Globalization's underbelly: capital flows and the Indian economy

Abstract

Recent capital flows to India have been predominantly portfolio flows and they have been associated with a deteriorating current account position. To induce foreign savings to finance current account deficits requires the interest rate in India to rise. When capital flows are associated with rising investment expenditure, economic growth is viewed as sustainable and foreign capital's willingness to share in the upside benefits through the acquisition of equity increases. To prevent the exchange rate appreciation associated with rising capital flows, the Reserve Bank of India has been accumulating foreign exchange reserves. This results in a rise in liquidity and a build-up of inflationary pressures. The RBI then resorts to sterilisation to mop up the excess liquidity in the financial system. This article discusses the implications of these processes for the financial system and the economy.