What if the capital inflows stop?

Here are some premature, and somewhat strange, cautionary observations. In the entire hullabaloo about capital inflows and the impact they are having on the domestic economy, is there any thought being given to what will happen when these inflows stop?

Simon Johnson, economic counsellor and director of the IMF’s research department, while releasing the analytical chapters of the Fund’s latest World Economic Outlook recently, said: "...What important lessons can be drawn from past episodes of surges in capital inflows (this is over the past twenty years), and particularly what kinds of macro policies could help ensure that growth remains robust after the capital flows stop (And the capital flows do, in our experience, always stop at some point)."

The crucial point is in the parentheses. What happens once the music stops? What kind of shape is the Indian economy in? Is it too dependent on capital inflows for its growth? These, and many other questions, must surely be exercising the minds of India’s central bank governors, who will be presenting their mid-term review of the annual monetary policy on October 30.

But these are long-term issues. The immediate concern is somewhat different. Like many other emerging economies in the region, and elsewhere in the world, India has been grappling with ways in which to tackle the wall of money that is washing up on Indian shores every day. Large sums of portfolio investments are finding their way into the equity markets, especially after the US Fed cut rates recently. This has put direct pressure on the rupee, which has been appreciating against the dollar.

A large section of exporters has been forced to shutter up. This has political ramifications, especially if the exporting units are labour-intensive, such as textiles. The central bank, to stem the appreciation of the rupee, has therefore been intervening in the forex market to buy dollars. This results in a surge of liquidity in the domestic system, which — acting through aggregate demand — could have implications for inflation management in the future. Thus, the central bank sells securities to soak up this excess liquidity, which also has a fiscal cost.

The Reserve Bank, in conjunction with the finance ministry, has tried repurposing policy contours to blunt the impact of capital inflows. First, the RBI imposed restrictions on inflows through the external commercial borrowings route.

It simultaneously also eased controls on fund outflows from the domestic economy. In addition, banks’ unremunerated reserve requirements were also raised to suck out liquidity. On the fiscal front, the government announced two packages of incentives for exporters, which even included lowering of interest rate for export credit. It might even be appropriate to view the recent controls on participatory notes, announced by the Securities and Exchange Board of India, as part of the same policy framework.

All this also brings into sharp focus what is known as the “impossible trinity” problem — the inability of central banks to simultaneously pursue an independent monetary policy, exchange rate stability and full capital mobility. Economists believe that it might be possible to achieve two of the three issues, but never all the three objectives.

The monetary policy regime in India follows a multiple-indicators approach, compared to some of the other countries, which either have an inflation target or currency value target. The RBI’s indicators focus on overall economic growth and the price stability, from which flow targets for credit growth and money supply growth. But, the central bank keeps a hawk-eye on one special variable — the price line.

Therefore, when the central bank governor’s meet on October 30, the policy language is likely to be influenced by what liquidity flows are doing to the current price line and their effect on future inflationary expectations.
There are two issues that allow the RBI and government to meet both the short-term as well medium-sterm objectives.

One is the larger and broader issue of the economy and its absorptive capacities. This has a direct bearing not only in tackling the current logjam but also for powering economic growth in the future. Governor Y V Reddy said as much in a recent speech: “...the absence of modern infrastructure and shortage of skilled manpower are the most critical barriers to growth. It is imperative to augment the existing infrastructure facilities, particularly roads, ports and power, to provide an enabling environment for industry to prosper.”

Secondly, the time might be just appropriate to introduce some more reforms in the money and foreign exchange markets, by allowing greater hedging flexibility. Specifically, the time might be right to allow a broader, exchange-traded, derivatives market in currency and interest rates, which offers the full suite of products (such as futures, options and swaps), while retaining an OTC market as well. This might give the central bank some breathing space.