Overdose of foreign capital triggering rupee fall: Viral V Acharya

An overflow of foreign funds, especially through capital markets as short-term investments, only helps to make the monetary system volatile and destabilise the exchange rate mechanism, Reserve Bank of India deputy governor Viral V Acharya has said.

An overdependence on foreign capital to ease financing pressures on expanding government balance sheets to offset the crowding out of funds by the private sector can trigger a collapse of the exchange rate with adverse economy-wide spillovers, if there is a “sudden stop” or exodus of these flows
While greater supply of money can facilitate ease of financial transactions, including the financing of government deficits, this can cause economy to over-heat in due course and trigger (hyper-) inflationary pressures or even a full-blown crisis that eventually require sharper monetary contractions, he said while delivering the A D Shroff Memorial Lecture in Mumbai on Friday..
Also, he said, excessive lowering of interest rates and/or relaxation in bank capital and liquidity requirements can lead to greater credit creation, asset-price inflation, and semblance of strong economic growth in the short term, but excessive credit growth is usually accompanied by lending down the quality curve which triggers mal-investment, asset-price crashes, and financial crises in the long term.
Sweeping bank loan losses under the rug by compromising supervisory and regulatory standards can create a façade of financial stability in the short run, but inevitably cause the fragile deck of cards to fall in a heap at some point in future, likely with a greater taxpayer bill and loss of potential output.
Political expediency often forces governments to compromise much needed interventions and structural reforms required for stable growth for populist expenditures in order not to displease incumbents. As a result, it might seem as an expedient solution to the government to ask/task/mandate/direct the central bank to pursue strategies that generate short-term gains but effectively create tail risks for the economy. 
To protect the economy from such short-termism, the central bank is designed to be at a safe distance from the executive branch of the government, he said.
Now, although the central bank is formally organised to be separate from the government, its effective horizon of decision-making can be reduced for short-term gains by the government, if it so desires, through a variety of mechanisms, inter alia,
  • Appointing government (or government-affiliated) officials rather than technocrats to key central bank positions, such as governor, and more generally, senior management;
  • Pursuing steady attrition and erosion of statutory powers of the central bank through piece-meal legislative amendments that directly or indirectly eat at separation of the central bank from the government;
  • Blocking or opposing rule-based central banking policies, and favoring instead discretionary or joint decision-making with direct government interventions; and,
  • Setting up parallel regulatory agencies with weaker statutory powers and/or encouraging development of unregulated (or lightly regulated) entities that perform financial intermediation functions outside the purview of the central bank.
Efforts that undermine the independence of central banks, if successful, induce policy myopia in the economy that substitute macroeconomic stability with punctuated arrival of financial crises, he said.
When governments make efforts to dilute the central bank’s policies and effectively coercing the central bank into such dilutions, banks and private sector spend more time lobbying for policies that suit them individually, at the cost of collective good, rather than investing in value creation and growth.
And, when important parts of financial intermediation are kept outside the purview of the central bank, systemic risks can build up in “shadow banking” with private gains in good times to a small set of players but at substantive costs to future generations in the form of unchecked financial fragility, he added.
The central bank, he said, can make mistakes, and is generally held publicly accountable through parliamentary scrutiny and transparency norms. This way, the institutional arrangement of independence, transparency and accountability to the public not only balance but also strengthen the central bank’s autonomy. However, direct intervention and interference by the government in operational mandate of the central bank negate its functional autonomy.