External shocks

Ashima Goyal

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

Abstract: After the global financial crisis, India was exposed to many external shocks from commodity prices and foreign capital flows. Although capital flow fluctuations were largely due to global risk-on risk-off factors, a widening current account deficit (CAD) contributed to India's vulnerability to external shocks. The major source of shocks was external, but policy mistakes increased India's vulnerability. These included inadequate attention to sectoral bottlenecks that reduced export growth and domestic financial savings, while substitution away from expensive oil imports was discouraged. Dependence on foreign capital, to finance the CAD, rose while degrees of freedom from continuing capital controls were underutilized to reduce exchange rate volatility and to smooth interest rates. Steep depreciations combined with volatility did not help exporters. Evaluation of measures to stabilize the exchange rate establishes that temporarily taking oil marketing companies demand out of the market was the most effective, since small demand-supply mismatches lead to large currency movements in thin markets. Prudential measures such as increasing position limits, margin requirements are to be preferred to a ban on a market or a transaction-type. If market restrictions become necessary, they should be carefully targeted. Accumulation and use of reserves, use of market information and of signalling can all help implement managed floating. Such an exchange rate regime can contribute to effective inflation targeting without the policy rate rising to reduce depreciation as in the classic interest rate defense.

Keywords: External shocks; current account deficit; exchange rate regime; volatility; market intervention (search for similar items in EconPapers)
JEL-codes: F31 F32 F36 F41 F42 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2014-11
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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