Volatile capital flows added concern, says Subbarao

Reserve Bank of India (RBI) Governor D Subbarao today added strong capital inflows and the consequent appreciation of the rupee to his list of concerns, apart from inflation.

Speaking at G-30 International Banking Seminar in Istanbul today, Subbarao pointed out risk appetite among Foreign Institutional Investors (FIIs) for emerging market stocks was returning. Since the Indian central bank might have to raise policy rates to arrest inflationary pressures, the resulting interest rate differential might lead to heavy inflow of funds by FIIs.

“Will capital inflows be modest or turn into a flood as in 2007? The latter concern is particularly relevant in view of abundant liquidity in the major advanced economies,” Subbarao said. He added that since India was running a modest current account deficit, any large and volatile capital flow could impose macroeconomic costs.

According to RBI data, FIIs had pumped $26.8 billion during 2007-08 (up to January 11, 2008), causing the rupee to appreciate to a high of Rs 39.26 to the dollar on 15 January 2008, from Rs 43.59 at the end of March 2007.

However, as the financial crisis set in and FII appetite for emerging markets soured, the rupee fell to a low of Rs 51.97 on March 3, 2009, on the back of heavy outflows.

On inflation concerns, Subbarao said, while there was a broad agreement that RBI needed to exit from the present excessively accommodative monetary and fiscal policies, there was less agreement on when and how this should be done.

He said there were incipient signs of recovery and Industrial production had picked up in the past couple of months, but export growth remained negative.

“An early exit on inflation concerns runs the risk of derailing the fragile growth, while a delayed exit may engender inflation expectations,” he said.

Referring to the impediments in the monetary transmission mechanism, Subarao said, while RBI had reduced policy rates and made liquidity available, bank interest rates on loans and deposits had not eased to the same extent.

Various factors were responsible for this, like higher rates of interest offered by small savings instruments, the high cost of deposits raised by banks during earlier tighter monetary policy regime and the large government borrowing programme, which pushed up yields on government securities.

Referring to the government’s large fiscal deficit and ways to reduce it, Subarao said expenditure must be seriously considered and India could not rely on fiscal consolidation through tax increase.

He added that financial sector regulation was likely to increase bank funding costs and lead to higher lending rates. “We will need to ensure that efforts at financial inclusion do not get negated by the ongoing tightening of the regulatory regime,” Subbarao said.