Encouraging outlook for emerging markets amid headwinds

Low risk appetite among global investors, deteriorating geopolitical situation and ever-increasing fiscal deficit may add to the challenges.

Fears of a taper tantrum 2.0 (a reduction in the central bank's asset purchase program) have deepened in many emerging market economies after ending the policy accommodation done during Corona and sharply increasing policy rates by the US Federal Reserve after March 2022. However, despite the concerns, emerging markets, including India, have shown considerable strength. This suggests that when the US And policy tightening in other developed countries created turmoil in financial markets and may tighten financial conditions in emerging markets. Strong domestic fundamentals can protect the economy from adverse economic shocks.

Changes in 10-year government bond yields across 16 emerging markets were looked at to gauge how global markets reacted to the Federal Reserve's policy tightening. Its results show that 10-year government bond yields rose by just 40 basis points in the first half of the year after the start of policy tightening due to the standard deviation in current account deficits in emerging markets. This statistically significant relationship indicates that countries with current account surpluses experienced fewer changes and were in a better position to withstand policy tightening than countries with current account deficits.

Moreover, pandemic-related fiscal spending on health and social welfare has also not affected the 10-year bond yield much. This could also be because various countries have spent less due to current financial constraints. In such a scenario, an increase in current account deficits of emerging markets could become a major macroeconomic drawback in the event of a sudden tightening of global financial conditions.

In 2013, the US Federal Reserve, which had been buying securities since the 2008 financial crisis, announced it was scaling back its program of quantitative easing. After this announcement, capital inflows to emerging markets like India suddenly declined. Due to this capital went out. At that time, India's current account deficit was wide. Following this development, the external value of the rupee fell sharply. It is noteworthy that India was not the only country to face this crisis. Many emerging markets were facing a similar situation.

However, this time the situation is completely different. India has handled the situation better due to which the currency market is stable. The Reserve Bank of India seized every opportunity to increase foreign exchange reserves. In 2020, capital inflows also helped after major central banks, including the Fed, provided liquidity. By 2022, India's foreign exchange reserves were to increase to $640 billion. A sudden rise in global interest rates and sharp swings in commodity prices due to the Ukraine war led to capital outflows but the Reserve Bank managed the situation well.