Capital flow surge to continue for now

ECONOMIC SURVEY 2003-04/ FINANCIAL SECTOR

The Economic Survey has predicted that the present surge in capital flows will continue in the medium term with the improvement in macroeconomic situation.

To tackle capital flows in the medium to long term policy initiatives aimed at improving the country's absorptive capacity need to be put in place even as an overall assessment of the developments during 2003-04 and prospects for 2004-05 provide grounds for optimism, the Survey said.

According to the Survey, which is a report card on the economy, the hardening of international prices of oil and non-oil commodities and the persistence of large capital inflows are likely to be key issues which could affect monetary conditions in 2004-05.

Sterilisation of capital flows through open sale of government securities involves quasi-fiscal costs in the form of difference between interest rate on domestic securities and return on foreign exchange reserves.

The Survey says that sterilisation, if it exerts an upward pressure on interest rates, could result in attracting more foreign currency inflows, thus, necessitating more intervention by the monetary authority.

Sterlisation, at best, is a temporary policy instrument to address inflows. Over the last two years, this has been one of the main objectives of the Reserve Bank of India's monetary policy.

The Survey emphasises that the exchange rate management policy needs to balance build up of reserves and domestic liquidity on the one hand and maintaining external competitiveness with low inflation and interest rate on the other.