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Inflows into India look set to remain high as a result of unconventional policy globally, requiring the RBI to deftly juggle its competing objectives

India’s central bank faces a triple challenge. Firstly, inflation is running high and beyond the 6% tolerance level over the past seven months. Secondly, government borrowing is set to reach a record high this year. The third, and biggest challenge, is that capital inflows remain strong.

While a surge in overseas cash may sound like a positive, it’s actually a problem for the Reserve Bank of India, as it needs to intervene in the currency markets – otherwise, the rupee will appreciate and hurt export competitiveness – but such intervention to mop the surplus dollars would add to surplus domestic liquidity, threatening to stoke an already fast inflation rate.

So the question is when will these large foreign capital inflows stop? To get a handle on this, it is important to look at what’s happening overseas.

Fiscal and monetary policy around the world have become far more adventurous and unconventional. The last few months have witnessed a dramatic rise in the use of terms such as Modern Monetary Theory (MMT), QE-infinity and yield curve control.

The MMT view of the world suggests that, as long as inflation is not a problem, governments can keep spending and central banks can keep printing money. Some believe that the exit from expansionary fiscal policy in advanced economies has previously been too abrupt. This time, they say, the loose fiscal stance should stay for longer.

And to ensure all this extra government borrowing doesn’t overwhelm the bond markets, several advanced central banks have used tools like quantitative easing - where they buy government bonds - and this time without any limits. Or they use yield curve control, which sets upper limits on government bond yields.

But what does this all mean for emerging markets like India?

Advanced economies might have earned the right to be more adventurous. However, India is still in the early years of implementing more basic reforms like inflation-targeting. Building up its credibility takes time and it’s too soon to tackle more complex strategies.

But even if EMs do not pursue unconventional policy, they would still find themselves at the receiving end of loose policy in advanced economies. And that could turn out to be a double-edged sword.

The good news is that advanced economies would do a lot of the easing for the EMs. Loose financial conditions and related economic recovery globally could help EMs both directly (via lower rates and growth enhancing inflows) and indirectly (via recovery in export demand).

But in some cases, the large quantum of easing could become a policy headache. For instance, loose policy abroad resulting in continued inflows into India, stoking domestic worries such as inflation.

Given this backdrop, what should the RBI do at its upcoming policy meeting on December 4?

It could perhaps strike a balance among its objectives on inflation, bond yields and the rupee by doing a bit for each but not going overboard on any.

We believe it shouldn’t make many changes. Keeping its benchmark repo rate unchanged at 4% while maintaining an accommodative stance may be the most prudent strategy.

Still, the RBI will likely have to update some of its macro forecasts, for instance marking up its inflation forecast for the current year, now at 5.8%. Or perhaps lowering its estimate of how much the economy will shrink this year on average, now at 9.5%.

It may also want to share its insights on some matters that continue to confound the market. Why is inflation so high at a time of weak demand? Is the liquidity glut at the short end of the yield curve expected to linger for long? What is the central bank's strategy for this? And for how long will the recovery need the crutch of excess domestic liquidity?

On the last question, we believe monitoring bank credit growth and core inflation is key. If the former picks up, or the latter holds steady, the RBI may want to recalibrate its strategy.

(Pranjul Bhandari is economist at HSBC. Views are personal and do not reflect Mint's.)

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