Central bank for calibrated approach to capital control

With increasing capital inflows threatening to put pressure on prices, the Reserve Bank of India (RBI) today said it would adopt a calibrated approach to these inflows.

“We will traverse the roadmap and reflect the lessons of the global financial crisis. It is also important to recognise that a lot of institutions, including the International Monetary Fund, control capital after the global financial crisis. We will adopt a calibrated approach,” RBI Governor D Subbarao said at a seminar organised by the central bank today.

In 2009, the net investment by foreign institutional investors (FIIs) in the country was around $17.45 billion, though in the current year, these institutions are net sellers of $576 million. Due to these inflows, the Indian currency rose 4.7 per cent in 2009.

The RBI governor said capital flows also had the potential to impair financial stability as “they never come in at the precise time or in the exact quantity you want them,” Subbarao said.

At the same time, he laid bare the central bank’s dilemma. “If central banks do not intervene in the foreign exchange market, they incur the cost of currency appreciation unrelated to fundamentals. If they intervene in the forex market to prevent appreciation, they will have additional systemic liquidity and potential inflationary pressures to contend with. If they sterilise the resultant liquidity, they run the risk of pushing up interest rates, which will hurt growth prospects,” he said.

The way in which emerging market economies manage the impossible trinity — the impossibility of having an open capital account, a fixed exchange rate and an independent monetary policy — will impact their growth prospects, price stability and financial stability, according to Subbarao.

“The challenge for central banks is to better understand the interplay of global factors and domestic variables and factor that into their policy calculus,” Subbarao said.

Concerns regarding capital inflows were also echoed by RBI Deputy Governor Shyamala Gopinath. “Capital flows are a risk not just for monetary but also for financial stability. We would not like to see high volatility in capital flows. There is a limit up to which high capital flows can be absorbed,” Gopinath said.

While commenting on the strategy of inflation targeting by central banks, the governor said a lesson from the global financial crisis was that price stability not necessarily ensured financial stability and there was a stronger assertion of a trade-off between price stability and financial stability.

“The more successful a central bank is with price stability, the more likely it is to imperil financial stability,” he said, adding that the mandate of the central bank should go beyond maintaining price stability to taking steps to prevent asset price bubbles.

“Opinion is divided, however, on whether central banks should prevent asset bubbles through monetary policy actions or through regulatory action,” he added.

Subbarao also raised the issue of whether central banks should perform the dual role of bank regulation and supervision. “There is a risk that a central bank may extend regulatory forbearance to a weak bank instead of allowing it to fall, since a failed bank could aggravate instability. Such actions become likely if the overall macro-economic situation is weak,” he said.

The governor also said that tensions between fiscal and monetary policies during the stimulus exit posed a threat to the independence of central banks.

“Beyond the short term, the threat to the independence of central banks emanates from factors apart from public anger...As countries contemplate exit from these expansionary policies, the familiar tensions between monetary and fiscal policies are showing up again,” Subbarao said. He cautioned that these tensions were unlikely to terminate even when world economies recovered from the financial meltdown, raising questions on the autonomy of central banks worldwide.