International Monetary Fund Managing Director Christine Lagarde today said Indian companies which borrowed heavily in foreign currency are vulnerable to strong dollar.

She also flagged risks of volatility in financial market and capital markets in India as US interest rates begin to rise.

The appreciation of the US dollar and the spillovers on the emerging markets of the prospective normalising of the monetary policy in the US are two challenges faced by India, the IMF chief said addressing bankers and economists at headquarters of Reserve Bank of India.

According to Lagarde, the world is perhaps approaching the point where, for the first time since 2006, the US will start normalising its monetary policy by raising short term interest rates later this year and due to this the likely volatility in financial markets could give rise to potential stability risks.

“Between 2009 and the end of 2012, emerging markets received about $4.5 trillion gross capital inflows, (roughly half of global flows), with India receiving about $470 billion. As a consequence, bond and equity prices rallied, and currencies strengthened. The danger is that vulnerabilities that build up during a period of very accommodative monetary policy can unwind suddenly when such policy is reversed, creating substantial market volatility.

This is similar to a “taper tantrum” episode in May and June 2013 when emerging markets including India suffered indiscriminate capital outflows.

“The timing of interest rate lift-off and the pace of subsequent rate increases can still surprise markets…As economic conditions improve in at least some advanced economies, portfolio rebalancing out of emerging market economies can be expected, and some volatility cannot be ruled out.  Emerging markets need to prepare in advance to deal with this uncertainty,” the IMF chief added.

Meanwhile, India is shining brightly among emerging markets, she said. No doubt India has seen a windfall gain from a sharp drop in oil prices – as have other oil importing countries. More importantly, however, India is reaping the benefits of good policies and policy announcements.


Reduce risks

As a precaution, she said that clear and effective communication of policy intentions can reduce the risk of creating very large market volatility. Also, emerging markets need to prepare well in advance. And if market volatility materialises, central banks need to be ready to act with temporary—though aggressive—domestic liquidity support to certain sectors or markets may be necessary, along with targeted foreign exchange interventions. Moreover, cross-country foreign currency swaps lines.

Lagarde adds that there is more work to be done. Apart from short term policy responses to deal with acute economic crises, it is equally important to continue building a safe and inclusive financial system with greater depth and efficiency of institutions and markets, as well as higher access of all its citizens to banks and financial instruments, there need to be speed limits while financial deepening takes place and there should be very little or no conflict between promoting financial stability and financial development if you choose the right regulations to focus on.

Despite a global boost with falling crude prices, the IMF expects the world economy to grow by about 3.5 per cent this year, picking up modestly next year to 3.7 per cent.

In emerging markets and developing countries, it has projected the growth to pick up from less than 4.5 per cent this year to a little more next year, she said.


Praises Rajan

Praising the Reserve Bank of India Governor Raghuram Rajan, Lagarde said, “He has deftly steered the Indian economy to safer waters after it was hit by the market turmoil following the “taper tantrum” episode of mid-2013—a point I will come back to shortly.

There are a few examples where good fundamentals, as well as decisive and swift policy responses, helped countries reduce, and cope with, market volatility. In India, the RBI took decisive action during and after the taper tantrum episode. It provided foreign currency liquidity support to key sectors, allowed the rupee to depreciate, and provided judicious foreign exchange interventions to minimise disruptive movements in the rupee.

The RBI also arrested the surge in gold imports, narrowed its current account deficits sharply, and started to rebuild foreign exchange reserves. In a very short time span, India successfully contained its domestic and external vulnerabilities more than in many other emerging economies, Lagarde added.