Large capital inflows are often associated with subsequent credit and investment booms, inflation, overheating, real exchange rate misalignments, current account imbalances and financial sector weaknesses culminating in financial crisis. Reversals of capital flows to the EMEs are often quick, as again shown by the current financial crisis, necessitating a painful adjustment in bank credit, collapse of asset prices, compression of domestic demand and output losses. Thus, the boom and bust pattern of capital inflows can, unless managed proactively, result in large employment and output losses, and macroeconomic and financial instability. Against the above backdrop of recurrent crises and large losses, it is noteworthy that, despite the large volume of capital inflows and outflows, macroeconomic and financial stability has been maintained in India and most other EMEs over the past decade or so.How has India managed capital flows of such an order and still ensured high growth and financial stability?
(i) Exchange rate stability and free capital mobility can be combined by adopting a permanently fixed exchange rate but has to surrender monetary independence. Example: Hong Kong. (ii) Monetary independence and free capital mobility can be combined by adopting a floating exchange rate but has to surrender exchange rate stability. Example: Canada. (iii) Exchange rate stability and monetary independence can be combined but has to surrender capital mobility. In other words, combine a fixed exchange rate and domestic monetary independence at the cost of a closed capital account. Example: China.
Capital InflowsDirect BenefitGenerally domestic savings not enough for development of economies leads to need Foreign capital to finance their investmentsIndirect BenefitsDevelopment of domestic financial sectorImproved macroeconomic policiesCapital OutflowsBenefitsPeople and Companies can diversify their portfolios and take advantage of growth opportunities elsewhereFlipside: Can lead to financial crisis and emerging markets do not have deep stable financial systems to absorb the capital flows and hence are more prone to crisis
Many countries opting for a managed float system in which the currency floats in the market but central bank can intervene in the market if there is an abrupt movement in the currencyWithin floating exchange rates, many countries opting for a managed float system in which the currency floats in the market but central bank can intervene in the market if there is an abrupt movement in the currency. The exchange rate regime in India can best be characterized as intermediate, i.e. between fully managed and freely - floating regimes.
Suppose a country is growing and in order to grow further would need to increase its investments. So far, its savings have been enough and now it needs foreign savings as well. As a result, the policymakers liberalise capital flows (inwards and outtwards) in the country. Given this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both. Why?Now suppose, the country is Japan whose currency is yen (“this is just an example”) and it has both objectives price and exchange rate stability. To achieve former, it maintains fixed exchange rate and for latter, it maintains an inflation target (implicit or explicit).As capital inflows are allowed, foreign investors take exposure in Japan and bring their dollars, convert it into yen and invest it.As a result the demand for domestic currency goes up. Ideally as demand goes up so should the price meaning exchange rate should appreciate (or go up from Rs 45 per dollar to say 40)But as currency is fixed, the Central bank needs to maintain the level and instead gives the foreign borrower the desired yen and keeps the dollars with itself.Now, as supply of yen increases in the economy so does inflation (too much money chasing few goods). As inflation stability is also an objective the entire thing comes on its head, hence the impossibility of making all 3 objectives work together.Note that higher inflation can also be controlled by sterilizing the flows i.e. Central Banks issue govt. securities and suck the money supply. But that means more expenditure for government and is not a long-term solution as govts are supposed to direct their expenditure towards enhancing capital base of the country and not for monetary and exchange rate stability.
Indeed, the better than expected performance of Indian economy last year had a lot to do with a significant fiscal stimulus and loose monetary policy. In fact, two stimulus packages providing tax cuts and increasing infrastructure spending in connection with lower interest rates have supported domestic demand. Yet, sooner or later the effect of fiscal incentives will fade leading to a slowdown in factory production. In addition, inflation is becoming a growing concern. Weaker monsoon has pushed cost of food significantly higher in the last few months. This price pressure combined with strong industrial production may soon lead to interest rate hikes and tighten credit availability.RBI has been given the task of managing both, monetary stability and exchange rates as its basic objective. The magnitude of capital flows has become quite large and if not managed properly, would lead to instability in the economy. Hence, given the current situation, RBI has to manage the trinity. Therefore, there is a need to evaluate RBI's policies on the basis of the objective given to it.
Indian economy was growing at 8.5% plus from 2004 to 2008 and with ongoing reforms expectations are towards sustenance of the pace. This has led to huge capital inflows in the countryAnother source of capital inflows in emerging markets has been due to interest rate cut by the central Banks in developed economies. An interest rate cut leads to a higher differential in interest rates between the yields in developed and emerging markets. This leads foreign investors to rush to emerging markets where yields are usually higher. (This problem has been expressed in RBI's Mid-Term review of Monetary Policy 2007-08). Government of India has been making efforts to invite more capital inflows in order to finance the increasing investment in the country. The rise in investments is largely on account of most businesses expanding their capacities. Moreover, investment is expected to only increase tracking the need to build infrastructure capacities in the country. The Government's focus to increase investments leading to further capital inflows poses further problems for the Central Bank.
