1. Introduction

V.1 The conduct of monetary policy in a globalised environment faces the challenge of managing the impossible trinity¹. It has become more complicated by spillovers from monetary policies of advanced economies in recent years. Announcement effects of the exit from unconventional monetary policies (UMPs) of systemically important central banks have exposed the limits on the effectiveness of monetary policy in spillovers-receiving economies. Risk-on risk-off shifts in market perceptions have imparted heightened volatility to cross-border capital flows and to changes in asset prices worldwide. Furthermore, because of hysteresis, implications for the real economy (especially the tradable sector) are not symmetric over phases of inflows and outflows.

V. 2 Prior to the global crisis of 2008, there was an apparent consensus that flexible exchange rates can engender the space for independent conduct of monetary policy, even if the capital account is open. After the crisis, however, there is a clear intellectual shift justifying a non-trivial role for capital flow management (CFM) measures to mitigate the externalities associated with global spillovers, irrespective of the exchange rate regime, and for a war-chest of international reserves as the first and often, the only line of defence. Thus, the trilemma has collapsed into a dilemma – independent monetary policy is possible only if the capital account is managed²,³.

V.3 The dominant influence of US monetary policy on monetary policies of most EMEs has been evident since the onset of the global crisis. Quantitative easing (QE) led to the hardening of global commodity prices which has been transmitted to EMEs in the form of rising current account deficits (CADs) and inflation. QE has also been a strong push factor driving surges in capital flows into EMEs, causing their exchange rates to appreciate and asset prices to increase beyond levels regarded as tolerable hitherto. QE-driven capital inflows, in fact, also helped countries like India to meet the financing gaps opened by sustained high CADs. Since May 2013, the effects of ‘taper talk’ that became evident in sudden reversal in debt capital flows and sharp depreciation of exchange rates have added a whole new dimension to the conduct of monetary policy in an interconnected world. This warranted a re-think on (a) degree of flexibility that monetary authorities need to retain to manage large anticipated as well as unanticipated globalisation induced shocks; and (b) the armoury of instruments and the associated costs in terms of achieving the final objectives of monetary policy.

2. International Experience

V.4 Over the last decade, trade, finance and sentiment channels have connected constituents of the global economy more than ever before. Repetitive episodes of crises have tended to focus attention on the negative effects of this integration relative to the gains. In particular, shocks emanating in AEs have amplified and prolonged risks to monetary and financial conditions in EMEs, making macroeconomic management for the latter a testing challenge, especially in view of the large influence of capital flows on macroeconomic fundamentals (Table V.1)⁴.

2.1. Post-Global Crisis Country Experience on Managing Surges in Capital Inflows

V.5 Faced with rapid inflows, Brazil imposed a two per cent tax (Imposto de Operacoes Financeiras or IOF) on portfolio (equity and debt) inflows in October 2009 and subsequently raised it in phases to six per cent (Appendix Table V.1). In addition, it also raised unremunerated reserve requirements on time deposits from 15 per cent to 20 per cent in December 2010. In January 2011, it imposed reserve requirements on banks’ short dollar positions in the cash market. However, anticipating a drop in foreign inflows once the US taper takes hold, Brazil scrapped the IOF tax in June 2013⁵.

V.6 Similarly, Peru introduced a gamut of measures during 2009-10. In July 2009, it enacted variants of controls on capital inflows to stem appreciation pressures (a ban on foreign purchases of central bank bills and increased fees on central bank liquidity draining instruments). In July 2010, it implemented additional capital requirements for forex credit risk exposure. Subsequently, in September, it imposed increased reserve requirements (to 75 per cent from 50 per cent earlier) on foreign currency deposits with maturity of less than two years and those on non-resident domestic currency deposits to 120 per cent (from 50 per cent earlier).

V.7 Indonesia introduced a one-month minimum holding period requirement for central bank paper in June 2010. In November 2010, reserve requirements on local currency deposits were raised to eight per cent (from six per cent earlier). Subsequently, in December 2010, it raised the reserve requirements on foreign currency deposits (from one per cent to eight per cent) and restricted short-term foreign borrowings by banks (to 30 per cent of capital), effective March 2011.

