The year 2022 is reminiscent of the crisis of 2008 when policymakers around the world met with their staff to discuss responses to a major financial challenge. These discussions and policy choices were aimed at providing emergency support to their respective economies in any way possible.
Fast forward a few years and we have a situation where the Eurozone was in crisis again and with interest rates rising in the US we saw currency weakening in major emerging markets. India was also among the five fragile economies. India’s situation is very different in 2022 than in 2013, mainly due to stronger growth momentum, higher reserves and steady capital inflows. It is likely that capital flows may not be as robust when the Fed rate hike begins, and with a high oil price there will be some pressure on the current account, but the large reserve vault with the RBI should help serve as a credible deterrent against any speculative mishaps against the rupee. A more controlled depreciation is likely and will not be much opposed by the RBI either, but it may have inflationary implications; the monetary policy committee will therefore be able to examine it at a later date.
It is natural that political choices are as complex today as they were at the start of the pandemic. In my view, it is a continuum of temporary shocks – some exogenous and some endogenous – that have occupied policymakers for much of the past few years. The final shock will come in the form of ripple effects from unilateral monetary policy decisions, which are of course guided by each central bank’s domestic inflation and growth considerations. This shock does not necessarily affect growth, but can also have an impact on inflation through exchange rates.
But it is almost certain that central banks are planning to raise interest rates in response to growing inflationary impulses. The argument is that a higher interest rate will help cool the economy and therefore reduce inflation. In a very simplified sense, the idea is to suppress demand through higher interest rates so that it meets the available supply of goods and services. But this assessment ignores the reality of supply and the fact that it is generally below pre-pandemic levels in many parts of the world. Take China: it continues to be blocked in certain provinces and, as a result, there is yet another disruption of supply chains. Or take the high oil prices due to the conflict in Ukraine. It is indeed true that rising interest rates will lower demand and therefore help to dampen inflation.
But the real question is whether tightening financial conditions is the optimal policy choice at the moment. Such a policy can have important distributional consequences, which again play a major role in shaping the economic conditions (or preconditions) for the future. India has tried to deal with supply shocks with monetary policy, and its experience has not been impressive. The Indian experience is a case of the limits of monetary policy, but somehow these limits have often been ignored over the past two decades. The same is likely to happen in 2022 and as a result we will face significant uncertainty and ripple effects that operate through various transmission mechanisms.
India can still do better from a macroeconomic and financial stability perspective, but the real vulnerability lies in emerging markets which have taken on large amounts of dollar borrowing, especially those which have increased their debt in response to the pandemic. . Needless to say, with China grappling with its own debt problems, another emerging market crisis may push a lot of funds into India in search of yield. But a general slowdown in emerging markets would drag down global growth, which would affect us through the trade channel.
However, India will most likely continue to retain its tag as the fastest growing major economy for most of the years to come. In fact, this could be the first decade in independent India’s history where its sustained growth rate would double that of China. Therefore, there must be optimism about India’s growth prospects as well as realism about the outlook given the expectation of lackluster global growth.
There is a silver lining: slower global growth would require further rate cuts. And for countries closer to the zero lower bound, asset purchases must be supported by their respective central banks. Therefore, we would be back to where we started after a period of constant tinkering and calibrating policy choices. Alas, no one will know the counterfactual: would we be better off if we adopted a different policy response?
New York-based economist