Abstract:
The East Asian crisis of 1997-98 and the Mexican crisis of 1994
generated much concern among policy analysts regarding the role of
macroeconomic policies in the management of capital inflows. A series
of economic reform measures including liberalization of foreign capital
inflows were initiated in India since the early nineties. Using the vector
autoregression (VAR) method, this paper specifically examines if the
external shock generated by capital inflows led to appreciation in the
real exchange rate as observed in the East Asian and Latin American
countries in the 1990’s. The role of monetary and fiscal policies in
managing the effect of capital inflows on the real exchange rate is also
analysed in this context. Based on the quarterly data from 1993.2 to
2001.4 and incorporating the variables such as the real exchange rate,
capital inflows, the rate of growth of domestic credit and the rate of
inflation, three important observations emerge from the VAR analysis:
(a) unlike the East Asian and Latin American countries, the real exchange
rate depreciates with respect to one standard deviation innovation to
capital inflows, (b) the dynamic impact of random disturbances generated
by capital inflows on the real exchange rate is persistent, and (c) the
dynamic response of the real exchange rate to capital inflows shock has
largely been influenced by monetary policy and not by fiscal policy.
The paper argues that the monetary policy was effective in avoiding
any serious distortion in the real exchange rate following the
liberalization of capital inflows in India while sacrificing its long-term
objectives. It addresses two limitations in the existing macroeconomic
policies i.e. (a) lack of fiscal consolidation and (b) lack of capital control
instruments which seems to have created undesirable pressure on the
monetary policy to realize its long-term objectives in the regime of
liberalized capital inflows.
