The year 2022 makes one recall the 2008 crisis when policymakers across the world got together with their staff to discuss responses to a major financial challenge. These discussions and policy choices were geared towards providing emergency support to their respective economies in every possible manner.
Fast forward a few years and we have a situation where the Eurozone was again in crisis and with the US hiking interest rates, we saw a weakening of currency across major emerging markets. India was also among the fragile five economies. The situation of India is much different in 2022 than in 2013—primarily because of stronger growth momentum, higher reserves and steady capital inflows. It is likely that capital flows might not be as robust when the Fed’s rate hike begins, and with a high oil price there will be some pressure on the current account, but the large chest of reserves with the RBI should help serve as a credible deterrent against any speculative misadventure against the rupee. A more managed depreciation is likely and will also not be much fought by the RBI—but it may have inflationary implications; so the Monetary Policy Committee may consider it later.
It is but natural that the policy choices now are just as complex as they were during the start of the pandemic. To my mind, it has been a continuum of temporary shocks—some exogenous and others endogenous—that have kept policymakers occupied for a major part of the last few years. The latest shock will come in the form of spillover effects due to unilateral monetary policy decisions, which of course are guided by the domestic inflation-growth considerations of individual central banks. This shock need not be one that affects growth but can also have an impact on inflation through exchange rate channels.
But it is almost certain that central banks are planning to hike interest rates in response to the growing inflationary impulses. The argument is that a higher interest rate will help cool off the economy and therefore reduce inflation. In a highly simplified sense, the idea is to suppress demand by 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 in general lower than pre-pandemic levels in many parts of the world. Take China: it continues to have a lockdown in some provinces and thus, there is yet another disruption in supply chains. Or take the high oil prices due to the Ukraine conflict. It is indeed true that hiking rates will push demand down and therefore help ease inflation.
But the real question is whether tightening financial conditions is the optimal policy choice at the moment. Such a policy can have significant distributional consequences, which again play a major role in shaping economic conditions (or pre-conditions) for the future. India has tried to address supply shocks with monetary policy—and its experience hasn’t been impressive. The Indian experience is a case of the limits of monetary policy, but somehow these limits have been often ignored over the last two decades. It is likely that the same thing will occur in 2022 and as a consequence, we will face uncertainty and substantial spillover effects that operate through various transmission mechanisms.
India may still do better from a macro and financial stability standpoint, but the real vulnerability is with emerging markets that have substantial dollar borrowings—specifically those that expanded their debt in response to the pandemic. Needless to say, with China dealing with its own debt problems, another emerging markets crisis can push a lot of funds into India in search of yields. But a general slowdown in emerging markets would drag global growth down, which will affect us through the trade channel.
However, India will very likely continue to hold on to its tag of the fastest growing major economy throughout much of the coming years. In fact, this might be the first decade in independent India’s history where its sustained growth rate would be double that of China. Therefore, there must be optimism about India’s growth prospects along with realism about the outlook given the expectation of lacklustre global growth.
There is a silver lining: slower global growth would require the rates to be lowered again. And for countries closer to the zero lower bound, asset purchases need to be supported by their respective central banks. Therefore, we would be back to where we started from after a period of constant tinkering and calibration of policy choices. Alas, nobody will know the counterfactual: would we be at a better place if at all we adopted a different policy response?
Karan Bhasin
New York-based economist
(karanbhasin95@gmail.com)