Four large economies have been busy generating excess liquidity that then spills over to other countries, creating problems for their central banks and finance ministries. The International Monetary Fund (IMF) says in a chapter of its new Global Financial Stability Report that easy monetary conditions in the US, the UK, Japan and the euro zone create challenges such as appreciating currencies and asset inflation in many countries, including India.

The Reserve Bank of India (RBI) is already struggling with a new round of worries thanks to the huge inflow of foreign money since the beginning of fiscal 2010. The rush of liquidity into the Indian economy has sent the rupee higher in both nominal and real terms. Equity prices are climbing. IMF says global liquidity has five times as much effect on local equity prices as domestic liquidity has. This is also something that most traders and fund managers instinctively know.

Illustration: Jayachandran/Mint

But the central bank and the finance ministry will have to have a strategy in place if capital continues to pour into the financial system. The policy recommendations by IMF are worth going over in this context. It is worth noting here that some of the policy options are not viable, given the current economic trends in India. Reducing interest rates is clearly not on the table when inflation is a whisker away from double digits. Tightening fiscal policy is not something that can be done in the short term; it is a process that will take a few years. IMF clearly seems to suggest that maintaining a flexible exchange rate is a good response, since “a floating exchange rate provides a natural buffer against surges in global liquidity and ensuring valuation pressures on domestic assets", but this strategy works best when a country has an undervalued exchange rate; India does not satisfy this requirement right now.

That leaves accumulation of foreign exchange reserves through sterilized intervention, prudential regulations and some restrictions on capital inflows, preferably moves to make them less attractive rather than outright bans. In short, we are back to the dilemmas of 2007 and 2008.

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