When the Fed initially floated the idea of tapering, the impact on emerging markets was more than anyone would have predicted, with a huge August sell-off and weakening currencies in EM Asia. In September, all of those currencies bounced back to some extent as investors took a second look at potential EM growth, but the Indian rupee and Indonesian rupiah have continued to lag. As Deutsche Bank analyst Taimur Baig explains, now is no time for those countries’ leaders to relax.

India aug sept reversal inr idr lag

India and Indonesia deficit financing

“For EM Asia, the postponement of the taper brings welcome respite, especially for its beleaguered deficit economies, India and Indonesia. Expectations that global liquidity will remain ample and cheap for a longer period will make deficit financing easier,” writes Baig, adding, “We worry that this window of respite might cause ongoing fiscal and monetary adjustment to be delayed.”

India at least hasn’t wasted any time. Even though the rate hike was not what the market expected (and not what many would have recommended), Bank of India Governor is clearly interested in strengthening his nation’s economy before tapering starts. “The postponement of the tapering is only that, a postponement. We must use this time to create a bulletproof national balance sheet and growth agenda, which creates confidence in citizens and investors alike,” said Rajan, and Baig largely agrees with his decision.

Raghuram Rajan on marginal cost of financing

“The RBI policy meeting today was the first test of its durability. We think they did well in making what were tough choices. In reducing the marginal cost of financing (lowering MSF), RBI gave some concession to growth. But equally by hiking the policy repo rate, it made clear that it wants to focus on inflation, and further its credibility,” he wrote.

But Indonesia is another matter. Indonesian politics may finally have some new blood, as Jakarta Governor Joko Widodo has emerged as front-runner for next year’s presidential elections, but that won’t help prepare for tapering that could begin as early as December.

Monetary tightening

“While clarity about next year’s political transition is helpful, immediate concern is about the economy,” writes Baig. “The extent to which the authorities are committed to pursue further fiscal and monetary tightening would likely determine if there is an orderly exit from the prevailing situation, with soaring inflation and widening current account deficit souring investor appetite, and the resulting outflow causing the rupiah to depreciate sharply.”

Indonesia is facing its first trade deficit in over a decade, real GDP growth has fallen below 6 percent for the first time in three years, inflation is set to go past 9 percent, and the rupiah is down 15 percent against the dollar so far this year.

India indonesia inflation 0913

“Add to this some policy missteps, including a dysfunctional FX market and no move by BI in its mid-August policy meeting, it is easy to see why Indonesia has fallen from grace,” writes Baig.

Bank Indonesia raising interest rates

Bank Indonesia called an extra meeting to remedy the situation somewhat, raising interest rates and shortening the BI certificate holding period from six months down to just one month to entice foreign investors, but confidence in the institution has still been shaken.

“The battle to restore macro-stability is by no means over,” writes Baig. “Macro headwinds won’t dissipate soon… but right policies should prevent the slowdown from becoming disorderly.”