‘Capital outflows mustn’t be encouraged’

Reddy also cautioned on intervention (mopping up dollars to prevent a sharp rise) in the forex market over a long period. “While interventions are with the objective of containing volatility in the forex market, intervention over a long period, especially when the exchange rate is moving in one direction, could make interventions less effective,” he warned.

However, a critical question is what would be the impact on expectations about future movements in forex markets if no intervention takes place. “A related issue is whether there should be sterilised intervention and if so, the timing and quantum of such interventions. There is usually a cost attached to sterilisation operations. At the same time, it is also necessary to assess the indirect cost of not sterilising if there are signs of a ‘Dutch disease’ caused by flows in the capital account,” Reddy said.

While the immediate focus is on managing excess capital inflows and some volatility in regard to the excess, it will be prudent not to exclude the possibility of some change in course, due to any abrupt changes in sentiments or global liquidity conditions, despite strong underlying fundamentals of the economy, he explained.

Strategic management of capital account would warrant preparedness for all situations, and the challenges for managing the capital account in such an unexpected turn of events would normally be quite different, added Reddy.