India: Needs Flows, But They Need to Be Well Managed :: Citi

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India: Needs Flows, But They Need to Be Well Managed


Given its robust structural growth story and high interest rate differentials,
India is no stranger to capital flows. In 2008, surging inflows brought to the
fore concerns on extent of currency appreciation and monetary policy
flexibility. To provide some perspective, total capital flows more than
quadrupled as a percentage of GDP during this period; to stand at US$92bn
(9.2% of GDP) in FY08 from US$10.8bn (2.1% of GDP) in FY03.
Data available for FY11 indicates that flows crossed US$40bn so far. We
estimate total flows of US$62bn for the full year. Similar to other emerging
economies, the INR has also seen significant appreciation over the past month,
to Rs44.5/$ now from close to Rs47/$ levels in early Sept (+4.7 %).


Calibrated Opening Likely to Continue – Hierarchy of Flows
Given higher funding costs, coupled with the need to facilitate growth through
investment by minimizing the cost of equity and debt, India has adopted a
calibrated approach in opening in the capital account. Bearing in mind India’s
widening current account deficit (we estimate the deficit to rise to 3% of GDP
in FY11 from 2.9% in FY10) due to higher oil and non-oil imports, there is a
need for capital inflows.
Policymakers have recognized a ’hierarchy in capital flows; favoring equity
flows over debt flows, and FDI over portfolio investment’. To this end, the RBI
has taken steps to selectively liberalize ECBs in favor of infrastructure-related
borrowings; and raise the cap for FII investment in (a) Sovereign bonds from
$5bn to $10bn and (b) Corporate bonds from $15bn to $20bn


…But Flows Need To Be Well Managed
Given India’s funding needs, Dr Rakesh Mohan ( Professor at Yale University,
Former Deputy Governor, RBI) and Muneesh Kapur ( RBI) believe that there
could be some microeconomic gains to market participants through improved
access to global capital markets7 . But they emphasize that an increase in
flows could be beneficial as long as the authorities are able to manage the
macroeconomic effects of such excess flows.
As Governor Subbarao often says ‘capital flows never come in at the exact time
or in the precise quantity you want’. Like-wise Dr Mohan and Kapur point out in
another study8, ‘large capital inflows are often associated with credit and
investment booms, inflation, overheating, real exchange rate misalignments,
current account imbalances, and financial sector weaknesses culminating in
financial crisis’. They underscore the need for a coordinated and calibrated
approach to simultaneous movement in financial market and sector
development on the one hand and gradual opening up of the capital account”.
The Impossible Trinity – Back in Play but Can be Managed
We believe that similar to FY08, the RBI could once again be caught in the trap
of the ‘impossible trinity’. However, by adopting a middle ground of managed
but flexible exchange rates and managed, but mostly open, capital accounts,
India was able to manage the Impossible Trinity. As Dr Mohan and Kapur say,
what helped was that the Central Bank used many instruments rather than a
single instrument. This was possible due to the fact that both monetary policy
and regulation of banks and other financial institutions and key financial
markets are under the jurisdiction of the Reserve Bank, which permitted smooth
use of various policy instruments.
How a country deals with capital flows depends on (1) its export dependence
and (2) inflationary/sterilization costs associated with dollar inflows. India has
several sterilization options including: (1) Market stabilization bonds – while the
cap on these bonds is Rs2.5trillion, given recent desequestering, the entire
amount is available (2) Liquidity Adjustment Facility (LAF) (3) Open Market
Operations (OMOs) (4) Raising the Cash Reserve Ratio (5) sell-buy forex swaps


Capital Controls: What to Expect
Due to an increase in absorptive capacity of inflows authorities haven't
intervened. However, as Governor Subbarao has pointed out in a recent
speech, this does not mean that India will not intervene in the future: ‘If inflows
are lumpy and volatile or if they disrupt the macroeconomic situation, we will
do so. Our intervention will be to keep liquidity conditions consistent with
activity in the real economy and to maintain financial stability’. To this end, the
RBI is likely to focus on keeping policy as stable as possible and towards a
prudent use of controls. We maintain our view that India will unlikely impose
‘punitive controls’. Instead, we could see:
 Some INR appreciation to offset inflationary pressures and continued
reserve build-up
 Macro Prudential norms, raising provisioning, curbing activity in real estate,
etc
 Tightening ECB and banking capital norms, reducing rates on NRI Deposits
 Encouraging Capital Outflows by liberalizing limits on FDI, outward
remittances overseas, mutual fund investments, etc