The outlook for the global economy has turned a shade brighter because of faster vaccinations and ongoing stimuli in the advanced economies. But the flip side is, faster growth has been accompanied by rising inflation. To boot, recovery has been uneven across countries and sectors, which spawns its own set of risks. For India, global growth is a double-edged sword. The good part is, the sharper rebound in global growth hasboosted India’s exports, which has now surged past pre-pandemic levels – handily outpacing the gross domestic product (GDP) claw-back. And the recent uptick in the growth outlook of India’s major trading partners augurs well for exports. The bad part is, the United States Federal Reserve (US Fed) recently raised its inflation forecast and hinted at earlier-than-expected normalization of its extraordinarily accommodative monetary stance. S&P Global now expects the Fed to announce tapering of asset purchases in the last quarter of 2021, one quarter sooner than previously expected. This is likely to be followed by two rate hikes in 2023 and two more in 2024. If inflation continues to surprise on the upside, the Fed may have to normalize faster than it is currently communicating. That can lead to capital outflows and disruption of asset prices in emerging markets, and India would not be an exception. Impact of external shocks on India’s financial conditions depends on their magnitude and the extent of India’s vulnerability to them. Domestic vulnerability is broadly a function of external liabilities, ability to absorb external shocks, ratio of reserves to short-term external liabilities, reserves relative to the International Monetary Fund’s measure of reserve adequacy, and domestic macro fundamentals.

Before 2013, India’s vulnerability to external shocks was high, on account of a weakening external position and worsening domestic fundamentals. Hence, even before the US policy normalization began, mere talk of liquidity tapering led to capital outflows and a large depreciation of the rupee. This time, however, external liabilities are expected to remain in the safe zone. Although the current account balance is expected to return to deficit (after being in surplus briefly last fiscal), the magnitude of deficit in relation to the size of the economy is expected to be less than in 2013 and 2018 (previous phase of normalization of the US monetary policy).

Thus, India is much better placed compared with the taper tantrum of August-September 2013 in terms of adequacy of forex reserves and short-term debt obligations/current account deficit (CAD). But weak growth, high debt/deficits, and rising inflation create vulnerabilities. Rapid monetary tightening in the US will constrict financial conditions in India as well and trigger adjustment in asset prices. In such a situation, the rupee, too, will come under pressure. The good part is, the Reserve Bank of India (RBI) has a significant war-chest of forex reserves to control excessive currency volatility.