This intervention consequently increased pressure on domestic money, forcing RBI to sterilise the added liquidity using Market Stabilisation Scheme (MSS) bonds, extracting close to Rs 1.8 lakh crore. The government had to pay market interest on this corpus, and more insidiously, pushed up the cost of the entire market borrowing programme. We had estimated then that net of sterilisation, RBIs currency intervention resulted in an approximate injection of Rs 2,49,000 crores, almost 30% of incremental M3 in 2007-08. The effect of this increase on inflation can only be surmised.
It is against this backdrop that current concerns of many emerging markets about a sudden surge of capital inflows, a lot of it speculative, need to be understood. Brazil and Taiwan have been among the first to impose some controls on speculative and arbitrage seeking capital flows. Should India begin thinking of appropriate controls
What exactly is the problem with such a surge in flows The first is that the resultant rise in a currency renders exports relatively uncompetitive. In Indias case, exports have begun to account for a significant engine of economic activity, accounting for over a sixth of GDP, using the simple (and probably simplistic) metric of magnitudes. Given that developed country imports remain weak, this just makes export growth more problematic.
The second problem is that associated swings in currency driven by volatile portfolio capital increases uncertainty and operational costs of not just exporters, but all entities with exposure to global trade and capital operations, should they wish to hedge their exposures. Indias total inbound and outbound interactions account for well over 100% of its GDP, having doubled over the past half a decade. This proportion will have been even higher for many other important emerging markets.
The third adverse impact is the potential buildup of bubbles (rise in asset market levels beyond that warranted by fundamentals, although this is notoriously difficult to ascertain). Policy authorities fear, justifiably, that foreign funds are diverted into uses different from those originally intended, and this is particularly difficult to monitor. Rapid rises in rates increases system volatility and interferes with many policy objectives.
Having said this, there are many benefits of a strong local currency. The first is an aid in inflation control, since a strengthening rupee reduces the cost of imports, allowing importers to pass on cost savings to domestic consumers. Thats the theory, at least; the actual pass-throughs will depend on specific market structures. Depending on the extent of the pass-throughs, importers profitabilities also improve, increasing their tax potential for the exchequer. For emerging markets like India, with significant external debt repayment obligations, the overall debt burden falls.
Policy authorities, therefore, have to balance competing considerations in taking a view on currencies and capital flows and of the most appropriate instruments to transfer the benefits and costs between various stakeholders. As a sidenote here, even in the academic literature, while there is near unanimity on the virtues of free trade, the jury is out on full capital account convertibility. So, if there is indeed a need for some controls on cross-border capital movements, what might be the best and cheapest way of imposing this, particularly given the potentially adverse effects on foreign investor confidence
We have already had a taste of the fiscal and other costs of currency intervention by RBI. If a more hands-off approach to the rupee is adopted, should exporters be compensated for their hit If so, how, particularly given the constraints of the WTO regime in which we now operate. If legally feasible, will direct transfers be less expensive than currency intervention Will more direct limits on the magnitude and nature of flows have less distortionary effect on overall activity (and in economic parlance, lower deadweight losses) Is portfolio capital really more volatile than other, supposedly more stable, flows like FDI and NRI funds Many studies of the 1998 Asian crisis found evidence that portfolio capital was not the main culprit, it was short-term debt capital.
There is bound to be strong reduction in portfolio flows, if some controls are imposed, but this is likely to be temporary. Capital with a relatively long-term returns perspective will still be attracted to Indias growth prospects. What the best approach might be requires deeper study, and we should do this as swiftly as possible.
The author is vice-president, business & economic research, Axis Bank. Views are personal