A Problem Of Plenty

India is not the first country to face this problem. Many other countries in the second phase of reform have had to cope with sudden and large inflows of capital. Different countries have responded differently. Some have given priority to dollar sterilisation over greater imports, while others have followed the opposite route. Some bolder countries have decided to remove all capital controls, which has worked in some cases and failed in others. Mexico provides an excellent example of the latter.

For India, much the best thing would be to further liberalise imports, and smoothen the path to investment in infrastructure in the fields of power, ports, airports, telecoms etc. This should lead to some increase in the demand for dollars and thus eliminate the other option of having to allow the rupee to appreciate, which might become inevitable if the current rate of inflow persists. An appreciating rupee would affect exports adversely and would hardly seem to be a sensible option, especially when exports are already a troubled sector.

Nor would it do much harm to liberalise the import of consumer and agricultural goods. This may not result in a very significant increase in the demand for dollarsat least in the short run. But, at the very least, it would be an effective way to continue with the reforms. The RBI could always buy up more dollars, of course, but the concomitant risk of pumping rupees into the system would be much easier to run if the fiscal deficit were smaller than it isbecause the deficit is already pumping money into the system and creating inflationary pressures.

The bigger worry should probably be with regard to exports, which have lost all momentum. It does not help that the same has happened across most of Asia, suggesting (according to some observers) that export capacities have been built up to the extent that price competition in international markets has become intense. In the old days, the answer would have been to devalue in order to help exporters compete. Such simple prescriptions are impossible today.