India needs to avoid the EM temptation of damaging capital controls

Federal Reserve Custody Holdings data released for the week ending 30 January showed a net -USD20.7bn decline in foreign central bank holdings of US treasuries, up from the -USD6.2bn decline the previous week. The decrease in foreign central bank holdings was driven by emerging market central banks using their reserves to defend their currencies in a week of turbulence.

While there have been some quick to call the end of emerging market volatility, it is likely that the fall out from G10 monetary policy is going to be a running theme of 2014.

Reserve Bank of India Governor Raghuram Rajan unexpectedly joined in with the EM rate hikes this week, raising the overnight lending rate by 25bps to 8 percent, the third rise in five months.

The hawkish stance from the RBI comes as India faces stagflation, with high levels of inflation while economic growth remains subdued. Indian GDP expansion slowed to 4.8 percent, from a peak of 9.8 percent in 2011 at the peak of the BRIC enthusiasm.

But while India and other emerging markets used cheap credit thanks to ultra loose US monetary policy and artificial interest rates to finance infrastructure spending and stimulate economic growth when the US Federal Reserve was in expansionary territory, the RBI governor said in an interview yesterday that the Fed needs to help developing economies with the comedown from QE highs. Speaking in an interview with Bloomberg India, Rajan stated that: "international monetary cooperation has broken down."

However, one has to question whether we have had anything resembling “international monetary cooperation” in the 40+ years since Richard Nixon brought the US off the gold standard on 15 August 1971 and the formal end of Bretton Woods. Instead, we had a period where monetary policy incidentally aligned, with ultra-loose policy implemented to fight credit contraction in developed economies while exporting cheap borrowing and inflation into emerging markets happy to snap up the cheap cash, fuelling massive expansion in infrastructure spending.

But as the Fed moves into a period of relative tightening, this week announcing a second round of quantitative easing tapering, developing economies are looking down the barrel of currency depreciation as capital flows from low-yielding G10 economies into higher-yielding emerging markets slow. And with the currency depreciation comes an inflation in the price of servicing foreign currency-denominated debts, as we have seen starkly in the case of Turkey as the lira collapses.

And rather than taking the John Connally approach to the exported effects of US monetary policy (the dollar "is our currency, but your problem.”), Rajan states that developed markets should do more to ease the transition into tighter conditions. "Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say we’ll do what we need to and you do the adjustment."

In the interview with Bloomberg India, Rajan added: “In an environment when there is external turmoil, we have to get our house in order and we can’t postpone that,”

“So a collateral benefit of getting inflation down is that you also strengthen the belief in the value of the rupee.

“When there is huge outside turmoil, even today post the Federal Reserve withdrawing stimulus further, it is extremely important that we both be seen on the same page."

In order to fight the fallout from the end of the Fed’s QE programme, Rajan hinted that he may be prepared to instigate capital controls to fight rupee depreciation.

Unfortunately, Raghuram Rajan seems to have fallen into the same transformation that afflicted Alan Greenspan before and after assuming the position of central bank head. In May 2012, Rajan slammed Keynesian monetary policies and central bank activism, arguing that rather than central planners pulling the levers of the economy, supply-side deregulation was needed to allow the productive parts of the economy to thrive.

In an article penned for the Council on Foreign Relations, Rajan criticised the folly of Keynesian stimulus programmes and of reliance on central bank policies over real economic growth. “Keynesian pundits have been quick to claim success for their policies, pointing to Europe's emerging recession as proof of the folly of government austerity,” said Rajan.

“In fact, today's economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side.

“Rather than attempting to return to their artificially inflated GDP numbers from before the crisis, governments need to address the underlying flaws in their economies.”

But while Rajan’s role does not dictate fiscal policies, since taking control of the RBI in September last year, he has been quiet on pro-reform measures, but quick to intervene in a series of credit-boosting central bank measures. In addition, he has ramped up controls on gold ownership and import tariffs, bleeding out the use of gold as a means of keeping Keynesians honest though a de facto competing currency increasing Rupee demand elasticity and fighting the expansionary measures he criticised before taking office while allowing savers to preserve wealth in a deflationary environment.

Rajan is not alone in bearing the brunt of global currency wars, but if he follows the herd and takes the easy short term option of meddling in his currency and clamping down on free markets, he will be more culpable for damage inflicted on the Indian economy than the Fed policymakers he currently points the finger at.