V.8 In June 2010, Korea introduced ceilings on forex forward positions of banks to lower leverage and elongate banks’ funding structure. In January 2011, it re-introduced a 14 per cent withholding tax on non-residents’ purchase of treasury bonds. In August 2011, Korea also imposed a macro-prudential levy on non-core liabilities, with the extent of the levy being higher for non-core liabilities with shorter remaining maturity.

V.9 Against the backdrop of high bond inflows, Thailand announced the re-imposition of a withholding tax on non-resident interest earnings and capital gains in October 2010. Subsequently, in November 2010, it announced a cap on loan-to-value (LTV) ratio for residential property at 90 per cent on condominiums, effective January 2011, and 95 per cent on low rises, effective January 2012.

V.10 In December 2010, Turkey reduced the withholding tax rate on bonds issued abroad by Turkish firms, with lower rates for longer maturities. Subsequently, it halted the practice of remunerating required reserves, raised the levy on interest on consumer loans and introduced LTV ratios for all mortgages.

2.2. Country Experience on Managing Sudden Capital Outflows

V.11 The Fed’s ‘taper’ announcement in May 2013 came as a major event shock for EMEs. As long-term US treasury yields hardened significantly, there was a huge sell-off in bonds all over the globe. Asian markets came under intense pressure as the bond sell-off was accompanied by flight of capital back into the US. Bond yields firmed up across the globe (Chart V.1). Countries that ran large CADs became particularly vulnerable. Equity outflows followed, first in portfolio and then in direct investment segments.

The subsequent announcement in September 2013 of deferment of the QE program moderated near-term uncertainties to a large extent. Moreover, in recent weeks, financial markets have been relatively calm even as the taper started in January.

V.12 Despite limited headroom, EME central banks have undertaken steps to counter stock market slumps and sharp currency depreciation (Charts V.2 and V.3). While some central banks (such as in Brazil and Indonesia) responded in a conventional manner by raising policy rates and using foreign exchange reserves, others have experimented with a range of unconventional policy measures. To illustrate, Brazil announced a US$ 60 billion currency intervention program in August 2013 involving swaps and repurchase agreements with businesses requiring dollars⁶. Turkey’s central bank is reported to have sold US$ 6-8 billion in foreign currency auctions since June 2013.

V.13 In June 2012, the BRICS initiated a plan to establish a US$ 100 billion fund in order to steady currency markets to address the potential fallout of taper spillovers, with participating members being able to draw a specified amount from the pool. Furthermore, countries have undertaken proactive measures towards rationalising non-essential imports in order to shrink their CADs. In June 2013, Brazil removed several capital controls, including taxes on foreign portfolio investments that were introduced in 2009. South Africa, in contrast, maintained an eclectic approach, favouring a market-determined exchange rate and maintaining an accommodative monetary policy stance.⁷

V.14 Faced with sudden capital outflows and adverse ramifications, several EMEs, including India, had to temporarily alter their conduct of monetary policy in addition to other measures. Some countries used short-term interest rates as the first line of defence, while others focused more on managing liquidity. Some countries employed forex interventions in the spot and/or the forward market, while others relied more on forex swaps. Most countries resorted to capital account management, using a combination of measures to encourage capital inflows and discourage or temporarily restrict capital outflows (Appendix Table V.1).

V.15 From this experience, it appears that for dealing with the challenges of globalisation-induced shocks: (a) a wide array of tools is available to central banks and the exact manner of using an instrument could vary; (b) monetary measures may pursue different objectives simultaneously in the face of large and sustained spillovers without compromising the medium-term goal of price stability; (c) forex swaps can be a good short-run tool but their efficacy in the long-run is constrained by difficulties in winding up swap positions; and (d) forex intervention can give some respite, particularly when reserves are perceived to be adequate.

