August 17, 2013 12:47:06 am
Tightening of capital controls signals a choice of strategy that will lead the way back in time.
In another retrograde move to defend the rupee,the RBI has tightened capital controls,placing restrictions on Indian households and firms investing abroad. This panic signal has done nothing to reduce the pressure on the rupee,which plunged to Rs 62/dollar. Imposing capital controls to defend the exchange rate is a statement of the monetary policys failure to manage the impossible trinity. As an economy matures,it cannot have all three an open economy,an independent monetary policy and a pegged exchange rate. High exchange rate volatility is the price an economy pays when it opens up. The government has made it clear that it does not want currency volatility. So there are two options either lose monetary policy independence or close the economy. The finance minister has said that growth should be one of the objectives of monetary policy,suggesting that the RBI should lower interest rates. This means monetary policy should be independent of the US policy,which will raise rates in the near future. In that case,the only option available to the RBI is to close the capital account.
The rupee-dollar market today is so large that the logical outcome of this choice of strategy will be to reduce all dollar flows,whether on the capital or the trade account. This can be done using the FEMA,which gives the authorities powers to restrict all flows. A much more closed economy will have a smaller currency market. At the same time,the derivatives markets will have to be destroyed so that they do not allow expectations of depreciation to be visible. Then,the RBI can intervene and prevent depreciation without losing much of its reserves.
Meanwhile,these steps will scare off that element of capital inflows that came into the country based on Indias growth prospects. The breaking down of barriers to trade and the capital account were among the most important steps taken in the post-liberalisation years and a reversal of these is not a sign of health and expected prosperity. This framework favours debt dollar inflows from NRIs,into PSUs and through ECBs. In an already vulnerable situation,a shift in dollar inflows from non-debt to debt flows could have a negative impact on expectations about growth and stability in India. Credit ratings could go down,equity capital flows could either slow down or reverse,FDI inflows may not pick up despite the more liberal norms and Indian capital could try to find ways to go abroad. The chosen strategy is wrong for India. Destroying the derivatives markets and imposing capital controls is not going to give us growth. Policymakers must,instead,accept rupee flexibility and keep the economy open.
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