Finance Minister Shri Pranab Mukherjee made the following intervention on ‘Managing Inflation and Capital Flows’ at Hanoi, today .
“Before the onset of global crisis, we faced food and fuel price volatility. During the global crisis of 2008-09, with collapse of demand, we experienced a broad flattening of prices. And, as the world experienced recovery from the crisis, different parts of the world faced highly differentiated recovery and inflationary conditions. Till about a few months ago, the slow recovering advanced economies, with few exceptions, still faced low inflationary conditions, while fast recovering emerging economies faced higher inflation.
This highly differentiated recovery and inflationary conditions threw up several challenges in global economic cooperation and the rebalancing exercise. Loose monetary conditions of advanced economies, to fight deflationary trends and foster recovery, have led to volatile capital flows and partly contributed to volatility in commodity prices. Today the entire globe is facing a simultaneous volatility in food, fuel prices and commodity prices. Thus, over the last four years, we have moved from a fuel crisis to a food crisis to a financial and economic crisis and now, we are back to a food and fuel price crisis.
In many EMEs particularly India, food price inflation has led to general inflation. However, due to several measures taken by the Government on supply side, measures to control fiscal deficit and eight successive policy rate increases by the Reserve Bank, this is tapering off. Recent volatility in global prices of food and fuel has, nevertheless, thrown up fresh challenges in management of inflation. Price volatility now appears to be on the way to becoming a long term and a global phenomenon.
We need to look closely at contribution of different factors to food price volatility and inflation, in order to understand and respond through policy reform. Since a significant part of inflation is due to imbalances and inadequacies in global financial and monetary management, one set of policies needs to address issues such as excessive liquidity and speculation and another set of policies need to address other issues of a transitory nature such as drought and floods in major producing countries, panic buying, exchange rate fluctuations etc. In addition, a third set of policies is required to understand and address the longer term underlying structural issues.
It is clear, therefore, that management of inflation, in addition to domestic efforts, will increasingly have to be a globally coordinated effort.
As a result of high growth and resilience exhibited by the economy, there has been steady revival of capital flows to India in 2009-10 and this trend has continued in 2010-11.
Both national and international factors have been responsible for the surge in capital flows. Strong economic fundamentals i.e. high growth rate, macroeconomic stability, stable policy regime and good governance are some of the domestic factors attracting capital flows to India. However, easy monetary policy in terms of very low interest rates and quantitative easing in advanced economies have led to increase in liquidity and lowering of long-term interest rates. These are also driving capital to emerging economies in search of higher yields.
As the recovery of emerging and developing countries has gained momentum, globally capital flows have surged back to near pre-crisis levels. These flows have exhibited considerable volatility, imparting macroeconomic instability in the event of sudden stops and reversals, eroding competitiveness and complicating the setting of macroeconomic policies.
I believe that policy prescriptions with respect to capital flows should be even-handed. So far as lumpy and volatile flows are a spillover from policy choices of advanced economies, managing capital flows should not be treated as an exclusive problem of emerging market economies and the burden of adjustment should be shared.
As regards multilateral strategies to managing capital flows, it is difficult to follow an approach that seeks to standardize, prioritize or restrict the range of policy responses of the member countries that are facing large surges in volatile capital inflows. Managing capital flows involves two important things. First, we need to make a judgment on how important the externalities are. And, second, we need to make an objective assessment of what combination of policies may be used to minimize their impact.
It is now broadly accepted that there could be circumstances in which controls can be a legitimate component of the policy response to surges in capital flows. Policymakers must therefore have the flexibility, and discretion, to adopt macroeconomic, prudential and capital account management policies. More importantly, they should be able to do so without a sense of stigma attached to particular instruments.
In India, we have found it useful to use a mix of policy tools in managing capital flows, mainly relying on prudent capital account management and flexible exchange rates, with good actual use of inflows.