For A Few Dollars Less

Why India needs to curb portfolio inflows to regain monetary policy autonomy from rich world travails

For a Few Dollars Less

Tanking stock markets may not be the best background in which to discuss curbing portfolio inflows into India. But to insulate Indian policymaking from the fickle twists and turns of the US Fed and regain monetary autonomy, India must impose capital controls on short-term portfolio flows.

This is no longer heresy even for the International Monetary Fund. IMF's Integrated Policy Framework includes, apart from monetary and exchange rate policies, capital flow management and macroprudential measures. Now, capital flow management is to capital controls what the birds and the bees are to sex education.

The situation is rather straightforward. Rich, Western economies are characterised by three unhelpful features: stubborn inflation, rising interest rates and a tight labour market. Unemployment is at historic lows in the US and the EU, and within the EU, in Germany. A tight labour market prevents higher interest rates from dampening demand and price rise.

As prices rise, workers seek higher wages in a tight labour market. Because workers are hard to come by, wage demands are met, more often than not. In Europe, the demand for higher wages is backed up with industrial action. While layoffs in the tech sector keep making news, the reality is that the US economy has been adding, month after month, lakhs of new jobs, and the unemployment rate in February was one of the lowest since 1969.

US Fed chairman Jerome Powell recently testified to the US Senate that interest rates could rise faster and for longer than previously assumed. The labour force participation rate peaked in the US in 2000, at 66%.

This ratio measures the proportion of the working-age population available for work: either employed or looking for work. Before the pandemic struck, it had already come down to 63.3%, and during the pandemic, it went down to 61.1%, and the last reading was 62.5% in February 2023, still below the pre-pandemic level. This rules out the still vigorous demand for labour being met with supplies from within the US.

That leaves immigration, as a way to replenish the ranks of potential workers. But immigration is stymied in partisan warfare between Republicans and Democrats in the US and in growing xenophobia across Europe, spanning the supposedly liberal Nordic countries and Italy, whose prime minister hails from a party whose forerunner used to hail Mussolini.

In the absence of liberal immigration, the rich world will continue to witness an unremitting wage-price-interest rate spiral. In the US, the government's Inflation Reduction Act is poised to induce large-scale investment in new energy-transition industries, even as the earlier CHIPS and Science Act and the Infrastructure Act are also showering incentives worth many hundred billion dollars on new ventures. This will spur demand for new workers.

That promises a combination of worker shortage and wage spiral, the like of which has not been seen in recent US memory. The only policy response the government would have, in the absence of any political will to open up immigration, is to raise interest rates further. Powell was not joking when he said that US interest rates would go up more sharply and for long.

As the US Fed keeps raising its policy rates, central banks in emerging markets such as India come under pressure to raise their own policy rates, to prevent further outflows of capital from the markets depressing the exchange rate. A depreciated local currency imports inflation, especially via the price of energy.

But higher interest rates inhibit the large-scale investment that India has sought to trigger in the current year, with GoI seeking to crowd in private investment with its own budgeted capital expenditure of ₹13.7 lakh crore, including grants for capital formation.

Passively to let our monetary policy be determined by the policy choices or compulsions of the Fed and the European Central Bank is to undermine our domestic growth agenda. That cannot be permitted. We cannot let foreign finance dominate our monetary policy and sacrifice much-needed growth that would create jobs, incomes and tax revenue.

We have to pay a price for such policy autonomy. That price is a few dollars less of portfolio inflows. Let in all the FDI that wants to come in, and all the portfolio flows that seek to stay put for at least a year. But curb the footloose capital that flows in looking for thin arbitrage opportunities and waits to stampede out at the slightest hint of a higher return back in their home economies, as policy rates are ratcheted up yet again, to combat unrelenting inflation.What would we lose with smaller portfolio inflows? Our stock prices would come down somewhat. Our mega billionaires would probably turn into the garden variety of billionaires. India's price-to-earnings and price-to-book ratios  would lose their feverish quality. And, more substantively, liquidity in the system would come down. We can easily live with all this.

When capital curbs are announced, expect a foreign portfolio investment (FPI)-led explosion of scandalised protest, a big outflow of hot money and downward pressure on the rupee. Then things would settle down to a more stable state of affairs, in which our monetary policy is free to respond to our inflation data and our growth requirements, instead of being held hostage to Republican tantrums against the Biden administration.