The Reserve Bank of India [Get Quote] is not in favour of encouraging capital outflows, to combat surging inflows, as it could have the adverse effect of attracting further inflows.

While encouraging some outflows, such as liberalising overseas investment by Indian corporates, is helpful, it would have to be supplemented with other measures to manage capital inflows.

Liberalising outflows might not be of a great help in the short run because a greater liberalised regime generally attracted more inflows, said RBI Governor Y V Reddy, speaking in Hyderabad on the management of capital account in India.

Reddy added that while resorting to some encouragement to outflows such as liberalising overseas investment by Indian companies was helpful, it had to be combined with other measures to manage the flows depending on their intensity.

While managing capital flows, it was necessary to first take a view on whether capital flows were of temporary or permanent nature, said Reddy.

"Prudence demands that, in terms of the initial reaction, all large capital inflows are treated as temporary and if these flows result in excess volatility in the forex markets, some intervention becomes necessary," said Reddy 

The components of the capital flow would determine the extent of excess volatility, in addition to the amount of the flow. The flows on account of foreign direct investment into greenfield projects may be considered to be of a more permanent nature, while flows on account of buyouts through channels that are only technically FDI may not constitute a stable element.

Portfolio investments could also be expected to be less stable than FDI. Besides, the market participants' views on what constitutes excess volatility are also critical in this regard, said Reddy.

The eleventh five-year plan, as approved by the National Development Council on December 19, 2007, had observed that external commercial borrowings and other short-term flows were areas where an element of control to moderate sudden surge could be introduced, noted Reddy.

However, the Plan had also outlined the need to make capital flows less attractive or alternative ways of managing inflows that did not require costly sterilisation in order to limit the cost of sterilising of large growth in reserves.

Reddy observed that Finance Minister P Chidambaram had, in the mid-term review in December, said that while there were international experiences in this regard with some successful and painful adjustment process, the specific Indian context required innovative policy responses and, going forward, this would be a major challenge.