With the liberalization of balance of payments, the monetary policy scenario in India underwent a sea change. While the merits and demerits of capital account liberalization have been debated, it is still not clear as to what extent the Indian economy has integrated with the global economy. There are basically two choices: either integrating with the international economy at a measured and orderly pace, or letting the world integrate with us in a disorderly manner on terms dictated by the international economy. The objective of macroeconomic management is to tailor the policies so as to maximize the gains of global integration while minimizing the adverse features of globalization. This article captures the dilemmas and challenges of formulating a favourable monetary policy and studies and projects the implications of the changing dimensions of monetary policy on the different parameters determining the banks� growth path. In the absence of RBI�s intervention, persistent capital inflows into the country could result in an unrestrained monetary expansion and a real effective exchange rate (REER) appreciation which in turn is likely to end up in a crisis. RBI has used a combination of the market stabilization scheme (MSS), the reverse repo, and the cash reserve ratio (CRR) to tackle the problem of excess liquidity. As CRR is considered a blunt instrument, RBI is suggested to use incremental cash reserve ratio to immobilize the excess liquidity from where it is lodged. In an extreme situation of excessive capital inflows, the author suggests the use of unremunerated reserve requirements on fresh inflows by foreign institutional investors. For the banks, large capital outflows could lead to a more difficult situation as pumping in of created money to restore liquidity could trigger further capital outflows. Remedial measures such as raising of interest rates, tightening of liquidity, and depreciation of exchange rate will have to be implemented in a non-disruptive manner so as to ensure that the economy does not go into a state of panic. For formulating a viable monetary policy, what is most important is to set objectives in such a way that there is a clear agreement between the government and the RBI. The present structure of the banking system is not conducive to the development of a strong and vibrant financial structure. There have been repeated recommendations to reduce government holding in public sector banks because of the government�s inability or reluctance to provide more capital to these banks. In the overall rapidly changing globalized scenario, the banks cannot remain isolated; they too need to keep pace and should therefore join the bandwagon.
How Effective are Capital Controls?
