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Managing the Impossible Trinity: Volatile Capital Flows and Indian Monetary Policy

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  • Mohan, Rakesh
  • Kapur, Muneesh

Abstract

Large capital inflows are often followed by credit and investment booms, inflation, real exchange rate misalignments, current account imbalances and financial sector weaknesses culminating in financial crisis and long-term output losses. While India has received large capital flows since 1993-94, macroeconomic price and financial stability has been maintained in a high growth environment. What explains this desirable outcome? This paper assesses external sector and monetary management policies and finds the outcome can be attributed to judicious use of a menu of options such as management of the capital account; restrictions on access of financial intermediaries to external borrowings vis-à-vis non-financial corporate entities; flexibility in exchange rate movements with capacity to intervene in times of excessive volatility; building up of reserves; strengthening of the financial sector; pre-emptive tightening of norms in sectors with high credit growth; and refinements in the institutional framework for monetary policy. As a result of this approach, growth in monetary/credit aggregates was contained amid growth in the real economy, structural transformation and financial deepening. Inflation was contained even as growth accelerated; financial stability was maintained even as the global economic environment experienced a series of financial crises. The impossible trinity was achieved by maintaining an open but managed capital account and a flexible exchange rate with management of volatility. Rather than relying on a single instrument, many instruments were used in coordination since the Reserve Bank’s jurisdiction over both monetary policy and the regulation of financial institutions permitted the use of various policy instruments. Key lessons from the Indian experience are that monetary policy needs to move away from price stability/inflation targeting objective, central banks need multiple instruments and capital account management has to be countercyclical.

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  • Mohan, Rakesh & Kapur, Muneesh, 2009. "Managing the Impossible Trinity: Volatile Capital Flows and Indian Monetary Policy," MPRA Paper 70632, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:70632
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    Cited by:

    1. Rajeswari Sengupta, 2015. "The Impossible Trinity: Where does India stand?," Working Papers id:6659, eSocialSciences.
    2. Rakesh Mohan & Muneesh Kapur, 2015. "Pressing the Indian Growth Accelerator: Policy Imperatives," IMF Working Papers 2015/053, International Monetary Fund.
    3. Sen Gupta, Abhijit & Sengupta, Rajeswari, 2013. "Management of Capital Flows in India: 1990-2011," MPRA Paper 46217, University Library of Munich, Germany.
    4. Ms. Prachi Mishra & Mr. Peter J Montiel & Rajeswari Sengupta, 2016. "Monetary Transmission in Developing Countries: Evidence from India," IMF Working Papers 2016/167, International Monetary Fund.
    5. repec:pra:mprapa:39771 is not listed on IDEAS
    6. Joshua Aizenman & Rajeswari Sengupta, 2013. "Financial Trilemma in China and a Comparative Analysis with India," Pacific Economic Review, Wiley Blackwell, vol. 18(2), pages 123-146, May.
    7. Eichengreen, Barry & Gupta, Poonam & Choudhary, Rishabh, 2021. "Inflation Targeting in India: An Interim Assessment," India Policy Forum, National Council of Applied Economic Research, vol. 17(1), pages 77-141.
    8. Bhandari, Pranjul & Frankel, Jeffrey, 2017. "Nominal GDP targeting for developing countries," Research in Economics, Elsevier, vol. 71(3), pages 491-506.
    9. Sayantan Bandhu Majumder & Ranjanendra Narayan Nag, 2016. "Understanding the Behaviour of Capital Flow and its Components: The Indian Experience," Margin: The Journal of Applied Economic Research, National Council of Applied Economic Research, vol. 10(3), pages 355-380, August.
    10. Gupta,Poonam - DECOS, 2016. "Capital flows and central banking : the Indian experience," Policy Research Working Paper Series 7569, The World Bank.
    11. Karl F Habermeier & Annamaria Kokenyne & Chikako Baba, 2011. "The Effectiveness of Capital Controls and Prudential Policies in Managing Large Inflows," IMF Staff Discussion Notes 11/14, International Monetary Fund.
    12. Nidhi Aggarwal & Sanchit Arora & Rajeswari Sengupta, 2021. "Capital account liberalisation in a large emerging economy: An Analysis of onshore-offshore arbitrage," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2021-013, Indira Gandhi Institute of Development Research, Mumbai, India.
    13. Ila Patnaik & Ajay Shah, 2012. "Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(3), pages 439-464, September.
    14. Radhika Pandey & Gurnain K. Pasricha & Ila Patnaik & Ajay Shah, 2021. "Motivations for capital controls and their effectiveness," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(1), pages 391-415, January.
    15. Kapur, Muneesh & Behera, Harendra, 2012. "Monetary Transmission Mechanism in India: A Quarterly Model," MPRA Paper 70631, University Library of Munich, Germany.
    16. Shivangi JAISWAL & Dr. N. KUBENDRAN, 2021. "Capital account liberalisation in India: Volatility of capital flows and selective policy issues," Theoretical and Applied Economics, Asociatia Generala a Economistilor din Romania / Editura Economica, vol. 0(1(626), S), pages 201-218, Spring.
    17. Nidhi Aggarwal & Sanchit Arora & Rajeswari Sengupta, 2022. "Capital account openness in India and a comparison with China: Then versus now," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2022-005, Indira Gandhi Institute of Development Research, Mumbai, India.
    18. Muneesh Kapur & Michael Debabrata Patra, 2010. "A Monetary Policy Model Without Money for India," IMF Working Papers 2010/183, International Monetary Fund.
    19. Pranjul Bhandari & Jeffrey Frankel, 2014. "The Best of Rules and Discretion: A Case for Nominal GDP Targeting in India," CID Working Papers 284, Center for International Development at Harvard University.
    20. Reserve Bank of India, 2017. "Macroprudential frameworks, implementation, and relationship with other policies," BIS Papers chapters, in: Bank for International Settlements (ed.), Macroprudential policy frameworks, implementation and relationships with other policies, volume 94, pages 179-187, Bank for International Settlements.
    21. Sur, Abhisek & Ray, Partha & Nandy, Amarendu, 2019. "India’s external commercial borrowing: Pulled by domestic fundamentals or pushed by global conditions?," Journal of Asian Economics, Elsevier, vol. 61(C), pages 65-77.
    22. Muneesh Kapur & Rakesh Mohan, 2014. "India’s Recent Macroeconomic Performance: An Assessment and Way Forward," IMF Working Papers 2014/068, International Monetary Fund.
    23. Philip Turner, 2012. "Weathering financial crisis: domestic bond markets in EMEs," BIS Papers chapters, in: Bank for International Settlements (ed.), Weathering financial crises: bond markets in Asia and the Pacific, volume 63, pages 15-34, Bank for International Settlements.

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    More about this item

    Keywords

    Capital flows; capital account management; Indian monetary policy;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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