Big forex inflows giving jitters

THE RESERVE BANK OF INDIA ANNUAL REPORT 2006-07

Excess foreign exchange inflows management is proving to be a tough task for the Reserve Bank of India (RBI). Capital flows in the country has remained substantially above the current account deficit and have implications for the conduct of monetary policy and financial stability, said the RBI in its annual report.

According to the RBI, monetary management at the current juncture in India is more complex than in other emerging market economies.

Higher capital flows have been driven by strengthening of macroeconomic fundamentals, greater investor confidence and ample global liquidity. Net foreign direct investment (FDI) inflows of $19.4 billion exceeded FII inflows (net) during 2006-07 aggregating $ 3.2 billion.

The debt flows (net) at $ 25.0 billion were led by external commercial borrowings reflecting strong investment demand. Net capital flows, after financing the current account deficit, led to accretion of $ 36.6 billion, excluding valuation changes, to foreign exchange reserves during 2006-07.

Monetary management is complex for the RBI as the cost of intervention for the central bank in the domestic foreign exchange market is higher than what it earns on overseas investment.

Additionally, the fiscal deficit and public debt in India is higher as compared to international standards. This restricts the flexibility available to fiscal policy to keep inflation relatively low.

Monetary management gets further complicated as the real sector in India has been liberalised over the years which constrains the ability to take administrative measures with regard to supply management.

The banking system has been gradually deregulated and the conduct of monetary policy is largely through the use of market-based instruments. This restricts the RBI's ability to use administrative instruments such as prescribing deposit and lending rates, which some other countries are able to use.

Moreover, some countries are managing capital account more actively than before. It is also important note that India is one of the few EMEs to record current account deficits, along with a significantly high trade deficit.