Large capital inflows in last few years have posed extraordinary challenges for the conduct of monetary policy for the Reserve Bank of India (RBI). Appreciating rupee, increasing sterilization cost, overheated asset markets, increased potential of crisis are some of the direct consequences of these flows. An article by Rahul Lahoti

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Capital inflows into India have skyrocketed in the last year. Portfolio flows have picked up strongly on account of Foreign Institutional Investors (FIIs), amounting to Rs.70940 crore during 2007 as compared to an inflow of Rs.31289 crore in 2006.  During the period of April-July 2007 FDI inflows were placed at US $ 6.6 billion as compared with US $ 3.7 billion in 2006. Also, there has been a 63 per cent increase in external commercial borrowings (ECB) made by Indian companies during the first seven months of fiscal year 2007-08. Though large proportion of inflows are non-debt creating they are dominated by Portfolio flows which tend to be volatile and short term.

Exchange Rate

One of the most visible impacts of the flows has been rupee appreciation. The Indian Rupee has appreciated 16% since July 2006 against the US dollar (from 46.85 to 39.33 per US dollar). The 36-currency Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) of the Indian rupee, which is an index measure of Rupee’s value against its major trading partners, appreciated by 12% and 12.86%, respectively, between July 2006 and September 2007. This indicates that Rupee has appreciated not only against the dollar, which has depreciated against almost all major currencies, but also against currencies of many of India's trading partners. 

Export Competitiveness

Exchange rate appreciation is affecting the export competitiveness of Indian Industry as Indian exports become expensive in foreign markets while imports get cheaper. Some initial indications of the slowdown are reduced growth rates of exports (18.2% in 2007 vs. 27.1% last period) and increased growth rates of imports (non-oil increasing 44% in 2007 vs. 10.9% last period). The Mid-Year Review presented by the Finance Ministry shows that sectors such as textiles, handicrafts and leather, that have low import intensity, have experienced low export growth. There have being several reports of lay-offs and shutting down of textile units – which are highly labor intensive – due to eroding viability of these units. According to the  commerce minister the job losses in the export sector could be as high as two million.

Sterilization Costs

The biggest challenges in the management of capital flows are the attendant implications for liquidity and overall economic stability. In order to limit the rupee appreciation due to the inflows RBI has been mopping up dollars in the foreign exchange market through interventions. In 2007, the Indian Foreign Currency Reserve accumulation was more than US $100 billion, making India's reserves fourth largest in the world at $266 billion after Japan, China and Russia.

When RBI accumulates foreign currency reserves it pays for them in Rupees, increasing the supply of Rupees in the market which can ignite inflation. In order to control inflation RBI uses several monetary instruments which in turn try to reduce the excess money supply. This process is referred to as Sterilization. These instruments include issuing bonds under the Market Stabilization Scheme (MSS), absorbing liquidity through net reverse repos under the Liquidity Adjustment Facility (LAF) and increasing Cash Reserve Ratio (CRR). Under MSS government issues bonds through the RBI in the open market and this reduces the money supply by the value of the bonds. However it has to pay interest rates on the order of 7-8% on these bonds. The total amount of issuances under the MSS has gone up by 159 per cent since March 2007. Under Liquidity Adjustment Facility (LAF), RBI carries out reverse repo operations in which it borrows money for short term effectively decreasing short term money supply. Liquidity absorbed in under this facility in 2007 was five times the amount in the corresponding period of 2006. Cash Reserve Ratio (CRR) is the amount of minimum non-interest bearing reserves banks should hold with RBI. A higher CRR means that more money is being absorbed by RBI through the banking system. CRR was raised by 150 basis points during April 2007-October 2007 to 7.5%.

All these instruments have both direct and indirect costs; either as direct fiscal costs due to interest payments on the bonds or as indirect costs due to inefficiencies they introduce in the banking system. With increased use of these instruments the costs are also escalating. The interest rate paid on the MSS bonds is far higher than one received on the foreign currency reserves, which are mostly invested in US treasury bonds. This interest rate differential is a rough estimate of the cost borne due to MSS. As per Mid-Year Review 2007-08 estimates, the cost of interest payments on bonds issued through MSS would be around Rs. 8200 crore for fiscal year 2007-08.

