Capital flows pose risk, RBI says all options open

Capital flows pose risk, RBI says all options open

Mumbai/New Delhi: Capital flows into the country and their impact on different sectors of the economy have emerged as key risk factors that economic policymakers have to grapple with, Reserve Bank of India (RBI) officials have said over the last two days.

All options to tackle it remain on the table, they said.

At a meet in New Delhi on Wednesday to launch an International Monetary Fund (IMF) study, Subir Gokarn, deputy governor at RBI, said the central bank’s interaction with the market ahead of its policy announcements showed capital flows were regarded as a significant challenge.

Compared with other emerging markets, India has allowed the impact of the flows to show up through an appreciation in the exchange rate, but circumstances could change, Gokarn said.

Separately, RBI governor D. Subbarao, at a Swiss National Bank-IMF conference in Zurich on Tuesday, said India’s flexible exchange rate policy is a disadvantage when trading partners or competitors have a fixed rate policy.

“If we have a flexible exchange rate and if other countries, which are our trading partners or competitors for the same export markets, have a fixed exchange rate, we get disadvantaged," Subbarao said, chairing a session at a conference on the “International Monetary System".

While the rupee appreciated 13% in nominal terms in fiscal 2010, in real terms the appreciation was much higher at 19%, “because of the inflation differential between us and our trading partners", the RBI governor said. “This has implications for our external competitiveness at a time when world trade is recovering and concerns about protectionism are resurfacing."

“When the competing nation’s currencies are also fluctuating, it evens out the loss incurred due to local currency appreciation, but it is very hard to compete against fixed currencies as that of China," said Ajay Sahai, director general of the Federation of Indian Export Organisations.

India has tight regulations on capital inflows into debt instruments or through debt instruments, while those regarding equities are relatively liberal.

The country is not contemplating levies such as a Tobin tax at this point to curb capital inflows, but Subbarao said, “No policy instrument is clearly off the table and our choice of instruments will be determined by the context."

Named after James Tobin, a Nobel laureate economist from Yale University, Tobin tax is a transaction tax on currency speculation.

When capital inflows exceed the level at which they can be absorbed by the economy, the central bank has to choose between letting the rupee appreciate or intervening in the forex market to prevent it from strengthening. Intervention in the foreign exchange market adds to liquidity in the domestic market, which if not sterilized, can be inflationary.

India’s inflation, as measured by the Wholesale Price Index, in March was 9.9%. The rise in inflation over the last few months is of concern, finance minister Pranab Mukherjee said at a Confederation of Indian Industry event on Wednesday.

Despite the challenges posed by capital inflows, Subbarao said there would be no sudden change in India’s approach to capital account convertibility.

He said India will continue to move towards liberalizing the capital account, “but we will revisit the road map to reflect the lessons of the crisis".

Net capital flows to India increased from $7 billion (Rs31,710 crore today) in 1990-91 to $45 billion in 2006-07, and further to $107 billion during 2007-08, according to RBI.

Capital flows dropped to $7 billion in 2008-09, at the height of the global financial crisis, but now they are estimated to have recovered to around $50 billion in 2009-10, Subbarao said.

The fluctuation in the capital flows and the resultant volatility in exchange rates show that India has a flexible exchange rate policy despite not having a fully convertible currency.

While in fiscal 2007 and 2008 the rupee appreciated 2.3% and 9%, respectively, the currency depreciated 21.5% in 2008-09 when capital flows thinned out, but by fiscal 2010 the rupee again recovered to appreciate 12.9%.

The local currency depreciated last week by 2.5%, but following the $1 trillion bailout package to Greece, it sharply rebounded to gain 1.4% in a single day on Monday to close at 44.85 against the dollar. However, on Tuesday, the rupee depreciated to close at 45.30. On Wednesday, it strengthened to close at 45.10 to the dollar.

According to Gokarn, a key challenge facing the central bank today is to find a way to normalize policy stance without disrupting recovery.