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Liberalization of capital inflows and the real exchange rate in India: A VAR analysis

  • Indrani Chakraborty

    (Centre for Development Studies)

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    The East Asian crisis of 1997-98 and the Mexican crisis of 1994 generated much concern among policy analysts regarding the role of macroeconomic policies in the management of capital inflows. A series of economic reform measures including liberalization of foreign capital inflows were initiated in India since the early nineties. Using the vector autoregression (VAR) method, this paper specifically examines if the external shock generated by capital inflows led to appreciation in the real exchange rate as observed in the East Asian and Latin American countries in the 1990's. The role of monetary and fiscal policies in managing the effect of capital inflows on the real exchange rate is also analysed in this context. Based on the quarterly data from 1993.2 to 2001.4 and incorporating the variables such as the real exchange rate, capital inflows, the rate of growth of domestic credit and the rate of inflation, three important observations emerge from the VAR analysis: (a) unlike the East Asian and Latin American countries, the real exchange rate depreciates with respect to one standard deviation innovation to capital inflows, (b) the dynamic impact of random disturbances generated by capital inflows on the real exchange rate is persistent, and (c) the dynamic response of the real exchange rate to capital inflows shock has largely been influenced by monetary policy and not by fiscal policy. The paper argues that the monetary policy was effective in avoiding any serious distortion in the real exchange rate following the liberalization of capital inflows in India while sacrificing its long-term objectives. It addresses two limitations in the existing macroeconomic policies i.e. (a) lack of fiscal consolidation and (b) lack of capital control instruments which seems to have created undesirable pressure on the monetary policy to realize its long-term objectives in the regime of liberalized capital inflows.

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    Paper provided by Centre for Development Studies, Trivendrum, India in its series Centre for Development Studies, Trivendrum Working Papers with number 351.

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    Length: 48 pages
    Date of creation: Sep 2003
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    Handle: RePEc:ind:cdswpp:351
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    1. Calvo, Guillermo A & Mendoza, Enrique G, 1996. "Petty Crime and Cruel Punishment: Lessons from the Mexican Debacle," American Economic Review, American Economic Association, vol. 86(2), pages 170-75, May.
    2. Sebastian Edwards, 1998. "Capital Flows, Real Exchange Rates, and Capital Controls: Some Latin American Experiences," NBER Working Papers 6800, National Bureau of Economic Research, Inc.
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