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Central banks like the US Federal Reserve and India's Reserve Bank of India set the rate of interest in their respective countries. This helps them regulate the supply of money in the market and effectively the inflation in the economy. After the 2008 global financial crisis, central banks around the world kept key interest rates near zero percent. This allowed investors to borrow cheap and invest in riskier assets where returns were higher. A large amount of institutional investment got into emerging market debt and equity. Raghuram Rajan is worried about the overuse of a loose monetary policy. He believes it raises the probabilities of a crisis. "My colleagues in industrial countries are trying too hard (to revive their economies), and I would prefer monetary policy to do less and other parts of the economy, including the political system, to do more," the RBI governor had said in an interview to the Central Banking Journal, an industry publication.
Stock markets and bond markets around the world witnessed money flowing in from the rich countries. While the idea of keeping interest rates was to let locals in the rich world borrow cheap to spend, thus fuelling demand and growth for companies. However, it allowed investors in the rich world to borrow cheap and bet on high return emerging markets. Rajan is suspicious of the effect of such sustained loose monetary policies. "I thought this was dangerous because monetary authorities across the world are boosting asset prices rather than real (economic) activity," Rajan said. Economic growth has remained flat in the rich world while stock markets have surged all over the world.
When foreign investors enter the market in droves, the values of stocks rise due to the buying pressure. The bull-run makes investors believe all is well with the markets. However, this is not in sync with the actual state of the underlying economy and corporate profits. The inflated valuations thus mask the problems in the economy. When central banks in these rich countries withdraw the loose monetary policy, money gets pulled out of riskier assets in emerging markets first. This further exposes world markets to risk of a crash in case this money is suddenly withdrawn.
The RBI governor warned that India will be at risk if the countries start tightening monetary policies and raise rates. Our stock markets were witness to the repercussions of such a sudden withdrawal. In May 2013, when the US Federal Reserve announced plans to slowly cut back on the easy money policy, markets crashed worldwide. India was one of the worst hit. The rupee went into a freefall and nearly touched Rs 70-to-a-dollar levels. This is because the underlying fundamentals of the economy did not deserve such high stock valuations. As investors started realising that money would not be as cheaply available in the US, they revalued their assets and found them to be very risky. Investors, thus, chose to exit. A hike in interest rates could cause such an fund outflow again in India. Foreign institutional investors own nearly 20% of the value of Indian shares listed.
Rajan's warning reiterates the importance of reforms by the political systems and governments. If problems in the economy are tackled, fundamentals will automatically improve. This means stock markets would get the high valuation they deserve reducing the risk of a sudden outflow of money from foreign investors. He also suggested better coordination between central banks in the world, especially the US Federal Reserve. He wants the rich countries to tighten the easy money policy slowly and not abruptly. This would ensure that emerging markets like India have enough time to take steps to stem a dramatic fall in asset prices.
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