Are foreign reserves enough to protect EMs from capital outflows? Not really, argues Reserve Bank of India’s former governor Duvvuri Subbarao in an op-ed for the Financial Times. For years, India has been building up its USD stock — and many have started to take for granted that, since the vaults are stacked with hard currency, capital volatility is just a minor nuisance. But FX reserves have been increasingly proving to be far from perfect, Subbarao says. They can protect from volatility in capital outflows, but often fail to address key sources of pressure, he adds.

FX reserves or not, pressure on capital outflows is an ever present reality: The Indian central bank has been eager to prevent a sudden appreciation of the INR and the way to do so is to consistently stock up on USD. The result is a flood of local currency liquidity that would either be let loose or swallowed up. Bond selling (which means letting the liquidity roam around) directs foreign investors to the stock market because they’d expect to make higher returns as interest rates remain low. Bond buying, on the other hand, directs those investors to carry trades and bond markets as it hikes interest rates.

Someone (or some area of the economy) has to foot the bill, says Subbarao. This means that, no matter how much reserves an EM might have, there’s always the need for central banks to stay vigilant to prevent erratic outflows.

The biggest source of anxiety at the moment is the US Federal Reserve, which — spooked by the spectre of rising inflation — signalled in its most recent meeting that it could hike interest rates twice in 2023, which is ahead of its earlier forecast and a move that would reverse extended pandemic-era monetary support.

Why the Fed’s actions are a reason for EMs to hold their breath: Fed tapering leads to a spike in US treasury yields, which makes EM assets less appealing and could mean bns of USD potentially seeking an exit. This has already been talked about more times than we could count in recent months, with the hype having reached its peak earlier this year. At the time, expectations of skyrocketing post-covid inflation prompted many to panic that the Fed will sooner or later lift its monetary support to cool down prices, leading to sudden surge in treasury yields and bringing back memories of the so-called EMs “taper tantrum” of 2013.

But why haven’t we been seeing this reflected in markets? This time around, signs are actually suggesting that we’re moving toward what could be rather thought of as “taper tranquility.” Investors seem calm even after the Fed’s announcement earlier this month that it’s comfortable unwinding stimulus, says the Wall Street Journal’s Jon Hilsenrath and Sam Goldfarb. There are two potential reasons at play, one good and one bad. The first is that US policymakers may have simply gotten better at preparing us for a policy pivot, and the second, more “problematic” explanation is that the Fed could end up being forced to move aggressively, meaning we’re “in for a rude awakening,” Hilsenrath and Goldfarb say.

Sounds familiar? At the onset of the pandemic, the Central Bank of Egypt’s stock of foreign reserves fell almost USD 10 bn from a peak of USD 45.5 bn as foreign capital fled the country, the vital tourism industry shut up shop, and the central bank stepped up purchases of strategic commodities and met debt repayments. Despite a recovery since then to FX reserves north of USD 40 bn in May, the threat of foreign portfolio outflows is ever-present.