India’s exchange rate policy is to allowdemand and supply conditions to determine the exchange rate movements over a period in withinnpre-announced target or a band, coupled with the ability to intervene if and when necessary, while allowing . The nature of capital flows, exchange rate management and foreign exchange reserves management are closely intertwined. If capital flows are perceived to be permanent, the exchange rate, in principle, should then bear the entire adjustment burden. However, if capital flows are volatile and are perceived to be temporary and reversible, then there is a case for smoothing the exchange rate adjustment. it is, difficult to know as to whether capital flows are temporary or permanent. For example, the wave of copious capital inflows that started in 2003, along with the emergence of large global imbalances, was viewed by most observers, until the emergence of the sub-prime led crisis, as permanent. Events over the past two years have clearly shown that capital flows are highly volatile and they can change course very quickly. On balance, it would be prudent to presume capital flows as volatile and subject to sudden shocks and absorb them into foreign exchange reserves.
Rbi and impossible_trinity
RBI AND THE IMPOSSIBLE TRINITY<br />BY GROUP D2<br />AJAY KUMAR VERMA<br />ANUSHA JOHN<br />RUCHI GUPTA<br />SAGAR SAXENA<br />SUMIT AGARWALA<br />
FLOW OF PRESENTATION<br />Introduction<br />Impossible Trinity<br /><ul><li>Capital Mobility
Exchange rate has been largely market-determined since March 1993.
The capital account has been liberalised in terms of inflows as well as outflows.
Monetary policy signals are now largely transmitted through changes in policy rates.</li></li></ul><li>IMPOSSIBLE TRINITY<br />The Impossible Trinity is the hypothesis in macroeconomics that it is impossible to have all three of the following at the same time:<br /><ul><li>Exchange rate stability
CAPITAL MOBILITY-FULL OR LIMITED<br /><ul><li>Capital Inflows</li></ul>Direct Benefit<br /> Generally domestic savings not enough for development of economies Need Foreign capital<br />Indirect Benefits<br /><ul><li>Development of domestic financial sector
Capital Outflows</li></ul>Benefits<br /><ul><li>People and Companies can diversify their portfolios and take advantage of growth opportunities elsewhere</li></ul>Flipside: Can lead to financial crisis<br />
EXCHANGE RATE - FIXED OR FLOATING<br />Fixed Exchange Rate Systems: Prone to crisis<br />Floating Exchange Rate Systems: Exchange rate fluctuation driven by international speculative flows volatile <br />Many countries opt for “managed floating system”<br />
MONETARY POLICY OR FISCAL POLICY<br /><ul><li>Fiscal Policy</li></ul>Direct role: To increase output getting limited <br />Indirect role: To enhance competition and private sector participation increasingly appreciated <br /><ul><li>Monetary policy</li></ul>Role: Maintaining low inflation important for sustained growth<br />
WHY SHOULD RBI DEAL WITH THE IMPOSSIBLE TRINITY?<br />The Preamble of Reserve bank of India Act 1934, <br />"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.“<br />Three years of growth over 9%, India's economy expanded 6.7% in 2008/09 fiscal year<br />This year projections start at 7.2%, some even believe that India can overtake China as the fastest growing nation in the world.<br />
WHY SHOULD RBI DEAL WITH THE IMPOSSIBLE TRINITY?<br />Significant fiscal stimulus and loose monetary policy<br />Inflation<br />Weaker monsoon has pushed cost of food significantly higher<br />The magnitude of capital flows has become quite large and if not managed properly, would lead to instability in the economy.<br />
MANAGING CAPITAL MOBILITY<br />BENEFITS<br /><ul><li>Financing Investment
Economic growth</li></ul>PROBLEMS<br /><ul><li>Push up money aggregates
Affect domestic financial sector </li></li></ul><li>RISING CAPITAL INFLOW<br />Indian economy was growing at 8.5% plus from 2004 to 2008.<br />Interest rate cut by the central Banks in developed economies.<br />Need to build infrastructure capacities in the country.<br />
MANAGING CAPITAL FLOWS<br />Restricting capital flows – credibility<br />The best way to absorb huge capital inflows is to strengthen the financial system.<br />The RBI has actively withdrawn liquidity from the system.<br />Some restrictions on capital inflows have recently been introduced, primarily on corporate borrowing. <br />
MANAGING FOREIGN EXCHANGE RATE<br />Predominant objective - Flexible exchange rate<br />The exchange rate policy is guided by the need to <br /><ul><li>reduce excess volatility
prevent the emergence of destabilising speculative activities
develop an orderly foreign exchange market</li></li></ul><li>MANAGING MONETARY POLICY<br />Domestic demand remains the key driver of economic activity<br />Monetary and credit aggregates was broadly in line with demands of the real economy<br />Monetary policy was conducted with a view to ensuring not only price stability but also financial stability.<br />
Sterilisation of interventions in the foreign exchange market through multiple instruments, including cash reserve requirements</li></ul>Monetary policy needs to move away from narrow price stability/inflation targeting objective.<br />
REFERENCES<br />“Exchange Rate Policy and Modelling in India” by PamiDua and Rajiv Ranjan<br />Working PaperNo. 401- “Managing the Impossible Trinity:Volatile Capital Flows and Indian Monetary Policy”By Rakesh Mohan and MuneeshKapur<br />Reddy, Y.V., 2008, “Management of the Capital Account in India: Some Perspectives”, Reserve Bank of India Bulletin, February.<br />“RBI and Impossible trinity” AmolAgrawal<br />http://www.imf.org/external/pubs/ft/survey/so/2008/CAR02408A.htm<br />http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=INR<br />http://www.investopedia.com<br />