Macro-economic management of the Indian economy: capital flows, interest rates, and inflation

This paper addresses the issue of surge in capital inflows into a relatively open emerging economy. One of the constraints in dealing with surges is that much of the theoretical analysis is motivated by developed economies with well developed capital and money markets, while emerging economies are characterised by missing market segments and incomplete integration of such markets. It tries to use the existing literature and empirical information on the concerned economy to derive practical policy suggestions for meeting and balancing the objectives of inflation control and sustained growth. One of the noteworthy recommendations is the introduction of an auctioning mechanism for the right to incur foreign debt. This is designed to correct or compensate for the negative externalities arising from such cross-border debt, given the possibility of sharp reversals arising from global external developments and global shocks. The auction of rights to borrow can act as a variable tax that taxes short term flows at a higher rate and adjusts to changing environment. A limited version of such auctions has been tried sucessfully under the supervision of the Securities and Exchange Board of India. The global environment that gave rise to this issue in India has changed dramatically the US financial crisis and global recession. The analysis however, stands and may be useful when the global situation returns to normal and another emerging economy is faced with a similar situation.