How will the Fed taper impact Rupee?

Mon, 30 Dec Pre-Open

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The global financial crisis of 2008 was a huge shock from which the global economy is still recovering. It forced global central banks to take up extraordinary measures to protect large banks from collapsing. At the forefront of these efforts was the US Federal Reserve. It began large scale purchases of debt securities from commercial banks and US treasuries. This program was called Quantitative Easing (QE). It sent US interest rates to record lows and was the cause of huge money flow in to emerging markets. We are now nearing the end of the third round of QE. The Fed has begun to taper off its QE program by reducing its purchases of securities by US$ 10 bn per month.

When the Fed first announced the start of the taper in June 2013, global markets went into a tailspin. Money flowed out of emerging markets and moved into developed markets, especially US stocks. This led to a spike in US interest rates and a rout in emerging market currencies. The Indian rupee fell sharply to an all time low of nearly 69 against the dollar. However the rupee has pulled back since then and is now trading at about 62 to the dollar. The question that is being asked is; with the taper having begun will emerging market currencies fall sharply once again?

According to a report in the mint, a repeat of the Rupee crisis of 2013 may not happen. While the dollar is expected to strengthen and US rates would rise, emerging economies may not see a big outflow of foreign money. The reason is that many emerging economies including India are now offering attractive investment opportunities for FIIs. Interest rates in India and other emerging markets are significantly higher than in the US and the Indian equity markets offer fundamentally sound stocks at decent valuations. In addition to this, traders are not expecting the US Fed to raise interest rates before July 2015.

However, this does not mean that the rupee will appreciate sharply any time soon. Foreign investors would weigh in factors like India's current account deficit and high debt to GDP ratio before making investment decisions. On both these aspects India fares badly. Countries like India that has to import capital to finance its domestic spending could see their currencies come under pressure in 2014 as the taper proceeds. Countries that have a current account surplus may not feel much of a pinch. In the end, it is clear that emerging market currencies like the rupee are not out of the woods yet.