Cap on foreign inflow in debt to stay: RBI

Regulator wants inflation, interest rates to fall before easing curbs.

Foreign capital flows into India's debt markets will continue to be controlled till wedges on account of higher inflation and interest rates narrow significantly, according to Reserve Bank of India (RBI) Deputy Governor Rakesh Mohan.

RBI's approach with regard to capital account has made a distinction between debt and equity, with greater preference for liberalisation of equity markets vis-a-vis debt markets. Equity markets provide risk capital and this can be beneficial for growth.

On the other hand, opening up of the domestic debt markets to foreign investors in the face of inflation and interest differentials, as is the case in India at present, can lead to large amount of arbitrage capital.

In view of higher domestic interest rates, open debt markets can attract large amount of capital flows and add further to the existing volume of capital flows, which are in any case well above the financing requirement of the country.

If the debt markets were open, such excess capital flows would have to be necessarily sterilised by RBI to maintain domestic macroeconomic and financial stability.

"This would further add to the sterilisation costs already being borne by the country's financial sector and the government," said the deputy governor.

He added that the enhanced levels of savings and investments and enhanced levels of capital flows and trade, all necessitated an efficient system for financial intermediation.

For household savings to grow further, households will need to see the continuation of adequate nominal and real returns. The efficiency of financial intermediation is then of the essence so that financial savings are indeed intermediated to their best uses.

As in the past, domestic savings are expected to finance a bulk of the investment requirements. In this context, the banking system will continue to be an important source of financing and there would be strong demand for bank credit.

Although bank credit has witnessed sharp growth since 2003-04, the credit-GDP ratio still remains relatively low. Moreover, a significant segment of the population remains excluded from banking services.

As the growth process strengthens and becomes more inclusive, it is expected that demand for financial products could continue to witness high growth in the coming years.

Thus, it is likely that growth in bank credit and monetary aggregates could be higher than what might be expected from historical relationships and elasticities in view of ongoing structural changes.

"This, however, raises critical issues for the central bank such as the appropriate order of monetary and credit expansion. In the absence of a yardstick, excessive growth in money supply could potentially show up in inflationary pressures over a course of time, given the monetary lags. Indeed, recent inflationary pressures across the globe are attributable, in part, to global liquidity glut," Mohan said.

In the absence of inflationary pressures as conventionally measured, excessive money and credit growth could also lead to asset price bubbles, with adverse implications for the banking sector stability and lagged conventional inflation.

Thus, RBI will have to face ongoing challenges to provide appropriate liquidity to the system to ensure growth in non-inflationary environment. This raises the critical issues of clarity in reading signs of inflation, asset prices and systemic liquidity from monetary and credit expansion, he added.