3. Indian Experience

V.16 In recent years, India has faced episodes of surges in capital flows and sudden reversals and has used a combination of exchange rate flexibility, capital controls, monetary measures, macro-prudential tools and reserves to manage them. Since 2002-03, India has faced four broad phases of volatile capital movements, each requiring different monetary policy responses⁸ (Chart V.4). During 2003-2007, capital inflows were a major challenge for monetary policy. Coinciding with the global crisis of 2008, capital outflows and exchange market pressures necessitated unprecedented monetary easing to avert a financial crisis and support a sluggish economy. In the years immediately after the global crisis, QE-induced capital flows helped to finance large current account deficits over successive quarters from Q2:2009 to Q1:2013, but without accretion to reserves and with rising external liabilities (against the backdrop of an appreciating exchange rate in real terms). More recently, sudden and large outflows in response to taper talk since May 2013 required monetary policy to respond directly to exchange market pressures, including through the use of exceptional measures.

3.1. Monetary Policy Response to Surges in Capital Inflows

V.17 Over the period 2003-04 to 2006-07, high growth operated as a ‘pull’ factor for surges in capital inflows, with easy global liquidity conditions providing the key ‘push’. Large inflows in excess of the absorptive capacity of the economy created concerns about erosion in external competitiveness through exchange rate appreciation, possible overheating of the economy and asset price bubbles, besides the growing risk of an abrupt reversal.

V.18 In response, a multi-pronged approach was followed which included, inter alia , phased liberalisation of current as well as capital account outflows; exchange market intervention and partial sterilisation; lowering of interest rate ceilings on NRI deposits; management of external debt through prepayment; moderation in the access of corporates and intermediaries to external debt; and greater flexibility in exchange rate movements.

V.19 Sterilising the liquidity impact of sustained accretions to reserves was the key monetary policy challenge, and a combination of higher CRR, reverse repos and open market operations under the Market Stabilisation Scheme (MSS)⁹ alongside some exchange rate appreciation was used for this purpose, which facilitated distribution of sterilisation costs across the financial system, the Reserve Bank and the Government (Chart V.5).

V.20 Reverse repos and outright OMO sales demanded the availability of adequate stock of government securities with the RBI, which became a constraining factor in sterilisation operations as the volume of capital inflows expanded. Moreover, reverse repo operations involved sterilisation costs, impacting the profit of the RBI, with implications for RBI’s operational independence. Using the LAF as an instrument of sterilisation tended to erode its utility as a day-to-day liquidity adjustment tool operating at the margin (RBI, 2003)¹⁰. It was in this context that the RBI introduced MSS¹¹. As the subsequent experience showed, the MSS brought with it operational constraints that impacted the conduct of sterilisation.¹²

3.2. Monetary Policy Response to Inadequate Capital Inflows/ Sudden Capital Outflows

V.21 Three episodes of drying up of capital and/or reversals are discernible in the recent experience. First, during the Asian crisis and sanctions applied after the Pokhran nuclear tests, i.e., 1997 and 1998, the Indian rupee came under several bouts of pressure. Besides interventions in the spot and the forward segments of the forex market, monetary policy measures were used to tighten domestic liquidity and monetary conditions (Appendix Table V.2). In August 1998, the scheme of Resurgent India Bonds (RIBs) was launched to attract capital flows from the non-resident Indian diaspora.

V.22 Second, the knock-on effects of the global financial crisis required pre-emptive crisis prevention measures, primarily in the form of adequate assurance on making available both rupee and US dollar liquidity in the domestic markets. Despite exchange market pressures associated with capital outflows, interest rate defence of the exchange rate was not resorted to in view of the risks to financial stability and growth. Moreover, there was a significant moderation in WPI inflation after the global financial crisis, which was partly the result of the crisis-driven crash in global commodity prices. Unprecedented monetary easing over a short time span was the chosen response, facilitated by the headroom created by the gradual withdrawal of monetary accommodation from September 2004 to August 2008 in response to inflation. With reverse repos, OMO sales, CRR cuts, unwinding of MSS balances and the opening up of special liquidity windows and lines of credit to apex refinancing institutions, the potential access to liquidity from the RBI was as high as around 10 per cent of GDP.

