Managing volatile capital flows has been one of the most time consuming efforts of India's central bank. Particularly so in recent times. With the foreign institutional investors (FIIs) playing truant, the RBI has to keep a hawk eye on several economic prospects. These include volatile currency movement, volatile stock markets and lopsided trade balances to name a few. But most importantly the impact on price levels (inflation). The RBI's inability to check the impact of capital inflows on price levels has left it most anxious.
In its latest annual report, the RBI has dealt with the issue of managing excess capital flows. Rather it has insisted on seeing foreign inflows as an opportunity than a problem. RBI's logic seems well justified given that a capital starved developing country like India could put the funds to good use in the long term.
But that itself is the problem. The US and European central banks have been printing currencies like never before. But soon their policies may have to be unwounded. Hence we are not too sure of the longevity of these funds in Indian markets.
As much as we would like to believe that the foreign investors are interested in India's long term story, statistics prove otherwise. Most foreign fund flows coming into Indian equities have been for a shorter duration. Particularly in times where the cost of capital was cheap and the returns here were attractive.
With cost of funds near zero in the developed markets for a extended period, the attractiveness of Indian equities may become perennial. Even if the underlying valuations do not support the same. Given such a scenario, the RBI needs to not just worry about currency movements and interest rates. But also the fact that excessive FII participation could bring in bubbles in Indian equities.
Further, there are two other matters that need to be handled with more care. With Indian corporate choosing to raise cheap credit overseas, domestic credit may remain unutilized. This may prompt Indian banks to lend to more risky ventures to keep themselves afloat.
Secondly with currency movements getting hit, exporters may need additional sops. The biggest hit will be blown on Indian IT sector that has already been a victim of volatile forex over the past two years.
The RBI suggests that we should treat capital inflows as an opportunity and not a problem. Even if that means some degree of disinterest for Indian investors, banks and exporters. But the question that remains is whether Indian will make good use of the funds?