Fed should go slow on unwinding balance sheet to limit impact of dollar in emerging markets, says RBI governor Urjit Patel

New Delhi: The US Fed should reduce the pace of unwinding of its balance sheet to limit the impact of shortage of dollar in emerging markets, Reserve Bank of India (RBI) Governor Urjit Patel said. In an article written in the Financial Times, he said that the Fed should carefully adjust the pace keeping in view the evolving macroeconomic conditions. “Global spillovers did not manifest themselves until October of last year. But they have been playing out vividly since the Fed started shrinking its balance sheet. This is because the Fed has not adjusted to, or even explicitly recognised, the previously unexpected rise in US government debt issuance. It must now do so,” he said. The good news, he said, is that there is an option available to the Fed that does not require it to change the overall policy direction. [caption id=“attachment_3938005” align=“alignleft” width=“300”]  File image of RBI Governor Urjit Patel. AFP[/caption] “It can simply recalibrate its normalisation plan, adjusting for the impact of the deficit. A rough rule of thumb would be to reduce the pace of its balance-sheet contraction by enough to damp significantly, if not fully offset, the shortage of dollar liquidity caused by higher US government borrowing,” he said. Such a move would help smooth the impact on emerging markets and limit effects on global growth through the supply chains that span both developed and emerging economies, he said, adding, otherwise, the possibility will increase of a sudden stop for the global economic recovery. It may hurt the US economy as circumstances have changed, he said. Observing that dollar funding of emerging market economies has been in turmoil for months now, he said, unlike previous turbulence, this episode cannot be attributed to the US Federal Reserve’s moves on interest rates, which have been rising steadily since December 2016 in a calibrated manner.

“The upheaval stems from the coincidence of two significant events: The Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts,” he said.

Given the rapid rise in the size of the US deficit, he said, the Fed must respond by slowing plans to shrink its balance sheet. “If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable. Consider the scale of both events. Starting in October 2017, the Fed began reducing reinvestment of the coupons it receives from debt securities holdings,” he said. That shrinkage will peak at $50 billion a month by October and total $ 1 trillion by December 2019. Meanwhile, he said, the US fiscal deficit is projected to be $804 billion in 2018 and $981 billion in 2019, implying net issuance by the US government of $1.169 trillion and $1.171 trillion, respectively, in the two years. So, the withdrawal of dollar funding by the Fed, as it reduces its reinvestment of income received, is proceeding at roughly the same pace as that of net issuance of debt by the US government, he added.