V.23 Third, the large depreciation of the rupee after May 22, 2013 – one of the highest among major EME currencies – required actions on multiple fronts, driven by the urgency of curbing speculative pressures on the exchange rate, narrowing the CAD and finding exceptional external financing. Taperdriven capital outflows – primarily in the form of debt portfolio flows – narrowed the spread between the G-sec yield and US Treasury yield significantly; the subsequent increase in money market interest rates and G-sec yields in response to monetary policy actions contributed to expectations of further depreciation, driven by uncovered interest rate parity conditions (Chart V.6, Appendix Tables V.3 and V.4).

V.24 In sum, the Indian experience in managing the challenges of two-way capital flows over different phases suggests that: (a) monetary measures address spillovers only indirectly, and are contingent on their impact on the growth and inflation outlook, but monetary measures occasionally have to respond directly to the disruptive impact of capital flows on financial markets; (b) the capacity of the RBI to sterilise/manage the domestic liquidity impact of net forex market interventions would have to be augmented significantly in respect of both inflows and outflows; (c) text book interest rate defence of the exchange rate will have to be an instrument of the first resort in order to “buy” time, but its use and sustainability has to be conditioned by the assessment of costs to the economy from rising interest rates and financial stability considerations; (d) if an external event entails the risk of a global recession which can dampen domestic growth prospects and raise financial stability concerns, preparedness for a swift monetary easing may be necessary, even if the exchange rate comes under pressure without compromising the medium-term goal of price stability; and (e) if the foreign exchange reserves are not perceived to be adequate, monetary measures to avert a free fall in the exchange rate may not be very effective. In these conditions the risks of a failed monetary defence of the exchange rate may get heightened into snowballing consequences propelled by unidirectional expectations and herding.

Recommendations

V.25 In view of the cross country and Indian experience with global spillovers driving episodes of large and volatile capital inflows as well as outflows, a flexible setting of monetary policy by the RBI in the short-run is warranted. This presages readiness to use a range of instruments at its command, allowing flexibility in the determination of the exchange rate while managing volatility through capital flow management (CFM) and macro-prudential measures (including sector specific reserve requirements)

V.26 With regard to inflows that are excessive in relation to external financing requirements and the need for sterilised intervention: (a) the RBI should build a sterilisation reserve out of its existing and evolving portfolio of GoI securities across the range of maturities, but accentuated towards a ‘strike capability’ to rapidly intervene at the short end; and (b) the RBI should introduce a remunerated standing deposit facility, as recommended in Chapter-III, which will effectively empower it with unlimited sterilisation capability.

V.27 As a buffer against outflows, the RBI’s strategy should be to build an adequate level of foreign exchange reserves, adequacy being determined not only in terms of its existing metrics but also in terms of intervention requirements set by past experience with external shocks and a detailed assessment of tail events that materialised in the country experiences. As a second line of defence, swap arrangements, including with regional financing initiatives, should be actively pursued. While retaining the flexibility to undertake unconventional monetary policy measures as demonstrated in response to announcement effects of QE taper but with clarity in communication and better co-ordination, the Committee recommends that the RBI should respond primarily through conventional policy measures so as to ensure common set of shared expectations between the markets and the RBI, and to avoid the risk of ‘falling behind the curve’ subsequently when the exceptional measures are unwound.

V.28 In addition to the above, the RBI should engage proactively in the development of vibrant financial market segments, including those that are missing in the spectrum, with regulatory initiatives that create depth and instruments, so that risks are priced, hedged, and managed onshore.

¹An independent monetary policy is incompatible with a fixed exchange rate and an open capital account.

²Rey, H. (2013): “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence”, Paper presented in the 2013 Economic Policy Symposium, Federal Reserve Bank of Kansas City, Jackson Hole, August 22 -24.

