Capital Inflows and Rupee Appreciation: Some Lessons

Economic Advisory Council to PM (India) in its Economy Outlook for 2007-08 had suggested three measures to counter the current problem of rupee appreciation and capital inflows:

1. Let currency appreciate
2. Absorb Capital Flows and sterilise the excess
3. Liberalise outflows and discourage inflows by pitting restrictions.

EAC did discuss these measures but that was the end of it. There was hardly any suggestion on what could be the best possible measures given India’s situation. RBI also disappointed in its monetary policy outlook yesterday.

IMF has come out with this new paper which discusses the experiences of number of European countries with the same problem. The summary is:

This paper reviews the experiences of a number of European countries in coping with capital inflows. It describes the nature of the inflows, their implications for macroeconomic and financial stability, and the policy responses used to cope with them. The experiences suggest that as countries become more integrated with international financial markets, there is little room to regulate capital flows effectively. The most effective ways to deal with capital inflows would be to deepen the financial markets, strengthen financial system supervision and regulation, where needed, and improve the capacity to design and implement sound macroeconomic and financial sector policies. These actions will help increase the absorption capacity and resilience of the economies and financial systems to the risks associated with the inflows.

The paper isn’t exactly what the doctor ordered, but is very useful as it covers number of countries’ experiences. It has very interesting tables and graphs and shows what kind of capital flows have come into each country. It also explains the effects of capital flows in economy and financial markets in each of the countries. Well, there are both +ves and -ves.

There is no consensus on what is the best way to control capital inflows as every country has done its own bit. So, the lesson is you need mix of mutually supportive policies. The appropriate policies could be:

  1. Greater exchange rate flexibility, where feasible, is often one of the best and most effective responses to large capital inflows, and part of a successful policy mix…….

  2. Even with flexible exchange rates and a strong commitment to price stability, monetary policy may need to respond to exchange market pressures. Intervention to limit undue market volatility, but not to resist changes driven by macroeconomic fundamentals, is consistent with exchange rate flexibility. A good communication strategy and ensuring that risks are borne by those creating them are essential in using interest rate changes and interventions in a mutually compatible and reinforcing way.

  3. Where monetary policy is constrained by a formal commitment to a pegged exchange rate, tightening fiscal policy and eliminating excessive fiscal incentives may be the only available option for aggregate demand management.

  4. Efforts should focus on reducing the risks and adverse consequences associated with the inflows, as opposed to affecting the flows and their composition. (Basically it means strengthen the financial system)


How do we adopt the learnings to India’s case?

1. Exchange rate flexibility….well we are clearly off the target. RBI intervenes whenever it wishes to and hence we can never be sure about the level of the rupee.
2. A good communication strategy….less said the better
3. There is no explicit exchange rate target but this paper by Ila Patnaik says Rupee has always been pegged. She says there is a difference between de jure regime (what the Central Bank claims) and de facto regime (what is in operations).
4. The efforts are being made here but they are very slow. Simple things like Corporate Bonds are still not there.

In nut shell, we need some clarity from policymakers. What does an exporter do in such times?


I have done some research on this issue of capital inflows in India. My stance has changed quite a bit reviewing literature and the way countries are managing the cappital flows. I don’t think IMF approach highlighted above will work in all countries. The capital flows are just getting bigger and bigger and policymakers in developing economies are finding it to be a big problem. Read ther post for details

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