Foreign Capital Inflow

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Effects of Foreign Capital Inflow on the Economy

Recently India’s Home Minister Mr. P. Chidambaram pointed out that surge in foreign capital inflow can be a cause of the rise inflation rate in the economy. This is true! With opening up of the economy, foreign capital has become one of the important factors affecting our economy. The country’s economic policies have changed. We are now an open economy affected by the economic and political happenings of the world. We therefore need to broaden our handling of domestic economic problems like inflation. Inflation is no more only due to supply constraints caused by domestic supply constraint caused by poor monsoon or floods. It is affected by global demand and supply of goods and capital.
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The surge in inflows should be matched with a corresponding growth in the absorption capacity of the country. It should be used for investments that cannot be otherwise undertaken by the country. For handling inflows better, the fiscal deficit has to be kept in control. A strong, deep financial system is required to utilize as well as cope with the highs and lows of foreign capital movements.

The traditional method adapted by Central banks to countering the effects of excess inflow (known as sterilization of capital flows) is to reduce the domestic component of the monetary base. This is done by methods like the open market operations, by selling Treasury bills and other instruments or raising the repo rate and CRR etc. But this traditional method has limited effect as instruments can be sold or interest rate can be raised only up to a certain limit. The bank faces a tricky situation here. Excess foreign capital inflow causes inflation; to check inflation Central Bank hikes interest rate; high interest rate attracts more foreign investments. Also, too much tightening of the monetary policy may hamper investment in the country. The government should therefore look into other ways of countering the negative effects of surge in capital inflow.

Some possible economic policies that can help to absorb inflow while maintaining an adequate monetary base in the
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