When Thailand introduced capital controls in the last few working days of 2006 one was compelled to revisit the subject of capital flows and their impact by comparing similar events that unfolded a decade back.

The crisis then (in 1997) had resulted in an Asian currency contagion when capital flight from Thailand triggered the collapse of the Thai Bhat, which in turn resulted in the collapse of various markets and currencies across continents.

If the sudden capital flight away from Thailand led to the swift fall of the Thai Bhat, the problem is exactly the opposite a decade later: significant capital inflows had resulted in a considerable appreciation of the Thai Bhat.

Paradoxically, this time around the excess capital inflows were found to be having a debilitating impact on the Thai economy as an appreciating Bhat was found to have a debilitating impact on the Thai economy.

In fact this is exactly the problem that India is facing for the past few months. When the Reserve Bank of India [Get Quote] allowed the Rupee to appreciate approximately by 10% in the recent months, Indian exporters are reported to have lost exports markets to their competitors significantly.

At the root of the current conundrum is the fact that post Asian currency crisis many countries found virtues in a weak currency resulting in 'competitive devaluation.' Under this scenario, many countries adopted a mercantilist policy to maintain their competitiveness with their central banks intervening in the currency markets by buying forex reserves, against their own currency.

This fetish of accumulating forex reserves, predominantly the US dollar, had a two-fold objective: buying forex would increase their reserves to greater levels in order to insulate their currencies from speculators as also to ensure that the value of their currency remains competitive.

But this arrangement too has its share of complications. For instance, when the central bank is unable to buy the US dollar for whatever reason, the rupee rises against the dollar -- just as the Thai Bhat rose by 16% against the dollar within months.

The Thai Central Bank panicked and introduced a tax on inward portfolio investment. After share prices fell by 15% in a day, the controls were hastily removed.

The drastic measures ushered in by the Thai authorities highlight the seriousness of a dilemma faced by central bankers elsewhere: how to curb domestic liquidity caused due to increased capital flows (which triggers domestic macroeconomic imbalances).

Understanding the sterilisation process

Let us understand the implications of all these on the Indian economy, which too has been flooded with excess foreign exchange inflows in the past few years. When RBI injects the corresponding Rupees into the economy for the US dollars received by it, it results in a rather disturbing situation of too much Rupee chasing too few goods -- the classical situation for inflation.

To precisely prevent this, the RBI sells securities to suck out the Rupees released into the economy. This operation of the RBI -- of sucking out the extra Rupees in the economy through the sales of securities it holds -- is technically called 'sterilisation.'

While allowing temporary and minor fluctuations, the RBI's stated policy has been to repeatedly intervene in the currency markets to ensure a relatively stable exchange rate for the Rupee while ensuring that the Rupee remains competitive vis-�-vis other currencies.

Unfortunately, this interventionist policy has its own limitations as the sterilisation process by itself becomes increasingly costly as a country accumulates reserves. It may be noted that the returns on the forex reserves held by RBI are typically lower than what it has to pay on the sterilisation bonds it has issued, with the differential interest costs to be absorbed by it.

What is important to note is the economic consequence of the sterilisation process and the costs involved. For instance, if the net inflow of capital continues as witnessed in India in recent times, then sterilisation will become endless and this could result in inflation with continuous upward pressure on interest rates.

Such increase in interest rates will only attract more forex flows and add to the upward pressure on the rupee to appreciate.

RBI on the horns of a policy dilemma

This leaves the RBI on the horns of a policy dilemma. If it shies away from buying dollars, the Indian rupee will appreciate fast and exporters will raise a hue and cry as it is happening for the past few months.

On the other hand, if it makes large-scale purchases of the foreign exchange, as it has been doing hitherto, money supply will increase causing inflationary pressures. Surely, while this will dampen the appreciation of the rupee, it would definitely impact interest rates and lead to other consequential macroeconomic imbalances causing higher inflation.

In order to check inflation if the RBI increases the interest rate, it could well lead to a greater inflow of foreign funds leading to a interest rate -- currency rate -- inflation cycle.

Thus, a managed-float of the Rupee as well as forex reserve accumulation caused by relatively weak domestic absorption of foreign capital has resulted in a significant challenge to the RBI on the monetary management front.

Alhough RBI has been highly effective in effectuating its sterilisation programme in moderating the control over the money supply within the economy, sterilisation costs are indeed becoming an issue.

Further, the buoyant growth witnessed in recent years in Indian economy had fuelled a demand for increased commercial credit, which has eased the pressure on monetary management in a significant manner.

In fact, thanks to the dexterous management of the situation by the RBI one feels that India had virtually achieved the mythical trinity of having capital flows, maintaining exchange rates and managing its monetary situation.

Nevertheless, some economists have repeatedly argued that the recent surge in capital flows is in response to positive return on investments in the face of a stable exchange rate.

Yet others are of the view that high reserve policy has run its course and must be abandoned in favour of a flexible exchange rate regime. It has to be noted that every economy has to pay some (implicit) costs while integrating with the global economy -- whether by sterilisation or through an appreciation of the Rupee.

When more or less is more or less a problem

The experiences of Thailand as mentioned above (or even that of India) suggest that managing forex flows is indeed a complex issue, far too complex than was originally imagined.

Experiences clearly demonstrate that this is certainly not an unmixed blessing. When the flow dries up as it did in the mid-nineties in East Asian Countries it created a crisis and when there is a sustained inflow as recently Thailand discovered, there is a problem, albeit of a different proposition.

To the eternal credit of RBI, India has managed forex flows rather well till date. However, if the Thai experience is any indication, sustained flow of forex into an economy is also fraught with huge risks. Abrupt currency revaluation due to sustained inflows would be as much an economic risk to Asian economies as abrupt currency devaluation was during the Asian currency crisis.

In fact, if the experience of the past few months in the Indian economy is any indication, it may be noted that RBI has allowed the Rupee to appreciate as a policy response.

While the Rupee has appreciated by approximately 10% since March 2007, it may be noted that it has been having a significant and debilitating impact on our exports. However, the appreciation of the Rupee did not dampen the sustained flow foreign exchange into the country, especially on the capital front.

While capital flows cannot (and in my considered view should not) be stopped, what is needed is a policy alternative that is suited to the Indian conditions.

Disengaging with the world is surely not acceptable but as it may seem as explained above, simply unsustainable. Naturally, the world over, economists -- especially in developing countries -- are caught on the horns of a policy dilemma.

It may be noted that the solution to both the scenarios -- excessive flow of capital as well as flight of capital is identical: capital controls -- read reversal of the globalisation process itself.

How much have times changed? Or have they? While one is uncertain whether the endgame in globalisation has begun or not, surely, the recent experience of Thailand (as well as India) has well demonstrated to all developing nations that more or less of forex flows is more or less a problem.

All these call for a complete revisit of the fundamental assumptions governing the Indian economy since reforms. For long we have held exports to be the chief driver of our economy, completely ignoring the fact that this is a country with a market of a billion plus.

Foreign players have a choice of ignoring India, albeit at a tremendous cost. The Government of India or the players from India do not even have that luxury.

It is time that we recognise this fundamental verity in formulating policies for the country. It is time that we think of boosting domestic consumption as a fillip to the Indian economy.

An exports-led model may as yet suit smaller countries like Taiwan, Singapore and Hong Kong. But when larger countries like Thailand, Malaysia and even China are having a rethink, it is time for India too to have a rethink.

Part II: Why we may turn back to Swadeshi economics

The author is a Chennai-based Chartered Accountant. Comments are welcome at mrv1000@rediffmail.com