American Monetary Policy and the Travails of the Indian Rupee

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Indore, India – The chairman of the US Federal Reserve Bank announced in June 2013 that the policy of quantitative easing may be withdrawn soon. This was an exceptional announcement that broke with the convention that the central bank of a country should never give any indication of the monetary policy it was going to adopt before the actual official policy announcement.

Through the policy of quantitative easing, which consists of buying private long term bonds instead of just government bonds by the Federal Reserve, long term interest rates were kept low and the availability of liquid funds was increased to stimulate capital investment and industrial expansion in the economy following the financial meltdown in 2008. Financial institutions (FIs) in the US now have huge liquid financial resources, because the whole world parks its excess finances with them.

Even after catering to the needs of the US economy, there is a lot of money floating around in the US FIs. Once the quantitative easing was in place, financial institutions put their excess funds in the stock and bond markets of emerging economies, where they hoped to earn a much higher rate of return than the rock bottom ones in the US. These economies then launched on an expansionist economic policy based on import-led growth using these excess foreign funds that were being pumped into their economies by the US FIs.

In India’s case, there was a huge increase in the fiscal deficit as the government went on a spending spree, and also a spree of subsidies given to industry and socially and economically poor sections, leading to an inflationary spiral.

However, the announcement that the Federal Reserve might withdraw its quantitative easing policy has spooked US financial institutions. These FIs generally behave with a herd mentality. As soon as one FI sells its investments in the stock and bond markets, the price of these equities and securities tend to come down and then the other FIs also begin selling to make profits and move out before they incur losses.

As a result, a huge withdrawal of funds began from emerging economies. In India, some Rs 60,000 crores (almost 10 billion US dollars) were withdrawn between June and September, causing a huge demand for dollars that resulted in a 22 percent decline in the value of the rupee to the dollar, with an obvious hit to the already serious problem of excessive inflation.

The high inflation that has been plaguing the Indian economy is primarily due to three reasons: the high fiscal deficit of the government and its tendency to force the Reserve Bank to print money to cover this; the high price of crude oil; and the black money that is circulating in the economy. This black money is of two kinds – some of it is generated internally, and the rest is brought back illegally from abroad where it is kept back as unreported earnings through under-invoicing of imports. The black money is mostly used to speculate in the real estate and commodity markets and to purchase gold, which is a good way to store this black money. The high price of crude oil, along with the high level of taxes on oil products, cascades through the economy because it is the most important source of energy.

The devaluation of the rupee only increases the inflationary burden, especially on the poor who have meager earnings, low consumption and non-existent savings. Inflation further eats into their quality of life.

Over a three month period, the emerging economies and even the strong economy of China and the crude oil-exporting economy of Russia were severely affected due to this prospect of a withdrawal of quantitative easing.

Then suddenly on September 19, 2013, the Federal Reserve announced that it was not withdrawing the policy of quantitative easing after all, and immediately US financial institutions pumped about Rs 5000 crores (more than eight hundred million US dollars) into the Indian equity markets in a single day, leading to a record increase in stocks indices and a firming up of the rupee versus the dollar.

The question then arises as to why the chairman of the Federal Reserve broke with convention and made a false announcement to spook the markets worldwide.

The US economy has not recovered completely and joblessness is still very high, especially among the less skilled population, and a withdrawal of quantitative easing could very well push it back into recession. The overwhelming suspicion among people who have suffered as a consequence of this policy sleight of hand will be that the US purposely did this to bolster its financial control of the world.

It must be remembered that a considerable part of the US economic and military might is based on the fact that the dollar is the world reserve currency, which enables it to spend far beyond its means, both economically and militarily.

In recent years, the European Union has been trying to vie with the US in economic terms, but that came a cropper due to the weakness of some of its economies, which began overspending without the same facility of having the euro as the reserve currency of the world, or enough clout with the European Central Bank to get their profligacy funded by it.

The emerging economies, especially the BRICS economies of Brazil, Russia, India, China and South Africa, then began having ambitions of emerging as an alternative power group on the world stage, so the US has now dealt a body blow to them. Even China, which normally takes a belligerent stance, was forced to request that the US government not make internal monetary decisions that would adversely affect the world economy.

The concern here is with what is happening in India. Ever since the oil price shock of 1974, the Indian economy has continually been plagued by a huge current account deficit arising from the large crude oil import bill.

Leaving out the difficult task of tackling the ubiquitous phenomenon of corruption, which exists to an extent in almost all countries of the world, politicians, bureaucrats, technocrats and policymakers in this country would be expected to exercise their minds on how to reduce the oil import bill by finding substitute sources of energy.

There were and still are many suitable options – abundant, efficient and green coal-based systems, even more abundant, efficient and greener bio-mass based systems, microhydel systems, and finally, solar and wind-based systems. Viable technological solutions in all these four systems were available from the beginning and over time their efficiency and ecological sustainability have increased even more.

Yet these alternatives are not being pursued and the Indian economy continues to be at the mercy of its huge and spiraling oil import bill and the vagaries of US monetary policy. 

Rahul Banerjee
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Rahul Banerjee, an alumnus of the Indian Institute of Technology Kharagpur, is a social activist and development researcher. He works along with the Bhil Adivasis (indigenous tribal people) in Western Madhya Pradesh to synthesize their traditional qualities with modern skills so that they can contribute to equitable and sustainable development as architects of their own future.

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