All emerging Asian economies are experiencing sizeable capital inflows, fuelled by a combination of flush global liquidity, increased risk appetite, attractive economic prospects, tempting local currency returns on equities, bonds and real estate, and expectations of currency appreciation.
These capital inflows are adding to the dollar glut generated by the sizeable surpluses on the current account of the balance of payments (India is an exception, as it is running a current account deficit), prompting intervention by the central banks to check the pace of currency appreciation.
The current account surpluses are a reverse of the huge deficits in the runup to the Asian financial crisis in 1997. Also, with the exception of China, Asian countries have been more open to allowing currency appreciation.
The current account surpluses in the region (ex China) are partly reflective of weak investment demand, resulting in an excess of saving over investment. Reflation remains a strong theme across the region, with rising property and equity prices, though inflation is a pesky issue predominantly in India.
The influx of capital is causing acceleration in the pace of monetary aggregates. But, unlike India, a benign inflation outlook in most economies offers considerable flexibility in living with faster monetary expansion, at least for now.
Indeed, Thailand and Indonesia have been cutting interest rates, while South Korea, Malaysia and the Philippines continue to be on hold, aided by little concern over the inflation outlook. China has been undertaking a glacial normalisation of its interest rates and the significantly undervalued exchange rate.
All regional economies (ex China and India) have substantially open capital accounts. Thus, a priori, the central banks in these economies should have a more difficult time in juggling the impossible trinity, essentially meaning that a central bank cannot simultaneously have a fixed exchange rate, unrestricted capital movement and an independent monetary policy.
However, a benign inflation outlook in almost all the economies offers flexibility that is not available to India owing to its domestic demand-led economic boom that is causing inflationary pressure and higher interest rates.
Excluding China, all countries have been open to substantial currency appreciation, though central banks continue to intervene in the foreign exchange markets to check the pace of appreciation. Even Malaysia, the original champion of capital controls in Asia, has allowed the ringgit to appreciate.
Additionally, several countries have encouraged capital outflows to ease the build-up in net capital inflows. China and India have also relied on hiking the reserve requirements to check the pace of monetary expansion, while the Philippine central bank has used a more benign measure to check the rapid build-up in excess liquidity.
But the most extreme reaction was by Thailand, which announced draconian capital controls in December 2006, though it had to reverse some of the measures owing to a collapse in the equity market.
The misguided shift toward capital controls came after a hefty 14 per cent currency appreciation in 2006, and a successful political coup in September 2006 that altered the prevailing economic ideology by the incoming military government.
The sizeable current surpluses in the region have kept interest rates in most countries lower than US interest rates. Consequently, sterilisation of the central bank's intervention in some countries (for example, China and Malaysia) does not have a direct cost, as these countries earn more from the investment of their foreign exchange reserves than what they spend on sterilisation.
But India is different from the rest of Asia in one key respect: it is the only country where government policy has actually encouraged more capital inflows, despite the flood of capital inflows that was already causing problems for the RBI. Indeed, last year the government increased the ceiling on external commercial borrowings (ECBs) twice to the current limit of $22 billion. There is a very good chance that the ECB limit was breached in 2006-07.
Surely one needs to question why a limit is there in the first place if the government cannot enforce it! But more importantly, the increase in the ceiling made managing capital inflows more challenging and compromised the effectiveness of monetary tightening.
The government finally acted to lower the interest rate ceiling over Libor for ECBs and has also banned the use of these funds for integrated townships, but has maintained the ceiling of $22 billion.
Essentially, the government is partly sending a signal that it is comfortable with the aggregate ECB-related capital inflow but only if the borrowings are by companies with much better credit profile. But what matters for monetary management is the volume of capital inflows.
Or the government is hoping that the revised guidelines will substantially lower capital inflows, though what will happen is that firms with strong credit ratings will still be able to borrow significant amounts, adding to capital inflows and making life difficult for the RBI.
The absence of a cut in the ceiling has been defended on the ground that a reduction will send a signal of reversal in a key reform. Surely, this cannot be taken seriously: last year's hike in the ECB ceiling undermined the RBI's monetary agenda and unnecessarily jeopardised monetary management. Basically, a policy oversight is being sold as a reform measure.
A striking feature of the current cacophony over the appropriate exchange rate policy for India is that the debate confuses several issues that individually have some merit, but collectively miss a key point: the RBI and the government need to first decide on dealing with capital inflows when there is an overriding need to maintain a tight policy.
Unlike the rest of Asia, India is moving to dismantle the restrictions on capital account transactions. It thus has a choice of the pace of easing bearing in mind the constraints imposed by the current tight monetary policy. The government's continued approach of providing a way out for companies to raise money overseas, despite being aware of the RBI's tight monetary policy and concerns over the difficulty in managing capital inflows, appears irresponsible.
There is a healthy consensus on further opening up the capital account, but the timing and scope of easing should not risk destabilising monetary management. The government should pay more attention to the concerns of the RBI, and design consistent policies rather than undermine the RBI's efforts and credibility. Ideological extremism is hardly what the government needs to pursue in the current challenging economic setting.
The writer is executive director at JPMorgan Chase Bank, Singapore. The views expressed are personal.