Active Stocks
Thu Mar 28 2024 15:59:33
  1. Tata Steel share price
  2. 155.90 2.00%
  1. ICICI Bank share price
  2. 1,095.75 1.08%
  1. HDFC Bank share price
  2. 1,448.20 0.52%
  1. ITC share price
  2. 428.55 0.13%
  1. Power Grid Corporation Of India share price
  2. 277.05 2.21%
Business News/ Opinion / Online-views/  Stem the flow
BackBack

Stem the flow

Stem the flow

Premium


There are no prizes for guessing the one big issue troubling India’s central bankers —the threat posed by strong inflows of foreign capital to the financial system.

In a speech he gave at the Peterson Institute at Washington, DC, earlier this month, Reserve Bank of India (RBI) governor Y.V. Reddy said RBI is “maintaining enhanced vigilance to be able to respond appropriately to the prevailing heightened uncertainties in global financial as well as monetary conditions".

Deputy governor Rakesh Mohan said something similar at a conference held in Spain in June. “Currently, the more serious challenge to the conduct of monetary policy… emerges from capital flows in view of significantly higher volatility in such flows…", he said, referring to all emerging markets. In case there are any lingering doubts, finance minister P. Chidambaram, who has not seen eye to eye with RBI on several occasions in the past, has also been flashing warning signals about “copious" capital inflows in India.

These are statements worth poring over in the run-up to the new monetary policy to be announced on Tuesday.

Three months ago, RBI had first hinted that financial instability was as important a goal as maintaining economic growth and keeping a lid on inflation. Since then, we have seen a credit market crisis in the developed markets, a sharp cut in US interest rates and a breathtaking (and unsustainable?) rally in the Indian stock market.

Meanwhile, the other economic indicators that the central bank keeps an eye on are remarkably benign. Inflation is at a five-year low, though this newspaper believes that actual inflation is far higher if we consider consumer prices and take into account the fact that domestic oil prices have been artificially capped despite soaring global prices. But inflation is a hydra-headed creature. The extra liquidity has lifted another set of prices—of shares and real estate. India’s inflation scenario is far less easy than is commonly assumed.

Despite these niggling worries, there is little doubt that higher interest rates and a strong rupee have cooled down the Indian economy a bit. Bank credit growth, too, is at more sensible levels. Industrial growth is close to double digits, though consumer goods output has dropped because of higher borrowing costs for consumers and many exporters are struggling to stay competitive in the wake of the rising rupee.

A low headline inflation rate and stuttering growth in some sectors have led to calls for an interest rate cut. To the extent that capital flows into India are a function of interest-rate differentials between India and the US, a decline in domestic interest rates could act as a disincentive to some global investors and also be an incentive for Indian companies to borrow locally rather than from international banks and bond markets. The danger here is that cheaper money could further fan asset price inflation.

Generally, however, interest rates have not worked in Asia as a tool to stem capital inflows. Central banks in the region, including RBI, have had to abandon the textbook approach and pull unconventional tools out of the bag, including full-blown capital controls. RBI may even be tempted to try out something more blunt than the usual hike in the cash reserve ratio, which is what it impounds from banks and thus cuts into their ability to lend. Or perhaps it would like to wait and gauge the true impact of the new restrictions on participatory notes, offshore instruments that hedge funds have used to invest in India.

At this complicated juncture, RBI is perfectly justified in worrying more about capital inflows than the threat of high inflation or a mild slowdown in growth. Some direct measures to curb net capital inflows as well as a 25 basis point cut in policy interest rates would be a good idea.

Should interest rates be cut? Write to us at views@livemint.com

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 29 Oct 2007, 01:32 AM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App