³Farhi, E. and I. Werning (2013): “Dilemma not Trilemma? Capital Controls and Exchange Rates with Volatile Capital Flows”, Paper presented at the Fourteenth Jacques Polak Annual Research Conference, International Monetary Fund, Washington D.C., November 7-8.

⁴IMF (2011): “Recent Experiences in Managing Capital Inflows – Cross-Cutting Themes and Possible Policy Framework”, February 14. Available at www.imf.org/external/np/pp/eng/2011/021411a.pdf, International Monetary Fund: Washington D.C.

⁵Ostry, J. D., A. R. Ghosh, K. Habermeier, L. Laeven, M. Chamon, M. S. Qureshi and A. Kokenyne (2011): “Managing Capital Flows: What Tools to Use?”, IMF Staff Discussion Note 6, International Monetary Fund: Washington DC.

Forbes, K., M. Fratzscher and R. Straub (2013): “Capital Controls and Macroprudential Measures: What are they Good For?”, MIT (Mimeo).

Alichi A., S. Choo Ryul and C. Hong (2012): “Managing Non-core Liabilities and Leverage of the Banking System: A Building Block for Macroprudential Policy Making in Korea”. IMF Working Paper 27, International Monetary Fund: Washington D.C.

Pradhan, M., R. Balakrishnan, R. Baqir, G. Heenan, C. Oner and S. Panth (2011); “Policy Responses to Capital Flows in Emerging Markets”. IMF Staff Discussion Note 10, International Monetary Fund: Washington D.C.

⁶IMF (2013): “Global Impact and Challenges of Unconventional Monetary Policies”, IMF Policy Paper, October. Available at www.imf.org/external/np/pp/eng/2013/090313.pdf, International Monetary Fund: Washington D.C.

⁷In January 2014, the Bank of Japan and the RBI expanded the bilateral swap arrangement between Japan and India from US$15 billion to US$50 billion effective for three years from 2012 to 2015.

⁸During the period of surges in capital inflows (2003-07), the real effective exchange rate of the rupee (REER-36 currency, trade based) appreciated by 11.7 per cent. In the immediate aftermath of the global crisis, reflecting nominal depreciation of the rupee, the REER depreciated by 11.1 per cent between September 2008 and April 2009. Subsequently, between May 2009 to March 2013, the REER appreciated by 15.9 per cent using WPI as deflator, largely reflecting higher inflation differential vis-a-vis the inflation of India’s major trading partners.

⁹The RBI in consultation with the Government of India introduced a new instrument of sterilisation, viz., the Market Stabilisation Scheme (MSS), which empowered the RBI to issue Government Treasury Bills and medium duration dated securities for the purpose of liquidity absorption. The scheme worked by impounding the proceeds of auctions of Treasury bills and Government securities in a separate identifiable MSS cash account maintained and operated by the RBI. The amounts credited into the MSS cash account were appropriated only for the purpose of redemption/buy back of the Treasury Bills/dated securities issued under the MSS. The introduction of MSS succeeded broadly in restoring the LAF to its intended function of daily liquidity management.

¹⁰Report of the Working Group on Instruments of Sterilisation (Chairperson: Usha Thorat), 2003.

¹¹The Reserve Bank had examined two other sterilisation options for India that would have required amendment to the RBI Act – one, to provide for flexibility in determination/remuneration of CRR balances so that interest could be paid on deposit balances of scheduled banks with the RBI; and two, issuance of RBI’s own paper, which was not favoured due to no sustainable progress on fiscal consolidation and the risk of market fragmentation stemming from issuing both Government papers and RBI paper.

¹²The requirement to go periodically to the Government for limit increases in respect of securities provided under the scheme and the time lag involved in approval processes severely circumscribed the effectiveness of monetary policy in terms of timing of sterilisation operations. It also added to the fiscal costs. The issue of ring-fencing of funds that were raised through securities flowing into the consolidated fund of India became a thorny legal issue.