The Taper Tantrum Series: Understanding its Fundamentals

This is part one of the two-part series, in which I explore one of the major short-term risks facing India’s equity market in the not-so-distant future.

This risk is popularly called “taper tantrum” and you’ll hear it more often in the following months as the global recovery gathers pace.

At the outset, please note that this is meant to be a simplistic discussion, primarily aimed at enlightening the fundamentals of taper tantrum and its potential impact on India’s stock market. It is not intended at delving into the finer, more nuanced aspects of the monetary economics – which is better left to monetary experts.

That said, it is imperative for every investor to be fully cognizant of this risk – it played out in 2013, when Nifty slumped by close to 18% and could play out similarly in the future as well.

What is Taper Tantrum?

Before discussing this term, we first need to understand how two policies – monetary policy and fiscal policy – work.

Remember that economies normally tend to operate in cycles of peak and trough. For our purpose, let’s begin with trough -- in the image below, this trough (or bottom) is marked by point A i.e., the economy is in recession.

When an economy is in recession, the government – in coordination with the central bank of the country– must figure out a way to (1) arrest the degrowth (2) boost growth.

The government does this through managing what we call the “fiscal” policy. In simple words, fiscal policy works through two fundamental tools. One, taxes. Two, spending.

To boost the economy, the government may reduce taxes so that people and corporates have more money in their bank accounts to spend.

More spending by them, in turn, results in higher employment and income.

Besides taxes, the government may also boost the economy by increasing its public spending. But on what? Primarily on building infrastructure such as bridges, canals, highways, railway, airports, and so forth.

This spending in turn results in greater employment – as more people are hired in projects – and therefore also national income.

So, as you see, the government may use fiscal policy to manage economic growth.

But besides the government, there’s also the central bank to the rescue. In the US’s case, it’s the Federal Reserve (or Fed) and in India’s case, it’s the Reserve Bank of India (RBI).

Just as the government uses fiscal policy to spur the economy, the central bank uses what we call the “monetary policy”.

Monetary policy – as the name suggests -- involves using “money” to stimulate economic growth.

How? By using two tools: Interest rate and money supply.

When the economy is slowing down, the central banks reduce interest rates in the economy or increase money supply in an attempt to make it cheaper for individuals as well as companies to borrow (on credit).

Higher borrowing (at low interest rates) in turn helps companies tide over short-term disruption to demand for their products. They are able to pay interest on existing loans through new loans or even pay operational expenses such as salaries through cheap borrowing. Thus, lower interest rates help the economy stand up again.

How do central banks reduce interest rate?

Either directly through reducing what we call the “benchmark” interest rate – in India, this is the repo rate – or indirectly, through purchasing treasury bonds from the open market.

For those who are new to this, the repo rate is simply the rate at which commercial banks, such as HDFC or Kotak or SBI or ICICI, borrow money from the RBI. Currently, this is at 4%.

The logic is simple: If the commercial banks can borrow money at cheap