The Hindu Business Line : Capital eddies

Just how far the Indian economy has meshed into the global context is mirrored in the opening sentence of the Reserve Bank of India’s annual report for the year ended June 2007. The RBI begins the economic review with the global scene and, at first glance, it might puzzle the reader as to why the buoyancy of the global economy for the fourth year running should be considered such an auspicious curtain-raiser. But the opening paragraphs provide the reference points fo r not simply the economy but for the issues that exercise the RBI at present.

As of old, the central bank’s preoccupation with inflation and price stability stands out prominently. In almost routine fashion so far, the RBI was wont to find the causes for price instability in monetary phenomena: excess liquidity, over-the top credit off-take and a price spiral dictated by overheating demand. There is a shift this time, with the apex bank recognising, belatedly, that shortfalls in farm output and poor infrastructure also contribute to the price rise. Uncertainty in global oil prices too adds its bit but the interesting twist is that the central bank finds inflation not just a matter of excess demand but also of structural supply constraints that policy makers would be well-advised to remove quickly. But the report introduces the reader to another problem that it has begun to take seriously: financial stability. The fact that the global environment flags off the report reflects the RBI’s worry about the effects of volatile capital flows, not just on the financial system but on the real economy too. With the US mortgage market in turmoil the RBI sounds the first alarm bells on the probability of hedge funds and private equity funds exiting Indian markets. As it is, the RBI gets nervous at the massive inflows of capital, not only because of their impact on the exchange rate and liquidity but also on account of their orderly management. Now it raises the fear of outflows. In the swirling eddies of sudden capital movement, the RBI reads danger: for exchange rates, for the more vulnerable investors and even for the large firms.

Price and financial stability worries, however, do not dampen the RBI’s GDP forecast, though it has pegged it down at 8.5 per cent from the 9.4 per cent of 2006-07. The apex bank bases its optimism on a strong global outlook. So long as the real economy, on the back of world trade keeps apace with capital flows, volatility in financial markets can be evened out. The RBI has managed inflows well so far; in the worst-case scenario, an economy blessed with real GDP growth should manage outflows just as well.

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