Capital account liberalization and conduct of monetary policy: the Indian experience

Abstract

The distinguishing feature of our overall reform process initiated in the early 1990s has been the acceleration in growth while maintaining price and financial stability even in the face of large and repeated domestic and foreign shocks. This successful outcome can be attributed, inter alia, to our calibrated and cautious approach to capital account and financial sector liberalization and our encompassing approach – multiple objectives and multiple instruments – to the conduct of monetary policy. For emerging market economies like India, monetary policy and exchange rate regimes have necessarily to be operated as fuzzy or intermediate regimes not obeying the almost received wisdom of purist approaches. The judgement on the legitimacy of such a regime must be based on their efficacy as revealed by the outcomes. On this count, India's macroeconomic, monetary and financial managers can justifiably claim a reasonable degree of success: economic growth is high and accelerating; inflation has shifted to lower sustainable levels; savings and investments are growing; financial markets have been growing and developing in an orderly manner; the health of the banking system has improved continuously and is approaching best practice standards; the external account is healthy in the presence of robust trade growth in both goods and services; increasing capital flows indicate growing international confidence in the Indian economy; and the Indian exchange rate has been flexible in both directions providing for reasonable market determination, in the presence of central bank forex interventions. As we ascend to a higher growth path, and as we have fuller capital account convertibility, we will face newer challenges and will have to continue to adapt. The key point is that with greater capital account openness, we have to develop markets such that market participants, financial and non financial, are enabled to cope better with market fluctuations. As we do this, we need to be cognizant of the vast range of capabilities of different market participants in as diverse a country as India: from subsistence farmers to the most sophisticated financial market practitioners.