It has been tragically amusing to see the government of India address the problem of "copious" capital inflows. These inflows are the result of some very bad policies that the government - the finance ministry (MoF), the Reserve Bank of India [Get Quote] (RBI), and Sebi - has advocated and implemented. The policies need correction, and how we correct the policies will determine whether or not copious is transformed into normal. The new policy on FIIs is an improvement in that it bans off-shore derivative trades.

In its present so-called improved form, however, it will not decrease capital inflows. That will only happen once all Indian stock market activity moves on-shore.

In the next two articles, (this and one appearing on Monday) I will try and explain why the policies have been bad, why they have been advocated, and what new policies should be implemented. Again, the objective of the new policies is identical to the goals of the government - stable, potential, inclusive growth.

And less capital inflows. Even advocates of unrestrained capital inflows do not contest the fact that in recent years, and especially in recent months, such inflows have become problematic. The direct effect of such inflows is to potentially reduce interest rates (which is a good outcome) and potentially appreciate the exchange rate - a bad outcome since a stronger currency affects competitiveness, and jobs, and the GDP growth rate.

The policy regime in India has so far been a case of not one but several self goals. First, we increased interest rates. This caused more capital to flow into India to take advantage of the higher interest rates.

Second, we allowed foreigners to legally hold positions in the stock market well in excess of the position limits prescribed by our own laws (this via P-notes). This led to excess capital inflows. Third, we prevented non-resident Indians from participating in the Indian stock market, while simultaneously making it more attractive for foreigners to invest in India.

Fourth, once the induced capital inflows came (and induced by our own self-goal policies), we threw up our hands and our minds and claimed that we could not cope with the onslaught of money; so we had to let the currency appreciate. So much has been our self-admitted incompetence in handling currency inflows that the rupee appreciated by the largest amount among all developing economies - by about 12 per cent, with most of the appreciation occurring around the Ides of March. Why incompetence - because almost all Asian economies have faced copious capital inflows. But all of them have got the best of both worlds - lower interest rates and minimal currency appreciation. Only we unabashedly (and rather embarrassingly) claim that we are incompetent to stem the capital inflow.

This incompetence has further increased capital inflows. Today, post-March, foreign speculators (foreign investment banks and their FII accounts) correctly smell blood.

Investments into India are now almost as riskless as they can possibly be. If the Indian authorities were incompetent to handle $7 billion (portfolio inflows in the last fiscal year) how could they possibly handle double that amount?

So the wink-wink word among savvy investors is that the Indian authorities are there for the taking. Why? Because a small country like Singapore can handle capital inflows, as can an OECD economy like Korea. But not uniquely incompetent India. So the recommendation of the mother gorilla of all "carry" trades - short the US stock market and long the Indian stock market.
The minimum worst-case scenario: 20 per cent extra gain each year - 10 per cent extra from the stock market and 10 per cent gain in the rupee. The investment banks have duly trotted out "expert" research to supplement the self-serving view that the rupee will be (should be!) 37 next year, 35 the year after, etc.

Gleefully hidden in the investment bank FII writings is the belief that this scenario will happen because of the self-confessed self-goal helplessness of the Indian policy makers.

Not one of the above five mistakes are followed by any other country in the world. How can we so massively get so many policies wrong? These puzzles about Indian economic policy have not been given the due attention they deserve. Attention should be paid to the right issues - why do we need FII licensing? Why should real interest rates be so high? This attention should not be diverted with obfuscation about hedge funds, laundered money and the like - as manifested by some self-interested private experts and some government officials.

The correct policy is in two parts. First, the authorities should completely eliminate the licensing of FIIs. Instead, there should be mandatory registration with Sebi. If the investor passes the KYC norms of the foreign and domestic banks, and subscribes to the laws of India, e.g. position limits below the allowed levels, she should be allowed to invest. Only on-shore derivative trades (with exposures also prescribed by law) should be allowed. Banning off-shore derivative trades (the only good outcome of the recent P-note imbroglio) is a welcome step. Note that this is not capital controls as some self-interested FIIs have self-righteously claimed. Off-shore derivatives allowed FIIs to achieve higher than allowed levels of exposure to Indian stocks - and hence helped cause copious inflows.

The second part of the transparent policy package (TPP) is to immediately move towards reducing interest rates by at least 100 to 200 basis points. Such high interest rates are propagated by those who ill-advisedly believe that the economy is overheating at 8.5 per cent; and also advocated by the tarnished egos of outdated monetarists. (There is considerable overlap between the two.)

The two policies together should lead to lower real interest rates, greater competitiveness, and less pressure on the exchange rate. Lower real interest rates can lead to overheating when rates are very low - not the case in India since real interest rates in India are among the highest in the world (see table).

This is based on the most comprehensive measure of inflation. The useless debate about whether the CPI or the WPI should be used is not necessary if one uses the price index for the entire economy, i.e. the GDP price deflator. A depreciating currency can lead to overheating, and therefore is a bad policy, when the current account is in surplus. Again, with perennial and large current account deficits, this is not the problem in India.