An important theme in The Rise of Finance is the excessive influence of and spillovers from US Federal Reserve's monetary policy actions on the monetary policy autonomy of central banks elsewhere. These influences work through both the interest rate and exchange rate channels. In fact, Helene Rey had pointed out that there was no trilemma but only a dilemma and there was a global financial cycle, which was significantly driven by the US monetary policy actions.
A new BIS working paper by Seshadri Banerjee and MS Mohanty examines the exchange rate channel by analysing data from India over the 2004-09 period.
Using a dynamic panel estimation model of non-financial firms, we show that US monetary tightening adversely affects firms’ net worth and reduces domestic credit relative to external credit. Using a sign-identified VAR model, we find that the contractionary US monetary policy leads to a significant downturn in the domestic credit and business cycles. The responses of firms and the impact on the domestic credit cycle suggest that the financial channel of the exchange rate is one of the conduits transmitting US monetary policy to India...
Our empirical analyses have three key findings. First, controlling for firm-specific factors, the micro-level results suggest that a tighter US monetary policy has an adverse effect on the financing conditions of Indian non-financial firms. Rupee depreciation combined with higher US interest rates and unhedged foreign currency debt precipitate a contraction in relative credit. Second, our panel estimation results suggest a statistically significant negative relationship between changes in US monetary policy andchanges in the firm’s net worth, confirming the importance of a balance sheet effect of international monetary transmission in driving credit variables. Rupee depreciation magnifies liabilities that are valued in dollars and leads to a decline in the net worth of the borrowing firms. The coefficient of interaction between the change in US monetary policy, the rupee exchange rate and the foreign currency exposure of firms turns out to be statistically and economically significant, underscoring the vital role played by US monetary policy in Indian non-financial firms’ balance sheet conditions and their access to credit. Finally, our macro-level analysis suggests that the domestic credit and business cycles go through a pronounced downswing nearly for six to eight quarters following the US monetary tightening. Comparing the accumulated effect of shock, we find that a one per cent hike in the fed funds rate/shadow rate can depress domestic credit relative to external credit by 6.6 per cent and output by 0.76 per cent from their respective long-run levels. The contractionary impact of a rise in US longer-term interest rate turns out to be stronger than that of the short-term rate. This assumes great relevance as the country looks into an uncertain near future with regard to US monetary policy. There is a raging debate in the US between those who argue that the extraordinary fiscal stimulus and continuing monetary accommodation have set the stage for a dangerous takeoff in inflation, and those who argue that any rise in inflation could be transitory. It remains to be seen who will be proved right.
But if the Fed starts to reverse course and communicate a tightening of its monetary policy (as looks likely atleast later part of next year), it's likely to lead to sudden stops of capital flows and capital flight from emerging markets and a strengthening of the greenback. The former will naturally put upward pressure on domestic interest rates and strain corporates relying on foreign credit. The latter will amplify the pressures on the largely unexposed foreign currency borrowings of corporate India.
Mitigating the adverse consequences of this likely reality over the next year or so (before a reversal) should be a priority for the central bank and for Indian corporates with significant foreign exposures. In the meantime, the central bank should not only eschew any further relaxations in External Commercial Borrowings, but should think of even reversing some of the current liberalised norms and also encouraging corporates to hedge for their forex exposures.
What makes this even more of a problem is that even accounting for the dollar's recent weakness, the rupee has steadily risen since early 2020 despite the pandemic shock, the sharp declines in the Indian economy, and the rising domestic inflation. Besides, the equity markets have been on a gravity-defying rise, despite foreign portfolio investments being on the red. Doubtless the splendid corporate performance has helped. However, these trends are clearly unsustainable and due for reversals. And the reversals are likely to overshoot on the negative side just as the boom has overshot on the positive side.
For now, the short assessment of the Indian economy goes something like this. The divide in the fortunes of the formal and informal India is stark. As indicated, corporate performance has been very impressive. Businesses have clearly used the pandemic to cut costs and shore up their bottom-lines, and corporate profits are now at record high. But despite the record profits and surpluses, non-finance private investment has touched historic lows - GFCF for FY21 fell 10.2%, leaving it 6.9% below 2018-19 levels. On the informal side, as evidenced by the rising unemployment and declined labour force participation, persistently high uptake of NREGS, and consumption indicators, demand remains constrained (see this and this) - private consumption declined 9.1% in FY21, just 3.1% above 2017-18 levels. There is enough to suggest that the brunt of the first wave pandemic shock has been borne by the lower middle class and the poor, the second wave has added to their woes, poverty has increased significantly, and there is little on the horizon which can help their recovery.
For the economy as a whole, while C and I remains depressed, G and NX (exports) have turned out to be the saviours. Public spending has provided the biggest backstop - rising 28.3% by Rs 12.3 trillion in the last quarter. Despite the limited fiscal wiggle room, the Government of India appears to have done reasonably to both increase spending and shift it towards better quality. The surprising tailwind has been from exports, which has risen sharply in recent months on the back of strong vaccine-backed recovery in the developed countries. This is likely to remain a strong positive in the months ahead as economies open up and the US economy powers ahead riding the multi-trillion dollar stimulus spending.
The questions though are how much of this recovery can be sustainable without revival of broad-based consumption, and how can this be triggered. As reports like that from Pew Research and Azim Premji University show, for broad-based consumption growth India has to not only should it re-ignite consumption among its vast majority less well-off but will also have to recover the significant lost ground on poverty. With household savings significantly depleted in surviving the lockdowns and at record lows, the space available in the vast majority of households to spend their way out is limited. The government's fire-power is limited and the impact of exports is more on the already better off formal India than the informal India. Apart from this, corporate India faces the headwind of higher commodity prices, which will increase their costs and erode their margins. The higher oil prices will dent the central and state government's tax revenues, thereby further eroding their fiscal space. This and this are good summaries based on latest numbers.
The possibility of spillovers from a change in the direction of US monetary policy have to be seen in this backdrop. It can be potentially damaging on the corporate sector, and also on public debt financing.
Finally, a point about the corporate performance. In the FY 2009 to FY 2021 period, for a sample of 1054 companies, revenues as a share of GDP fell from 41.7% to 34.4% and net profit as a share of GDP rose from 2.5% to 2.6%. In other words, the ratio of profits to revenues rose from 0.06 to 0.075, pointing to significantly increasing returns to capital.
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