India's Record-High Capital Inflows Pose Policy Challenge- IMF Survey

India's favorable environment has attracted the attention of foreign investors. Capital inflows have surged over the past two years. In 2005, net capital inflows amounted to $25 billion. By 2007 (January-September), they had more than doubled, to $66 billion.

Lending to Indian corporates has been the biggest contributor, although portfolio investment has also risen rapidly. Foreign capital has been attracted by India's productivity-driven growth boom, its increasing financial integration with the global economy, and higher interest rates than abroad. Inflows are projected to remain significant, reflecting India's continued strength at a time when the world economy is weakening.

Although capital inflows are supplying much-needed financing to Indian corporates and banks, they are also making monetary and exchange rate policy more challenging. Capital inflows caused the rupee to appreciate by 7 percent in real effective terms last year. This has raised concerns about India's competitiveness, particularly in the labor-intensive textile, garment, and leather industries.

Capital inflows have also increased the money supply, which then raises inflationary pressure. In short, according to IMF, India is facing the policy challenges of the "impossible trinity": when there is free movement of capital, it is impossible to both target the exchange rate and maintain an independent monetary policy.

The Reserve Bank of India (RBI) has responded to this policy challenge in a flexible manner. It allowed exchange rate flexibility to absorb pressures from capital inflows, as noted above, although it has also intervened heavily in the foreign exchange market: last year, reserves rose by nearly $100 billion, to about $275 billion.

The RBI has also actively withdrawn liquidity from the system. And monetary policy has been tightened, with the result that India has maintained a wide interest rate margin with the rest of the world (though this may, in turn, be encouraging more capital inflows). Finally, the RBI is gradually liberalizing capital outflows in line with India's medium-term objective of capital account liberalization.

Some restrictions on capital inflows have recently been introduced, primarily on corporate borrowing. According to IMF, International experience suggests that these restrictions are unlikely to have much impact on capital inflows because investors and borrowers find ways to evade them. But, to the extent that they do bite, they raise concerns about the potential impact on financing for infrastructure projects, which tend to require the longer-term financing that may be more readily available from foreign lenders.

Despite such restrictions, IMF feels that India's vibrant outlook and sizable capital demands mean that capital inflows are likely to remain large. This would be consistent with the experience in other Asian countries around growth take-offs. Since restrictions on capital inflows are not likely to be effective, allowing greater exchange rate flexibility and improving liquidity management may be a better way to deal with continued capital inflows.

(Extract from an IMF assessment dated February 04, 2008)

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