quite unrelated to fundamentals. • – if you intervened, but did not sterilize the resultant liquidity, you become vulnerable to inflation pressures and asset price bubbles. – if you intervened in the forex market and sterilized the resultant liquidity, you may find interest rates firming up – which attracts even more flows – a classic case of dutch disease. – what all this says is that there is really no benign option for dealing with volatile capital flows. there is one other important issue relating to forex intervention. both currency appreciation and currency depreciation, quite unrelated to fundamentals, are bis central bankers ’ speeches complex problems. but there is a significant asymmetry between intervention for fighting appreciation and intervention for fighting depreciation. • when you are fighting currency appreciation, you are intervening in your own currency. your capacity to do so is, at least in theory, unlimited, quite simply because you can print your own currency. • but when you are fighting currency depreciation, you are intervening in a hard currency. your capacity to intervene is, therefore, limited by the size of your forex reserves. what complicates the dilemma is that the market is aware of this. • so, there is the real danger that by intervening in the forex market, you could end up losing forex reserves, and not gaining on the currency. the lower your reserves dip, the more vulnerable you become. and the vulnerability can become quite serious if your reserves go below the level markets perceive as necessary to regain market access. • it should also be clear that a failed defence of the exchange rate is worse than no defence. so, when you are intervening in the forex market, it is important to make sure that your intervention is successful. in that context, the questions on this topic of forex intervention are the following : ( i ) under what conditions is it appropriate for countries to intervene in the forex market? ( ii ) under what conditions is forex intervention preferable to capital controls? ( iii ) in most cases, countries claim that they are intervening in the forex market, not to target any particular rate, but only to manage the volatility in the exchange rate. is it necessary then to define upfront your measure of volatility that will trigger intervention? 2. reserves • the optimal level of reserves that countries may hold has been one of the important policy issues post - crisis. • an argument in support of countries holding size

controls. [ for example, deposits from non - resident indians, which are an important source of capital flows into india, are controlled through the interest rates banks can offer, a price variable. external borrowing by indian corporates is controlled through both quantity and price variables. ] bis central bankers ’ speeches • our experience has been that while quantity controls are more effective in the shortterm, they can also be distorting, inefficient and inequitable. capital controls vs prudential measures • there is also an argument about whether capital controls can be substituted by prudential measures. • it is not clear that they are always exact substitutes. if capital inflows are intermediated through the banking system, then prudential measures can be applied directly on domestic banks, circumventing the need for controls. • but what if the inflows are direct, that is to say, loans directly from foreign entities to domestic companies? in that case, the only mechanism to prevent excessive leverage, and foreign exchange exposure, may be by imposing controls. against that backdrop, the questions on capital controls as a short - run stabilization tool are the following : ( i ) can we define the distortion that capital controls are meant to correct? for example, how do we determine if capital flows are excessive or dangerous? ( ii ) what have we learnt about the effectiveness of capital controls as a stabilization tool? ( iii ) when can prudential measures be substituted for capital controls? ( iv ) what criteria should we adopt to choose between price based and quantity based controls? ( v ) are capital controls symmetric as between inflows and outflows? in other words, should we use one type of controls to control inflows and another type to limit outflows? iii. foreign exchange intervention • the third important issue on which the pre - crisis consensus has dissolved is foreign exchange intervention. • the pre - crisis consensus, at any rate among advanced economies, was that intervention in the forex market is sub - optimal. • that consensus no longer holds, with even some advanced economies defending their currencies from the safe haven impact. • emerging markets, for their part, have had long and varied experience of struggling with forex intervention. the policy dilemma in the event of receiving capital flows, beyond the country ’ s absorptive capacity, can be quite complex. • if you didn ’ t intervene in the forex market, then you would have currency appreciation