Capital inflows may rise, pose a challenge

The Reserve Bank of India (RBI) on Tuesday said there was a possibility of return of another phase of capital inflows, indicating this might pose a challenge for currency and interest rate management. Unlike the pre-global crisis, economies now favoured use of soft controls to deal with excessive capital flows, it said.

“There is a possibility of return of another phase of surge in capital flows to India in response to the global search for yield in an environment of easy liquidity in advanced economies and the prospect of relatively higher return on investment in India in view of its superior growth outlook,’’ RBI said in its annual report for the year ended June 30. While a stronger growth could help absorb higher foreign capital within the limits of sustainable current account deficit, excess inflows would entail the risk of exerting appreciation pressure on the rupee, which in turn could weaken the competitive advantage of Indian exports, the report said.

Sterilised interventions could limit this pressure but might lead to higher interest rates, it said. Unsterilised intervention, which could relieve pressure on both exchange and interest rates, would involve excess liquidity creation. In an environment of high inflation, this could worsen the situation. High inflation would also hit export competitiveness through the appreciation of the real effective exchange rate and the widening of the current account deficit.

Excess capital inflows would continue to pose a challenge for the exchange rate, the interest rate and the inflation environment and might weaken the beneficial impact of capital flows on economic growth, RBI said.

In emerging market economies, any sharp rise in capital inflows often led to a rise in prices of assets, along with the strengthening of the exchange rate, RBI said.

India would have to strike a balance between growth and financial stability, it said. In emerging market economies, any sharp rise in capital inflows often led to a rise in prices of assets, along with the strengthening of the exchange rate, RBI said.

RBI sees some risks from capital flows. Share change in the global growth environment could lead to flight to safety. The funds could exit India and other emerging markets in such event, putting pressure on Balance of Payments, according to RBI deputy governor Subir Gokarn.