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Taping the Money Supply

In this week's FinMail we understand Tapering and Taper Tantrums - the plausible risk to India's Bull run.

The Story:

On Wednesday, 22nd September 2021, the world had their eyes on the US' Federal Bank Meet (Central Banking System of US) as they were going to discuss the possible tapering in their economy.

For starters, Federal Bank in US is the most influential institution, the impact of their decisions is not limited to just US, it impacts all the major Global markets including India. The Bull Market that we have been witnessing in the domestic market (as well as other global markets) for about last 18 months is happening due to eased up money supply to boost the economic activities, mainly in US, and the FII/FPI flow coming to our domestic markets is one of the reasons of markets rally among other domestic factors. So yes, India will experience some waves of this decision too.

Cut to the outcome, the Federal Bank decided to go ahead with the tapering by the end of this year which will be continued till mid-2022. The exact period of when the tapering would start would be decided in November. So yes, it is at least 2 months before Tapering starts.

But, hey! Why is it such a big deal? And why are we discussing an event happening in the US in FinMail? Like said, it is going to impact Indian Markets too. But how? Why exactly? And what in the god's sake is Tapering? All in this FinMail, let's go!

What exactly is tapering?

Tapering in general means the process of gradually reducing something. Let's understand Tapering with an example of a train about to reach a station. Have you ever noticed that whenever the train is about to reach a station, it doesn't just apply breaks to stop. But instead, when it is about to approach the station, it gradually slows down its pace. It slows down to a pace when it is safe to apply the breaks to bring the train to a complete halt. If breaks are applied to the train all of a sudden, it has the risk to get off track, risking the lives of all who are riding in the train.

In Finance too, Tapering has a similar context. Tapering is when a central bank gradually reduces the relief that the central bank had been providing in the past. Tapering also means that the central bank will slowly reduce the rate at which it was pumping liquidity in the economy. It is done so that the abrupt stop of inflows doesn't impact or damage the economy in the long run.

But to fully understand tapering, let us understand why it is even needed in the first place.

Need for Tapering:

As we understood that Tapering is a process of gradually cutting off the relief that is being provided by the central bank/government. Now the reason why relief is provided can vary as per the condition of the economy.

The relief can be provided when an economy is facing a liquidity crisis or when the economy is going through a recession and the economic activities are needed to be pushed via relief or when there's a global slowdown, or when there's a pandemic (like the current one) that has affected the economy in a bad way.

So in order to push the economy and ramp up the economic activities, the central bank with the help of the government tries to revive the economy by providing various reliefs and/or by pumping the money into the system. It is called an economic stimulus as we know it.

But the relief is temporary and is supposed to be for a limited period of time. Well, because of the very obvious fact that the government/central bank can not just keep pumping the money into the system, duh! Or if it does, even then the economy can get badly impacted.

Let's take the example of US during the pandemic. The US printed almost $4 trillion in the year 2020-21. Now it can't just go on printing money like this to meet the needs of its economy (US actually does go on printing money for every economic problem, but this is not sustainable in the longer period). If there's more than the 'required money' in circulation, it leads to increased Inflation and we know how dangerous it could be.

So once the purpose of the relief/stimulus is achieved it is necessary that the relief be stopped so that the inflation can be controlled (while it can be) and also bringing the economy on track. But the relief can't be stopped abruptly and here is where tapering comes into the picture whereby the central bank slowly reduces the relief being given and keeps on reducing till it is at a halt or at a normal pace (as per the requirement).

Back to our example, US printed over $4 trillion worth of US Dollars between March 2020 - September 2021 which is more than 20% of the total US currency currently in circulation. Now, this is insane!

You might be wondering how this newly printed currency is pumped into the economy. This is done by Open Market Operations in which the Central Bank of a country buys Financial Securities (mostly Government Bonds) from the people and the government. This way the money reaches in the economy and the overall liquidity in the market increases, further decreasing the interest rates as there is ample supply of money in the system.

