Is the era of easy money over in India and other emerging markets?

The last two weeks have seen The Lords of Finance issuing edicts and decrees. Liaquat Ahamed coined this evocative phrase to describe the heads of central banks in his eponymous book about the Great Depression (1929-’37).

Central bankers attract less attention than finance ministers. Yet, in many ways, they are more important than the politicians. It is the central bankers who set limits on money supply and decide the cost of money by setting policy interest rates. Those variables influence inflation and create conducive (or less conducive) conditions for economic activity, consumption and global trade.

In theory, most central banks are independent entities that operate outside political control. Since 2007, when the subprime crisis broke in the US, central banks have deployed desperate measures in an attempt to keep the global economy from freezing. The basic concept was to flood the world with quantities of cheap money. The hope was, given cheap money, consumption would continue and people would also invest in creating assets. The methods used varied little from central bank to central bank.

The US Federal Reserve kept interest rates very low (at 0% effectively) and bought huge quantities of bonds, thus releasing money into the hands of investors. This quantitative easing went through three phases.

The Bank of Japan went a step further, compared to the Fed. It applied a negative interest rate (depositors literally pay for the privilege of lending) and also launched a quantitative easing. The European Central Bank also set a negative interest rate and bought bonds, as it launched its own quantitative easing.

Arguably, this flood of easy money worked. One fear in a financial crisis is that all economic activity will stop, and easy money prevented that. As safe debt returns disappeared, investors took risks to find some returns. They bought equity and other risky assets. Since credit was cheap, businesses borrowed to try and expand. Consumers also spent freely. Investors indulged in something called a “carry trade” – they borrowed cheap in hard currencies and bought emerging market assets in the hopes of higher returns.

End of easy money?

The global economy has recovered, to a great extent, though there have been hiccups and the recovery has been uneven. The US economy has expanded now for several years. The European Union saw decent growth in 2017 and growth continues in 2018, though it has slowed. Japan is still in its decades-long recession but there appears to have been some growth even in the land of the yen.

The Fed started to taper down its quantitative easing in 2013 and ended it in late 2014. It started hiking interest rates in 2015. The quantitative easing and negative rates from the European Central Bank and the Bank of Japan continue.

The latest round of central bank policy updates occurred in June. The Fed hiked its policy rates and will do so again. The Bank of Japan will continue with its easy money policy for now. The European Central Bank is going to maintain a negative rate but it will start tapering its quantitative easing and probably end it by December.

Net-net, the supply of cheap hard currency is going to reduce as the European Central Bank tapers. As US interest rates rise, returns from dollar debt will look more attractive. Money supply could tighten further, as and when, the European Union goes back to positive rates, or the Bank of Japan tapers, or goes back to positive rates.

In addition, the Fed is now into a phase of quantitative tightening. It created a massive portfolio of bonds during the quantitative easing. As those bonds mature, the Fed is not replacing them. So, it is not putting that cash back into circulation. Over 2018-’22, the Fed is going to tighten some $2 trillion – that is almost the size of the entire Indian economy.

So, while hard currency money supply remains easy for now, investors can see a future where it is steadily tightening.

Fate of emerging markets

So what happens to India, Indonesia, China, Brazil, South Africa and all the other emerging markets that have been beneficiaries of that regime of easy money? All these markets saw tons of foreign portfolio investment. The conventional wisdom is that global investors will start pulling out, leading to bearish stock markets across emerging markets. In addition, the dollar will strengthen versus all these currencies.

That is certainly what we have been seeing in the past few months. Overseas funds are pulling out of six major Asian emerging markets at a pace unseen since the global financial crisis of 2008 – withdrawing $19 billion from India, Indonesia, the Philippines, South Korea, Taiwan and Thailand so far this year, according to data compiled by Bloomberg.

Every emerging market of any size has seen losses in dollar terms in the calendar year 2018. The numbers for India are illuminating. Since January, foreign portfolio investors have sold Rs 4,482 crore worth of equity and Rs 36,356 crore of rupee-denominated debt. In rupee terms, the Nifty has gained 2.6% between January 1 and June 19. But in dollar terms, the Nifty has lost 4%. That is because the rupee has moved from Rs 63.67 per dollar on January 1, to Rs 68.15 on June 19. The rupee has also lost 3.6% and 10% versus the Euro and the Yen.

If this trend holds, the rupee is likely to fall further – it is already close to record low levels. That may not actually be a bad thing. India has a huge trade deficit and it is grown from $47.7 billion in 2016-’17 to $87.2 billion in 2017-’18. Across April-May 2018, the trade deficit hit $28.3 billion for April and May combined – that is about 5% higher than for the same period of the last fiscal.

A weaker rupee might be good medicine since it would inhibit imports and encourage exports. The lower the rupee goes, the cheaper exports become. That could boost exports – assuming of course, that Trump’s Trade War does not derail exports. On the other hand, imports become more expensive. Well, that provides some protection for domestic businesses, which complain constantly about being swamped by cheap imports mainly from China.

On the negative side, a weak rupee guarantees higher inflation if only because India is a massive energy importer. Indeed, the RBI has started raising interest rates. It is worried about higher inflation. The last six months have seen a trend of continuously rising inflation.

Whether it helps the economy or not, it would be useful at the personal level to assume that the rupee will continue to be under pressure. That means overseas trips become more expensive. If you have an export business or an exportable skill however, you could make more money in rupee terms.