The chapter on India promises to be a riveting tale of how the government successfully managed to make things worse for the RBI and for itself in dealing with capital inflows. It did this in two key ways. Firstly, it surprisingly misread the evolving economic trends toward acceleration in economic growth and related risks to inflation that would warrant tighter monetary policy (forget about getting any help from fiscal policy).
Indeed, the focus seemed to have been on higher and higher economic growth, with puzzling claims that suggested higher investment spending in an economy already growing above its realisable potential is non-inflationary in the short term.
It was conveniently forgotten that a boost to economic activity - even if it were designed to expand capacity eventually - would worsen demand-driven inflation pressures in the near term. The inflation scare, driven by both demand and supply factors, finally forced the government to undertake a reality check.
Secondly, the government appeared to favour a cowboy-style accelerated pace of capital account liberalisation at a time when the central bank was already having difficulty in dealing with the existing magnitude of capital inflows. These signals were being sent out at a time when unprecedented global liquidity was sloshing around searching for higher returns and waiting to be parked. Obviously, more capital came India's way, further complicating economic and monetary management.
The lack of policy coordination between various policymakers, and the widely reported counter-productive undermining of the central bank only worsened the problem for the RBI and, ultimately, for the government. Financial markets thrive on policy inconsistencies and differences between policymakers.
Indeed, the finance ministry's reported disagreements with the RBI on some policy issues only served to cement expectations that the ministry would have its way, and the non-independent central bank will have little choice but to capitulate (reality turned out to be different, vindicating the RBI's concerns and its stance).
Most importantly, the case study will show how the government was romancing higher capital inflows without first - or concurrently - preparing the economy for the surge in capital inflows. The government's approach seems to be similar to the advice given to a new driver to step on the accelerator when the car he is driving hits a slippery patch.
India's inability to deal with capital inflows is partly a result of the government doing less of what it should do more of, and doing more of what it should do less of. There is precious little in terms of economic reforms, but the government has gone to great lengths to encourage more capital inflows. Of course, it is a different matter that it was totally overwhelmed when it got what it had wished for.
Essentially, the government was signalling accelerated capital account convertibility that was poorly timed, without adequate preparation, and without ample tools to deal with the resulting flood of capital. The RBI was basically left in the lurch to deal with increased capital inflows. The signals of accelerated pace of capital account convertibility only fuelled expectations of further rupee appreciation, already in place owing to a combination of the attractiveness of India's economic rise, weaker US dollar and surging global liquidity.
Unfortunately, these signals were being transmitted without any meaningful reform-oriented changes in the real economy that would increase the absorptive capacity of foreign capital inflows and also justify further real exchange rate appreciation.
One sensible shift that appears to be taking place now is that the calls for a totally hands-off approach toward the rupee are either receding or being altered to more practical and palatable approaches. The key is to manage the pace of rupee's appreciation, and that will be dictated by the political tolerance for the "pain" inflicted by the rupee's strength.
So far, we have only seen the hit on exporters' margins and job losses in some labour-intensive export industries. The next round of pressure - admittedly with a lag - will come from how cheaper imports impact domestic producers. One could be more confident that the broad private sector, especially the unlisted one, will be able to effectively deal - perhaps even surmount this challenge - if the government was doing its bit in making the India story even better by moving rapidly on infrastructure and education. But the approach toward education appears to be an enigma wrapped in a riddle, while there is more talk than action on infrastructure.
The only sustainable solution in dealing with capital inflows lies in increasing the absorptive capacity of the economy for these flows. The government needs to undertake reforms that will lower structural rigidity in India's inflation owing to supply constraints and infrastructure bottlenecks. Such initiatives will facilitate foreign capital to fuel higher levels of sustainable non-inflationary growth. There is only so much monetary policy can do for lowering trend inflation expectations; the real upside lies with the government moving forward on reforms that enhance productivity.
A lack of preparation in and the limitation of tools to deal with surging capital inflows have pushed the government and the RBI in a corner. As anyone can make out, the track record of what has been done in the last two-three years to justify greater real exchange rate appreciation is pretty sad. Having worked hard to fuel expectations of outsized rupee appreciation, the government is now on the back foot, as it is finding the recent appreciation pressure unbearable.
It is fair to say that the recent restrictions on some kinds of capital inflows have worked, as the magnitude of these specific inflows would have been even higher in the absence of the restrictions. Further, the restrictions were also meant to check the misuse of these channels. But restrictions are hardly a sustainable approach.
It is important for the government to move forward by adequately preparing the economy for capital inflows. Not doing anything is not an option, and such an approach risks the government being blamed for spoiling the India story.
Undertaking more economic reforms is not easy but has to be done: the government can either manage the process or competitive forces will bring it upon us in a lopsided manner. The ball is in the government's court.
The author is Executive Director at JPMorgan Chase Bank, Singapore. The views expressed are personal.