Forex flows key to monetary control: Mohan

Liquidity impact of capital flows has become a more important problem for monetary management than it was before, Reserve Bank of India Deputy Governor Rakesh Mohan said last week.

The globalisation of financial markets, even if imperfect, has now magnified the impact of monetary policy actions taken in one country on others, he said.

Mohan was speaking on financial integration in Asia at a meet in Singapore on Thursday. RBI released the text of this speech on the weekend.

"Policy accommodation pursued until recently by the US had a global impact, affecting the rest of the world with an abundance of liquidity," Mohan said.

Low US rates encouraged capital to flow to emerging markets. That development built foreign exchange reserves and excessive liquidity in many countries in Asia, amplifying the US central bank's policy stance, he said.

"Complicating the environment of monetary and exchange rate management further, there is now increasing evidence that exchange rate pass-through to domestic inflation has tended to decline from the 1990s across a number of countries," he said.

The sustainability of current account deficit depends on the perceived stability of capital flows, which, in turn, would be dependent on assessment of growth prospects of the economy by foreign lenders and investors, Mohan said.

"Whereas it is understood that a more open economy that has access to international capital flows can run a higher current account deficit than a less open one, our approach to this issue will remain informed by appropriate caution in the interest of financial stability," he said.

The expansion in the current account gap during 2005-06 has masked the strength of capital flows, Mohan said.

"It needs to be mentioned that oil price increases typically result in higher remittances to India as well as non-resident deposit inflows in the capital account, producing non-linearity in the impact of international crude prices on the Indian economy," he said.

These factors strengthen the capability of the Indian economy to sustain higher current account deficits than in the past, he said.

Going forward, there will be a continuous need to adapt the strategy of liquidity management as well as exchange rate management for effective monetary management and short-term interest rate smoothening, he said.

Global developments are expected to have an increasing role in determining the conduct of monetary and exchange rate policies in Asian countries.

He said, economic reforms have propelled India to a higher growth path of 8 per cent-plus economic growth.

"Our challenge in monetary policy making now is to ensure that such a growth path can be preserved, or further accelerated, while we provide a macro-economic environment that is characterised by monetary, price and financial stability," Mohan said.