Warning about the potential risk swelling capital inflow could pose to the domestic business, the Prime Minister?s Economic Advisory Council said it was not against the Reserve Bank of India?s (RBI) intervention, but hinted at correcting the imbalance between the capital account surplus and current account deficit.
The council said in India the surplus on capital account greatly exceeded the deficit on current account and, therefore, the RBI had to resort to large purchases of foreign currency to prevent excessive appreciation. This purchase of foreign currency increases the money supply, which in turn fuels inflation.
?In India, the magnitude of capital inflow and their potential to induce large changes in relative prices will have serious repercussions on both the domestic and export markets,? the report warned. So, the council suggested that the debate was not
to stop intervention but to bridge the imbalance between current account deficit (CAD) and burgeoning capital inflows.
?We do not think that the solution is to simply stop intervention. The underlying imbalance between CAD and capital inflow need to be bridged,? the Council?s chairman C Rangarajan said. The excess of capital inflow in 2006-07 was five times the size of the CAD.
To check this imbalance, the council has recommended three policy instruments?letting the rupee appreciate further, absorbing the capital inflow into reserves and sterilising the excess over what is regarded as appropriate, and liberalising capital outflow while putting restrictions on some capital inflow (like external commercial borrowings or ECBs, especially by the real estate sector). The panel further urged for a ?judicious mix? of the three instruments instead of using only one of these.
The council said, ?The intervention should continue to be directed towards ?orderly conditions? as has been the RBI policy for long, but further it should be reconciled with gradual real appreciation of the currency.?
While the panel did not carry out a sectoral analysis for absorption of foreign funds, it singled out real estate sector for subjecting to restrictions. ?Real estate is one sector where inflows can be moderated,? Rangarajan said. The panel, however, discouraged limiting equity inflows calling such a move ?most unwise?.
?Equity investment is high risk and policy continuity is an essential to maintain such flows; they cannot be turned on and off at will. However, on the debt side, there are some areas that can do with some scrutiny (read ECBs).?
The council also made out a strong case for removing administrative and procedural impediments for encouraging outflows of Indian capital. Though making a case for letting rupee appreciate, Rangarajan said there were limits to which it could be allowed because beyond a point it hurts exports.