The logic of restricting capital inflows into India originally came from issues about our ability to handle debt servicing and the reversal of flows. Today, our large level of forex reserves make that argument redundant. However, we have a new problem which may tempt the government to continue with the current ECB limits. This is the problem of excess capital inflows which are putting an upward pressure on the rupee.
These inflows are a result of the RBI's currency and monetary policy. The period since June 2002 has seen pressure on the rupee to appreciate. By keeping daily movements of the exchange rate between the US dollar and the Indian rupee restricted to a narrow band of about 10 paisa per day, the RBI has created expectations of slow appreciation of the rupee. Forward premia have reached historically low levels. This has made it possible for a firm to exploit interest differentials between India and international markets while being fully hedged.
Instead of imposing administrative controls, MoF and RBI have the option of using the market mechanism to tackle capital inflows. One, the forward premia should better reflect the interest differentials. This can be achieved by managing currency expectations. If the rupee is allowed to be more volatile, it would soon reach a level where further appreciation would not be expected. While this could create some turmoil in the market, it is unlikely to create a crisis given our large reserves position. The change in expectations would not only reduce hedged dollar borrowing by firms, it would also reduce unhedged dollar inflows such as by NRI's.
Second, domestic interest rates need to be reduced to lower the interest differentials. While international interest rates have come down sharply, interest rates in India have not moved correspondingly. While this was not a problem when the Indian economy was a closed economy, today's open level of capital account openess do not allow the RBI to pursue both a highly managed rupee and an independent monetary policy with the same ease. It is important not to revert back to controls like FERA which inevitably create illegal channels, but to alter incentives in the market.
The author is at ICRIER. These are her personal views.
Ila Patnaik
ila at icrier dot res dot in