter to 4.8 per cent, though the growth impulse continues to be weak. Foreign currency reserves have also been augmented through a series of measures initiated by the RBI. While these explain the equanimity in the markets, the fact is that the clouds have not lifted entirely yet. As the tapering process gathers steam over the next few months, there is bound to be both a pull-out of capital from India and reduced allocations for fresh investment as funds chase rising rates in the U.S. This means the current account deficit has to be managed by pushing exports more, especially to a resurgent U.S., and by taking steps to attract fresh foreign direct investment. Policymakers, including in the RBI, need to address these challenges.