Are too much foreign flows bad?

 Sometime back, we saw that current account surplus position became headache for policymakers because of too much dollar inflows. On one hand, India is a capital starved country and hence we chase after money through FDI. On the other hand, large inflows create problem for Central Bank which faces impossible trinity which states that policy makers can choose any two, but not all macroeconomic objectives - foreign capital mobility, fixed exchange rate and inflation management. Cut interest rates too far and risk scaring off foreign capital. Raise borrowing costs too much to fight inflation and funds rush in, sending the currency higher and strangling exports. 

The developed world central bankers are likely to create more than $10 trillion of new money. Most of it is deployed in the Government bond markets earning next to nothing. Some of this liquidity will find its way into Indian assets as well. 

Let's suppose RBI fixes interest rate independently at 8% because India's inflation is higher. This interest rate is higher than 7% in country 'X' which causes money to flow from country 'X' to India which shall result in appreciation of Rupee. Higher rupee liquidity will cause fall in interest rate leading to higher inflation. So, RBI has to curb capital inflows. This means it can either choose to be independent or control flows.

Similar to impossible trinity in capital flows, recentCentral Bank policies can also be reframed as another trinity - of inflation targeting, liquidity and government bond interest rates or yields. Large government deficits are pushing yields upwards. Higher yields lead to higher interest rates which in turn threaten economic recovery. If central banks increase liquidity to control bond yields, they give up on inflation targeting. If central banks focus on inflation and liquidity, they give up on yields. 



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