Mains Paper: 3 | Economic Development
Prelims level: Economic Policies
Mains level: Emerging market economies should not depend excessively on foreign debt, even if it is easily available at a lower cost
• The Indian rupee tested fresh lows last week, falling below the psychological level of 70 against the dollar.
• It has depreciated about 10% since the beginning of the year.
• There are multiple reasons for this weakness.
• The current account deficit is widening.
• Financial conditions in global markets are tightening because of the ongoing reduction in size of the US Federal Reserve’s balance sheet and higher bond issuance by the US government to fund the budget deficit.
• Further, inflation is picking up in the US and markets expect the Fed to continue to raise interest rates.
What are the causes for this damage?
• The immediate cause of weakness in the rupee, along with other emerging market currencies, is the crisis in Turkey.
• The Turkish lira is in free fall, which is affecting sentiment in financial markets, resulting in a sell-off in emerging economies.
• The Turkish administration is in denial and is unwilling to take corrective measures.
• It is also engaged in a diplomatic and trade feud with the US, which is not helping.
What are the Economic cause for this damage?
• The real cause of the crisis is economic mismanagement.
• The Turkish economy was overheating with double-digit inflation and a widening current account deficit.
• It was essentially booming on foreign debt, but the music has now stopped and the party has ended.
• Foreign currency debt in Turkey is over 50% of gross domestic product and the crisis had been brewing for some time.
• The main policy challenges are to rein in domestic demand to reduce imbalances, contain other growing risks, and rebuild buffers.
• It requires tightening and rebalancing policies in a measured yet credible manner, and focusing on critical structural reforms.
The Historical Context between India and Turkey
• Five years ago, India and Turkey were clubbed in the same dubious group of Fragile Five.
• However, India did well to learn its lessons and made the right policy interventions, which helped in strengthening financial stability and regaining growth momentum.
• India reduced its current account and fiscal deficit.
• The adoption of flexible inflation targeting showed that India is serious about keeping inflation in control.
• The Reserve Bank of India (RBI) used excess capital flows to build foreign exchange reserves.
• Some of the other countries such as Turkey and South Africa were not able to correct their macro imbalances.
• It has not allowed the central bank to act freely and believes that higher interest rates are the mother of all evil.
• This has affected the credibility of the Turkish central bank.
How the crisis can be resolved?
• Financial markets will remain focused on Turkey for now.
• Since the administration has very little credibility in financial markets, it is not clear how things will improve.
• Companies in Turkey have significant borrowings in foreign currency and it will become increasingly difficult for them to repay with revenue in lira.
• Foreign financial institutions with exposure to Turkish companies will face losses, which could lead to risk aversion in the global financial system.
• Turkey is also likely to see a sharp reduction in output.
• The strengthening of the dollar on the back of higher interest rates and safe haven demand could put further pressure on emerging market currencies.
• There is not much for India to worry about at this stage, as the rupee was overvalued in real terms.
• The central bank has sufficient reserves to keep volatility in check.
• The depreciation in the rupee should help contain the current account deficit.
• The policymakers will need to remain vigilant as markets tend to overshoot in the short run.
• The RBI has done well by raising policy rates pre-emptively, which will help contain inflationary expectations and increase investor confidence.
What the crisis has a number of lessons for emerging market economies?
• The emerging market economies should not depend excessively on foreign debt, even if it is easily available at a lower cost.
• Financial conditions in global markets can change very quickly and raise financial stability risks.
• Years of loose monetary policy in the developed world and the search for yield have built financial excesses.
• A reversal will be painful for some emerging market economies.
• It is important to take corrective measures quickly once the risk to financial stability emerges.
• India did well in this context in 2013.
• It decided to raise foreign currency deposits and took measures to reduce the fiscal and current account deficit.
• Turkey could have raised interest rates, handled diplomatic issues better, and approached the IMF in time.
• It is important to respect the operational independence of institutions like the central bank.
• It may not always have “the punch bowl removed just when the party was really warming up”, but is still in a better position than politicians to take corrective action in containing inflation and excessive demand.
• This is not to suggest that the government should not be responsible.
• The lira crisis highlights the value of pursuing orthodox economic policies in emerging market economies.
• It is often argued that the RBI should not raise rates and tolerate inflation, or the government should run a higher deficit.
• To push growth. Policymakers should always avoid such ideas, for they can lead to financial stability risks, as they did in 2013.
Link – https://tt93a.app.goo.gl/myJuWZfGFHJBLyAn7