This cost is almost double the allocated amount for India’s premier Child Development scheme – Integrated Child Development Services (ICDS) for 2006-07, which was Rs.4543 crore.  It is also more than double the amount which the Prime Minister promised in his Vidharbha Relief Package for farmer suicides (Rs. 3,750 crore).

Equity Markets 

FII investments in equity markets have lead to a whooping increase of more than 200% in the BSE sensex since January 2005.  Last year also saw the highest-ever mobilization of Rs.45,137 crore through public equity issues, according to PRIME, the database on the primary capital market. This is 83 per cent higher than the previous year. Though markets have sky-rocketed, the volatility in markets has increased.

FII investments fell abruptly in Feb 2007 along with the collapse of global markets caused by drops in the Chinese markets. The end of summer and late December FII flows turned negative due to renewed concerns about the US financial crisis. Although there was no fundamental change in or related to the Indian economy, each of the aforementioned occasions have resulted in a nose-dive drop in the Indian stock markets. A shock in an unrelated emerging market economy or shocks in developed countries, that makes investors reassess risk and flee to safety, can cause inflows in India to dry up. Given the prolonged rally in the Indian markets and financial crises in developed countries, such risks have increased exponentially. Such a halt in inflows can lead to higher exchange rate fluctuation (even a significant depreciation of the Indian currency), stock market collapse, and current account imbalance and affect India's long term growth prospects.

A far bigger issue than stock market collapse is the effect on economy in event of likely crisis due to sudden stops of flows. There is strong consensus among economists that unrestricted capital flows into developing countries do not necessarily bring benefits and increase the probability of crisis – backed even by studies by the International Monetary Fund (IMF). In the 1990’s East Asian countries like Malaysia, Thailand, Indonesia experienced high growth rates and huge capital inflows. Despite a lack of significant or fundamental change in the economies of these countries in 1997 the inflows suddenly stopped and even reversed, resulting in severe recessions in these countries. Several Latin American countries have witnessed similar episodes of sudden discontinuation of inflows and recession. There is no evidence suggesting that India is immune to similar events. To avoid such economic depressions and tribulations, India needs to manage its flows carefully.

The Reserve Bank of India and the Government of India has tried unsuccessfully to reduce capital inflows through encouraging outflows and putting restrictions on External Commercial Borrowings (ECB). However, none of the measures have helped. Outflows remain a small fraction of the inflows and ECB's continue to rise. 

Given the increasing cost of inflows indicated by lower export competitiveness, rising fiscal costs due to sterilization and increased risk of crisis, the Finance Ministry and RBI should take more concrete measures to manage India's inflows. In the Mid-Year Review and various public statements, the Finance Minister has acknowledged the costs and risks to growth due to the inflows. However, the Ministry has been reluctant to impose any form of capital controls or limits on inflows. RBI Governor Y.V. Reddy has hinted that he would be ready to take a more flexible approach and even consider some controls. The reluctance of the Finance Ministry comes due to opposition from the stock markets and Business lobby against any such restrictions on the flow of capital. One example of this pressure was evident on October 16th, 2007 when one of the instruments used by FII’s to invest in India – Participatory Notes – were banned. The markets nose-dived 8% and within two hours Finance Minister was making statements trying to calm the markets.

While some Latin American countries that have faced similar patterns in capital inflows have experienced recessions in the past due to sudden stops, others have found better ways to deal with such inflows. For example, various economists, including Nobel Prize winner Joseph Stiglitz have praised the Chilean government for managing its flows by using reserve requirements. Chile's strategy has been successful at discouraging short term flows, with no affect on long term flows.  Chile accomplished this by placing reserve requirements on all inflows for a short time period (a percent of inflows were deposited with the central bank, with no yield or returns to the investors). The reserve requirements’ then were changed depending upon the amount of flows.

India should learn about the cost of its capital inflows, from other countries that have witnessed similar patterns of growth and the unforeseen decline that tends to follow. At the least, India should learn from countries like Chile and figure out ways to manage its inflows in order to avoid similar economic catastrophes.

The author is a student at Columbia University’s School of International and Public Affairs pursuing a Masters degree in Public Affairs. He can be contacted at rahul.lahoti@gmail.com