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

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.