India should prepare a plan to respond to volatility in global currency markets that may come as the US Federal Reserve reduces its monetary stimulus measures, IMF staff said in a report.
While India’s finances have improved since last year, a coordinated plan is needed in case capital account pressures re-emerge, the IMF said.
Any plan should make rupee flexibility the key defense and include measures to raise the benchmark interest rate, impose cash curbs, open foreign-exchange swap windows and raise diesel prices, the IMF said in an annual review of India’s economy.
“The principal risk facing India is the inward spillover from a tightening of global liquidity interacting with domestic vulnerabilities,” the IMF said in the statement.
Pressures associated with India’s “still-significant external financing need” could lead to higher borrowing costs, fund outflows and “disorderly adjustments” in the exchange rate, it said.
India has reduced its current-account deficit, increased interest rates and built up foreign-exchange reserves after the rupee plunged last year on news the Fed would curtail its US$85 billion in monthly bond purchases. The rupee has gained about 11 percent since hitting a record low in August last year, the best performance among major emerging-market currencies.
“The ministry of finance and the RBI [Reserve Bank of India] have the tools to handle the volatility should it arise again,” Thomas Richardson, the IMF’s senior resident representative in India, told Bloomberg TV yesterday.
Bringing inflation down can make the current-account deficit lower, providing a buffer for volatility in international markets, he said.
“We see India much more resilient than they were about the middle of last year to external shocks, but global financial market volatility is still a risk,” Paul Cashin, the IMF’s mission chief to the country, said on a conference call.
“It has been surprising how little the Fed tapering impact has been on India, largely because the current-account deficit has shrunk,” said Tushar Poddar, a Mumbai-based economist at Goldman Sachs Group Inc.
Reduced imports due to curbs on gold purchases from overseas, efforts to build foreign-exchange reserves and commitment to control inflation “have helped to take the sting away from the impact of the Fed tapering,” he said.
The US central bank last month reduced purchases to US$65 billion a month in the second consecutive US$10 billion cut. Federal Reserve Chair Janet Yellen pledged on Feb. 11 to maintain her predecessor’s policies by scaling back stimulus in “measured steps.”
Reserve Bank of India Governor Raghuram Rajan last month criticized the lack of a synchronized global monetary policy, saying in an interview that developed countries cannot “wash their hands off, and say we’ll do what we need to and you do the adjustment.”
Indian officials “pointed to the need for greater clarity and communication by policymakers in advanced economies” regarding the pace of tapering, said the IMF report, which was prepared last month following consultations in November last year.
“If faced with a similar round of capital flow volatility, they indicated that the thrust of their response would likely be similar, using a combination of exchange-rate flexibility, some monetary tightening and, if needed, limited use of foreign-exchange reserves,” it said.