Understanding the origin of the crisis

Sometime in the recent past; precisely in June 2012, Dr Manmohan Singh was murmuring at the varantas of the Los Cabos G20 venue. At the summit speech on the next day, Dr. Singh in a free flowing way, urged for undisrupted flow of foreign capital from the developed world to the developing countries. The Prime Minister expressed the concerns about the impact of the crisis on the developing countries due to disruption in capital flows.

His demand came when the G20 has prioritized discussions on Eurozone problems at the meeting. The main agenda was the rescue plan for Europe and not capital flows to the emerging world. Being the only state leader turned at the summit Dr. Singh’s view was widely appreciated by the leaders from the developing world.

Economists, like Dr Manmohan Singh and Raghuram Rajan had good understanding about the risk of financing trade deficits using the wind fall monetary expansion made by the central banks like the US Fed.

After the continuous fall of the Rupee, on Friday, 30 the 2013, in his speech at the Parliament, Dr Singh again hinted at the policies of the US Fed responsible for the present capital flight.

There is now increasing consensus that the monetary expansion adopted by the central banks who issues hard currencies ( internationally acceptable currencies like the US Dollar), creates inflow of such money into the emerging world. This is because in their home countries, the return for investment is low and hence the expanded money will flow into the emerging world, anticipating higher returns.

During the last ten years, there occurred two prominent cycles of such monetary expansion in the US due to the Fed’s easy money policy (more bank loans available at low interest rate).

The First global excess liquidity cycle

The first one was in the period 2002-2007. The Fed reduced rate of interest, promoting loans to boost household expenditure in housing and in consumer durables. Rational for such easy money policy was that expansion of household expenditure may accelerate economic activity and employment in the US. But a sizable portion of the expanded money and loans from the US financial system has flown to the emerging world to extract more returns.

Here, the easy money policy adopted by the Fed caused huge capital inflow into the emerging world. For example, net capital inflow into India expanded from just $12 billion in 2002 to 108 billion in 2008. Stock market boomed, GDP growth rate peaked and government’s tax revenue rose to the Finance Minister’s dream figures.

But the financial crisis of 2007 has ended this global excess liquidity cycle. Dollars flown back to the US, stock market crashed, Rupee depreciated and growth slowed down.

The recent excess liquidity cycle

After the financial crisis, the US government has introduced fiscal stimulus programme to rescue the economy from recession. But over expenditure by the US government has created high debt and thus the US fiscal deficit became one of the highest in the world. Failure of many national governments like in Greece compelled the US government to restrict its stimulus programme.

Now, the Federal Reserve took charge the leadership of macroeconomic policy to revive the recessing economy. Here, the Fed has adopted some sort of an unconventional monetary policy to bring down interest rate in the economy to promote loan financed expenditure by the households. The new policy was to reduce interest rate by purchasing bonds. Here, large scale purchase of bonds will promote loans in two ways. Firstly, it will result in increased funds with the banking system (bonds go to the Fed and in return money will go to the banking system). Second, it will reduce the overall interest rate in the economy.

The Fed’s balance sheet thus expanded from 0.7 triillion to 3 trillion in four years. This means that money supply also has increased. Banks were holding a major part of this expanded money with the Fed itself; so inflation not appeared.

The bond purchase programme otherwise called quantitative easing has created the second wave of capital flows to the emerging markets. Stock markets revived, and economic activities in the EMEs reactivated. But the inflow of capital was despite the continuing weakening of growth in the EMEs. So when the Fed announced the slowing (tapering) of the bond purchase program, the capital flew back to the US; producing dollar shortages and currency crises.

These events in the last one decade show that monetary policy of the US Fed influences the entire world. Money supply, financial and liquidity cycles are synchronized and globalised.  

We need strong decoupling fundamentals like competitive manufacturing sector, exports, and disciplined fiscal and monetary policies. Without these, the EMEs may continue to swing to the tunes of migrating capital which ultimately depends upon the Fed’s monetary policy.