The capital inflow dilemma

Amid hopes of returning to the heady days of 9% growth, the government’s macro-economic managers will have to walk the wedge while handling a surge of foreign capital inflows into the capital-scarce country.

Amid hopes of returning to the heady days of 9% growth, the government’s macro-economic managers will have to walk the wedge while handling a surge of foreign capital inflows into the capital-scarce country.

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Abundant global liquidity, particularly since the launch of the second round of quantitative easing (QE2) in the US, has created notable policy challenges in emerging economies associated with dollar depreciation, portfolio reallocation and an increase in global inflation expectations.

Many emerging countries are beginning to impose tighter capital controls to prevent domestic asset price bubbles and sharp appreciation of their currencies.

In October Brazil tripled its financial transaction tax on foreign portfolio inflows into fixed income securities to 6%.

Thailand is ceasing a 15% foreigners’ tax exemption on income from domestic bonds, while Taiwan has restored curbs on foreign investment in debt instruments. Other countries too are mulling similar options.

India has so far avoided imposing any such controls on the grounds that the effect of such controls is but temporay, while they hamper growth and productivity and cannot even fully prevent the fund inflows.

“Abundant global liquidity poses significant challenges to EM policymakers, not only in the form of appreciation pressures, but also of commodity price increases,” Barclays Capital said in a recent report.

“A reversal in capital flows and lack of an investment revival are downside risks to the Indian economy,” said Sonal Varma of Nomura.