Reserve Bank of India (RBI) Governor D Subbarao said the concerns of capital inflows in India due to the interest rate differential were less severe than other emerging market economies. This is because capital inflows helped India to finance its capital account deficit.
In August 2010, the US Federal Reserve had announced its plan to buy $600 billion worth of government securities in the second round of quantitative easing. This could have had a significant negative impact on emerging market economies, said Subbarao. He said the quantitative easing also seemed to contribute to rising global commodity prices, which intensified inflationary pressures. “This combination has put some emerging market economies in a policy bind, since rising inflation necessitates tighter monetary policy. However, higher interest rates would only intensify volatile capital inflows, potentially putting more pressure on exchange rates and domestic stability,” he said.
He added while the quantitative easing contributed to a stronger and more durable recovery in the US, it also benefited emerging market economies, including India.
While addressing the Swiss National Bank- International Monetary Fund conference on the international monetary system in Zurich today, the RBI governor said there was a need to develop a proper framework for analysing linkages among economies. “We cannot do this by using current trade equations and attributing all the other spillovers to exogenous financial shocks. We need a deeper, truer, understanding of the channels and mechanisms that link our economies together,” he said.
In order to deal with spillovers, Subbarao said there could be policy agreements through which countries could abandon policies that create negative spillovers, in exchange for other countries taking policy action with positive external spillovers for them. “Designing such deals and getting countries to agree to them, however, would remain a major challenge,” he said.
He added RBI did not intervene in the foreign exchange market since the last two years. “This policy has served the economy well, since it allowed the exchange rate to serve as a buffer, depreciating to help the economy when it was weak and appreciating to reduce excess demand when it was strong,” he said. The RBI governor also said India’s policy was subject to negative externalities from countries that maintain undervalued exchange rates, undermining competitiveness in third markets and efforts to contain the current account deficit.