Stating that initiatives are being taken to explore new means and instruments of sterilisation, a Reserve Bank of India report has expressed concern on enhancing the economy's absorptive capacity to achieve higher levels of real investment.
The RBI, in its 'Report on Currency and Finance 2002-03' has also pointed out that 'openness (of the economy) should, however, be preceded by deregulation and strengthening of institutional framework in order to limit contagious influences.'
The monetary policy in India has been responsive to the developments in the external sector and has been able to reinvent itself in tune with the new priorities and changed operational environment.
A new challenge in the last two years has been the high order of capital flows. This has resulted in burgeoning reserves and raised concerns regarding the ability of the RBI to continue its sterilisation operations into the future.
"A medium-term concern in this respect relates to enhancing the economy's absorptive capacity to achieve higher levels of real investment," it added.
The stock of the government securities -- the main instrument of sterilisation -- declined from Rs 1,46,534 crore (Rs 1,465.34 billion) at end-March 2001 to Rs 36,919 crore (Rs 369.19 billion) by January 16, 2004, the report said.
India's approach to sterilisation has ensured monetary stability without any adverse impact on interest rates, it added.
The RBI report said while managing capital flows, a clear distinction should be made between debt and non-debt creating flows, private and official flows and short-term and long-term capital flows.
"The experience with capital flows suggests that these flows are highly beneficial if they are absorbed. However, if the current account deficits are too large and unsustainable then the reversal of capital flows could cause major problems," it said.
Forex market intervention accompanied by sterilisation allows the monetary authority to build up international reserves that could help to withstand future shocks and provide comfort and confidence to market participants.
On the other hand, prolonged sterilisation may exert an upward pressure on interest rates, which could, in turn, attract further foreign exchange inflows neutralising the impact of sterilisation, it said.
Unsterilised intervention in foreign exchange markets could lead to an alignment of domestic interest rates with international rates, which could have beneficial effects on investment and growth.
In the short run, however, unsterilised intervention could lead to asset price volatility, imprudent lending and adverse selection, which could have inimical effects of the real economy with possibilities of capital flow reversals.
Referring to the openness, the RBI report said among the most visible impacts of the increased openness of the Indian economy has been synchronicity of domestic and international business cycles and increasing effects of trade cycles within the economy.
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