A speculator who looks back sees that episodes of capital controls, or increased MSS limits, merely served as forecasts of future rupee appreciation. Not surprisingly, speculators know that either the rupee will stay where it is, or it will appreciate. In other words, the rupee is a one-way bet. The belief that the rupee can move only in one direction is leading to large amounts of speculative capital coming into India. This is larger than what it would have been had the rupee moved both ways and witnessed genuine volatility as in the currencies where central banks do not intervene. The policy of the RBI buying dollars might have been created to prevent rupee appreciation, but it is actually increasing the pressure on the rupee to appreciate. Critics of globalisation harp on unstable capital flows. But it is the policy mistakes of the government that are destabilising the capital flows.

The best way for India to respond to the surges in capital flows is to let the rupee be flexible. As a fast growing economy, India will continue to attract capital, but the short-term speculative capital betting on rupee appreciation would be reduced. Further, concerns about job losses in export sectors such as automobile parts, textiles and leather could be addressed by giving direct compensation to workers and meaningful retraining programmes. Not only would it prevent distorting the entire Indian economy in order to be geared to supplying the US consumer with cheap Indian goods, even the costs of these programmes would be lower than the fiscal cost of this policy today.

... contd.