The Indian impulse is to resist either-or trade-offs of the sort that economists like to pose. Inflation, thus, is sought to be kept under 4% by monetary policy, even while the currency is restrained from rising too far above Rs 39-40 to the dollar, and that too, in an economy largely open to foreign capital flows. Economic logic dictates that only luck can create such a wonder. Otherwise, one of the three conditions is bound to fall apart. Now, price stability is worthwhile in itself, not just to safeguard the poor, but also to stabilise the currency?s domestic value so that long-term investments can be made on more reliable rupee calculations (of discounted future cashflows and so on). Low and stable inflation is good for growth. It is not clear if exchange rate stability should follow similar logic, since the dollar price of a currency plays a role in making external sector market adjustments. But so long as surging capital inflows keep pushing demand for the rupee and its price up while exports suffer, this peculiar circumstance could call for a currency peg. If this is the policy combination of choice, India must keep stretching its coffers to mop up the liquidity caused by dollar purchases in defence of the peg. Beyond breaking point, the only sustainable way to contain inflation would be through capital controls.
Will capital controls be needed? It depends on inflows. The current differential between the US Fed fund rate and RBI?s repo rate is a huge 425 basis points. Though the RBI detects no clear causal link between this gap and capital inflows, it still fears volatility on this front, which is why it is looking to the government for ?decisive policy actions? here. Now, capital account convertibility remains a no-no, and ECBs and PNs were partially restricted earlier this fiscal. There is word in the air about clamps on ?hot money?. These could take the form of lock-in periods for inflows, or a Tobin tax, which is a levy on foreign exchange transactions designed to deter speculative short-term inflows. Both are bad, if not equally so. The former are so harsh that they would jeopardise India?s reputation for openness, and the latter has a ?red? image acquired in Latin America. It?s a tough call. Perhaps if global capital market players turn more sensitive to India?s concerns (in their own enlightened self-interest), no such clamps would be needed.