Now the interest rates can't be kept low all the time as this can trigger high inflation (because the money is in high supply and the resources are limited, the prices of the resources would go up which will lead to overall increase in inflation). US in particular is pumping $120 billion every month in the markets since March 2020 by purchasing Government Securities. The Fed has now decided that it will carry Tapering by reducing the rate at which it was buying the US Securities by $15 billion every month. And will carry on reducing till the buying reaches to zero.

Okay so now we know what is Tapering and what is the need for it but, why are we even discussing an event happening in the US? And is it even a big deal?

Well, yes and no. Yes because Tapering is a big move and it has its own effects but the bad ones are for a shorter period of time. And so whenever Tapering is to be done, central banks approach this with cautious moves. This is because Tapering has been a result of an effect that the economists call - Taper Tantrums.

Taper Tantrums:

You know the meaning of the word Tantrum right? 'Drama' And Taper Tantrums just explain the meaning of the word - The Drama and Tapering.

Let us just explain what it means and what exactly happens.

The market and the economy became used to the cheap money that the Central Bank and the Government were giving out but once they stop/reduce it, there is going to be some 'drama' in the form of panic and this is what 'Taper Tantrum' is.

It was coined after the events of 2013 when the Fed announced the Tapering. Remember they had not started yet. The 2008 housing crisis had badly affected the US economy and hence Fed had to step in and provide some relief.

This relief was carried till 2013 whereby Fed was regularly buying financial securities to push more liquidity in the economy but as we know it was a temporary solution. Fed ultimately decided to go for tapering the relief gradually.

Now, this did not go positively with the investor expectations and what happened next was definitely a drama. With the Fed about to take a step back from being of the world's largest buyer, the demand for financial securities was going to drop. And as you know, lower demand leads to a drop in the prices of the bond and investors realised the same & decided to exit before they start suffering losses. As a result, a massive sell-off happened in the bond market

And due to sell-off Bond Prices fell. And the yields of the same shot up.

Now, understand this - Bonds provide a fixed rate of interest at a regular period. So if a bond costing ₹1000 which is giving 6% p.a. is now available at ₹950, an investor is definitely going to earn better if they purchase the bond. And hence this is why the bond yields shot up with a fall in bond prices.

On the other hand, the equity market too fell as there were concerns with liquidity, as low liquidity would mean low volatility as well. But the fall was not too much and it also did not sustain for a longer period of time. And all of this happened just when the Fed announced that it was going to do Tapering. The Tapering was not even started.

The effect of the Taper Tantrums were even felt in India as the Indian Rupee fell by as much as 15% against the Dollar. Thanks to Dr. Raghuram Rajan that the fall did not worsen as he brought up a Fixed Deposit Scheme exclusively for NRIs at a higher return to attract them to invest in India.

What is the effect of Tapering in India?

The effect of Tapering in US is not just limited to US. It also affects other global economies like India. The Bull Run that we have witnessed here in India for the last 18 months, there has been a major part of FPI/FIIs investing in India and helping fuel the bull run. FPI/FII funds play a major role in any emerging countries' markets. In India too, FPI/FIIs are big players and when there are liquidity crunches in their own economy, they would surely reconsider their investments.

So yes, the big players will surely be cautious before investing in foreign countries like India. We might face low liquidity in our markets as well, which in turn could slow down the bull run in India.

But should you be worried?

Taper Tantrums are just a speed breaker in the journey. Ultimately it is for the greater good which is to stabilise the economy so that it can run smoothly after. So the answer would be definitely no. You should not worry. Even if there's a bad outcome out of Tapering, that is for a limited period of time. Apart from this, investors are now kind of used to Tapering which can be the reason why there has been no Taper Tantrums yet. So there are possibilities that the Tantrums might not even happen. Let's hope for the best.

So that is it for this week's FinMail. Stay safe & keep the drama on ;)


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