Deputy Governor Rakesh Mohan, in a paper for a Bank of France seminar in Paris posted on the RBI's Web site www.rbi.org.in, said large remittances and a sustained spurt in software exports were complicating exchange rate management.
"(These) coupled with capital inflows have the potential for possible overvaluation of the currency and the resultant erosion of long-term competitiveness of other traditional and goods sectors," Mohan said.
India is part of the way through a three-phase, five-year plan towards greater capital account convertibility.
The economy, Asia's third-largest, has grown at an average 8.6 percent over the last four fiscal years, and has attracted massive amounts of foreign investments and capital.
This has been driving up the partially convertible rupee, which hit a nine-year high of 40.28 per dollar in late May, and the central bank has been intervening in the currency market since then to stop it from rising further.
Mohan said opening up the capital account meant market participants needed to be better able to absorb greater volatility and shocks.
"In the context of progress towards further capital account convertibility, the market participants are going to be faced with increased risks on multiple accounts: volatility in capital flows, volatility in asset prices, increased contagion and state of ability of legacy institutions in managing risks."
While India has inflation goals, Mohan said inflation targeting may not be appropriate, partly because financial markets were not developed enough.
Mohan said interest rate deregulation was essential to smooth monetary policy transmission, but policy makers were constrained by special considerations in a large and developing economy.
Particularly, monetary policy transmission was muted by administered interest rates on small savings schemes and provident funds, as they competed for funds with banks.
Mohan said the RBI may need to step up open market operations in the government bond market to improve the transmission of monetary policy.
Such operations could differ from its daily and weekly operations to manage cash in circulation and capital inflows.
As the government bond market was yet to develop depth, "there is a case for secondary market operation across the yield and maturity spectrum", he said.
There would also be a continuous need to adapt liquidity and exchange rate management strategy, and global developments were expected to have an increasing role in monetary and currency policy.
"In an environment of global convergence, retaining independence of monetary policy may become increasingly difficult, calling for hard choices in terms of goals and instruments," he said. Read more from: http://in.today.reuters.com/news
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