Capital flows and financial fragility in India

The Indian economy has been experiencing a surge in volatile capital flows since 2003-2004 and gained unprecedented growth in 2007-08. It is pertinent to note that sudden capital flows are associated with credit and investment fluctuations, real exchange rate misalignments, current account imbalances and weakening of financial sector culminating into sharp booms and busts. In light of this, an attempt has been made to find out the impact of volatile and reversible capital flows over the macroeconomic variables. The paper assesses components of capital account and the way they create fragility in the financial system. Further, a linkage between monetary policy, floating but managed exchange rate, and capital flows is attempted. In the light of surge in foreign investment flows, the RBI has been proactively intervening in the foreign exchange market through sterilization to minimize the exchange rate movements and thereby helping in sound management of trade balances. Moreover, adequacy of reserves in gauging the ability to absorb external shocks is being questioned. However, there is a cost of holding borrowed reserves in terms of higher interest paid on the government securities and lower returns earned on the foreign exchange reserves. Therefore, it is indispensable for the Indian economy to tackle the capital flows very cautiously as this could lead to the financial fragility and make the economic system unstable and prone to crisis.