How fiscal stimulus in the U.S. will impact emerging economies

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 3- Uneven economic recovery at the global level and policy challenges it poses

The article highlights how the faster recovery of the U.S. economy aided by the faster vaccination and stimulus packages may pose a policy challenge to the emerging economies.

About the fiscal stimulus in the U.S.

  • With the recent passage of Biden’s $1.9 trillion coronavirus relief package, the cumulative fiscal stimulus amounts to 25 per cent of GDP. 
  • This reliance on fiscal stimulus is in sharp contrast to the policy response in the aftermath of the 2008 global financial crisis (GFC) when monetary policy was the main tool.
  • The over reliance on fiscal measures is because of the “liquidity trap” — interest rates are already treading close to zero.

So, what does this mean for the US and emerging economies?

  • From the US perspective, this is good news.
  • The U.S. economy is expected to converge to the pre-pandemic GDP projection after the third quarter of 2021, exceeding it by 1 per cent in the fourth quarter.
  • The impact on emerging economies is less certain.
  • A booming US economy generally bodes well for global growth as higher demand “spills over” to the rest of the world.
  • However, the sectoral contribution to US growth presents a different picture this time.
  • Private consumption of goods (tradable) is already back to pre-pandemic levels, while consumption of services remains significantly below pre-pandemic levels.
  • As the vaccination drive gathers pace in the US and the economy slowly opens up, it should be fair to assume that the non-tradable sector would be driving growth.
  • But given the expected nature of the underlying growth, the positive impact on emerging economies will perhaps be softer.
  • With smaller fiscal stimulus in emerging economies and the slower vaccine roll, the US recovery largely being led by the non-tradable sector will result in a divergence in growth between the US and emerging countries.

Policy challenge for emerging economies which is different from GFC

  • Post-GFC, a combination of zero interest rates and quantitative easing in advanced economies led to a significant surge in capital inflows to emerging countries in search of higher yield leading to an appreciation of their currencies.
  • Now, the situation is exactly the opposite.
  • The differential rate of recoveries has already led to capital outflow from emerging economies.
  • The rise in yield in the U.S. may further fuel capital outflows in coming days leading to tighter monetary conditions in emerging markets.

What should be India’s policy response

  • As far as India is concerned, the macro-economic fundamentals are much stronger than during the taper-tantrum days.
  • The foreign exchange reserves remain at historically high levels, the current account situation is comfortable and the inflation rate remains within the target band of the RBI.
  • In the event of capital outflows, the RBI should let the currency depreciate as the first line of defence to preserve India’s external competitiveness and intervene only to smoothen out extreme volatility.
  • It should avoid the temptation to increase interest rates at the risk of hurting the pace of economic recovery.

Consider the question “Uneven economic recovery on the global level poses a policy challenge to India. In this context, discuss the possible impact of uneven recovery and suggest the policy measures to deal with it.”

Conclusion

Uneven recovery at the global level demands an unconventional policy approach. The policy approach of India should be based on this premise.


Back2Basics: Taper Tantrum

  • The phrase, taper tantrum, describes the 2013 surge in U.S. Treasury yields, resulting from the Federal Reserve’s (Fed) announcement of future tapering of its policy of quantitative easing.
  • The Fed announced that it would be reducing the pace of its purchases of Treasury bonds, to reduce the amount of money it was feeding into the economy.
  • The ensuing rise in bond yields in reaction to the announcement was referred to as a taper tantrum in financial media.
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