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Flipside Of High Inflows

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The International Monetary Fund's (IMF) Global Financial Stability Report (GFSR) has a number that is a bit of a shocker: over the next 24 months, banks around the globe — but mostly in the developed countries — will need $4 trillion to refinance their assets. The IMF goes on to say that governments will have to play an important role in recapitalising the banks. So QE2 or the second round of quantitative easing — read that as governments printing more money — may be much bigger than anticipated thus far.

In a world where global liquidity is already very high, estimates of the amount of capital flows to emerging markets, including India, will also have to be revised upwards significantly. But is that necessarily a bad thing? Foreign institutional investor (FII) money has been flowing in steadily: around $4 billion just in September, and the trend is likely to continue.

Given the trade gap (imports over exports), those inflows help cover the balance of payments (BoP) position more than adequately, especially if import growth continues to rise as it has been. The latest BoP numbers are positive $3.7 billion, which seem manageable. The quality of inflows could be cause for worry. In 2007, when inflows were similarly huge, non-FII inflows (through foreign direct investment or FDI, remittances or banking capital) were much greater than they are this time around.

The Reserve Bank of India (RBI) has little scope for intervention. The rupee is appreciating, but liquidity fuelled inflation is rising, too. For the government, these inflows will help the disinvestment programme (the amount needed is Rs 40,000 crore-plus). Besides, the government has already spent what it got through the 3G and broadband wireless spectrum auction on its first set of supplementary grants.

The widening current account deficit may have upset the RBI's supply/demand calculations for foreign currency (mainly dollars) and made intervention complicated. Then, there is currency appreciation that could hurt exports. At a recent conference, Brazilian officials expressed concern over their appreciating currency against the dollar, referring to the ‘currency wars' that are impacting their export competitiveness.

A day later, finance minister Pranab Mukherjee said capital flows into India were welcome; and a day after that, RBI deputy governor Subir Gokarn expressed concerns about the speed and quantity of inflows, and the absorption capacity of the Indian economy of these inflows without driving the exchange rate or inflation higher.

What options does the RBI have to neutralise the impact of very high and volatile capital flows? Raising the cash reserve ratio — where all the liquidity ends up — would impose direct costs on the banking system, and drive interest rates up. Credit offtake has been anaemic and higher rates would slow that down further. It could reintroduce the market stabilisation scheme (MSS) and sterilise an adequate amount of inflows. That could increase costs for government that will pay interest on the MSS bonds, but cannot use the money. On top of everything, if the inflows become outflows rapidly, the shock to the banking system could be severe. RBI will have to figure out a way of taking away the punch bowl without spoiling the party.


(This story was published in Businessworld Issue Dated 18-10-2010)