Advanced‐country policies and emerging‐market currencies: The impact of US tapering on India's rupee

• Date: 01 May 2019
• DOI: http://doi.org/10.1111/infi.12145
• Published date: 01 May 2019

35

International Finance. 2019;22:35–52. wileyonlinelibrary.com/journal/infi © 2018 John Wiley & Sons Ltd

DOI: 10.1111/infi.12145

ORIGINAL MANUSCRIPT

Advanced-country policies and emerging-market

currencies: The impact of US tapering on India's

rupee

Denis Medvedev

1

|

Martin Rama

2

|

Yuki Ikeda

3

1

Finance, Competitiveness, and

Innovation Global Practice, The World

Bank Group, Washington, DC, USA

2

South Asia Region, The World Bank

Group, Washington, DC, USA

3

The Asian Development Bank,

Mandaluyong, Manila, Philippines

Correspondence

Denis Medvedev, MSN F 5P-504, 2121

Pennsylvania Ave NW, Washington, DC

20433, USA.

Email: dmedvedev@worldbank.org

Abstract

The global financial crisis and its aftermath triggered

extraordinary policy responses in advanced countries. Their

impacts—from asset price bubbles to currency deprecia-

tions—have often been felt in the developing world, and the

same can be expected from their undoing. India's experience

around the Fed's ‘taper talk’announcement of 2013 offers

insights which could be relevant for other countries as

quantitative easing programmes wind down and monetary

policy is ‘normalized’. This paper estimates the contribu-

tion of external and domestic factors to long-run trends and

short-term fluctuations in the value of the Indian rupee

around the 2013 depreciation episode using a rich dynamic

model that controls for a large number of exchange-rate

determinants. The paper finds that a global surprise factor,

more than domestic vulnerabilities, was the main driver of

the large rupee depreciation in the summer of 2013.

1

|

INTRODUCTION

The global financial crisis and its aftermath triggered extraordinary policy responses in advanced countries,

with consequences felt throughout the world. The onset of quantitative easing in the United Stated is often

identified as one of the drivers of asset-price bubbles in several emerging economies. Conversely, a number

of emerging-market currencies came under stress following the US Federal Reserve chairman's

congressionaltestimonyon22May2013,whichraisedspeculationofanearly‘tapering’of the asset-

purchasing programme. The ensuing market turmoil lasted several months, with immediate concerns

© 2018 The World Bank International Finance © 2018 John Wiley & Sons Ltd

2

|

MEDVEDEV ET AL.

36

assuaged by the Fed's 18 September 2013 announcement of no change to its asset purchase programme and

subsequent clarity provided by the Fed's 18 December 2013 decision to begin actual ‘tapering’.

The impact of this ‘taper talk’reverberated through developing countries, with 36 of 53 emerging-

market economies analysed by Eichengreen and Gupta (2015) experiencing some exchange-rate

depreciation. The currencies of half of these economies lost more than 5.5% of their value between

April and August 2013. Within this diverse group of countries, India was one of the most dramatically

affected, with the rupee falling by 16% in the same period (Basu, Eichengreen, & Gupta, 2014). This

so-called ‘rupee crisis’took place despite the Reserve Bank of India (RBI) raising interest rates and

losing US$13 billion in reserves defending the currency (Gupta, 2016).

Emerging markets experienced renewed volatility in September 2017, after the Fed's

announcement of a balance-sheet roll-off beginning the following month. The declared goal was to

move forward with a widely-anticipated plan to shrink the Fed's $4.5 trillion balance sheet. In practice,

this involved selling up to $6 billion worth of government bonds, and $4 billion in mortgage-backed

securities, every month. The expectation was for a rate hike in December 2017.

Global markets fell again sharply in February 2018 after the release of better-than-expected

employment and wage data in the United States. The realization that the economy could be picking up

faster than previously thought led to the expectation that the Fed could soon be tightening monetary

policy. The sudden change in the perception about future liquidity hit financial markets in the United

States, but also across emerging countries.

These recurrent episodes of emerging-market turbulence were triggered either by official

announcements or by changes in market expectations regarding the ‘normalization’of monetary policy

in advanced countries. Volatility increased substantially in each of these episodes, despite the fact that

almost 5 years have elapsed since the first one. Recurrent turbulence suggests that emerging economies

may not be sufficiently prepared for the winding down of the extraordinary policies triggered by the

global financial crisis. A better understanding of the sources of their vulnerability is therefore needed.

A commonly held view was that, once underway, tapering would lead to further depreciation of

emerging-market currencies (e.g. IMF, 2014). Consistent with this view, a cross-country analysis of

the consequences of the first ‘taper talk’found that large foreign-investor positions, sizeable current-

account deficits, and real exchange-rate appreciation during the preceding period were the strongest

factors explaining the extent of currency depreciation (Eichengreen & Gupta, 2015). The intuition for

this finding is that investors can and will more easily rebalance portfolios in countries where markets

are deeper and more liquid.

This paper adopts a complementary perspective by conducting an in-depth analysis of India's

experience with the ‘taper talk’. This case is particularly relevant both because of the size of the Indian

economy, and because it was among the most severely impacted among emerging markets. Lessons

from this episode may be useful to determine what to expect going forward, and to identify the risks

faced by emerging markets as extraordinary policy measures in advanced countries unwind.

By mid-2013, with its slowingeconomic growth, high inflation, and large fiscaland current-account

deficits, India was often singled out as an example of macroeconomic vulnerabilities leading to large

movements in the currency. In August 2013, The Economist proposed that ‘India, Asia's third-biggest

economy, is more vulnerable than most’, while The Financial Times judged that ‘India remains the

biggest concernfor most investors with the pessimism there drivenby questions about the government's

economic management’(Kazmin, Wigglesworth, & Crabtree, 2013; The Economist, 2013).

Just a few months later, however, assessments turned much more sanguine. India's exports

rebounded, imports contracted, the current-account deficit shrank, and capital inflows resumed. In

December, The Financial Times commented that ‘[f]ears over the impact of the taper have been allayed

in particular through moves by Reserve Bank of India head Raghuram Rajan’and that, although ‘India