Two regulators have come out with major policy statements within a week of each other. On October 25, Sebi approved a revised policy on the vexing and long debated issue of P-notes. Five days later came the Governor's mid-term review of monetary policy for 2007-08. The latter explicitly states that "on the domestic front, the biggest challenge for monetary policy is the management of capital flows and the attendant implications for liquidity and overall stability."

"Reflexivity", an expression coined by Gorge Soros in his The Alchemy of Finance, to describe the interchangeability of cause and effect, is a standard feature of the way financial markets react. The dollar goes up because it has gone up (in recent weeks, the other way round). So do share prices. And, given the preponderance of trend followers and momentum players, this feature can often take prices well away from so-called fundamentals. On the other hand, central banks are supposed to act counter-cyclically.

However, even as our central bank seems helpless in the face of the capital flooding in, one feels that its own actions, and indeed, inactions, have contributed to the flow. For one thing, when it let go the rupee in Q1 of the current year, this obviously created an additional incentive for foreign money to come into the domestic equity market -- investors could hope to gain not only from the rising equity market, but also from the appreciation of the rupee. The central bank did change expectations of the investors as far as the exchange rate is concerned -- but one is not sure whether this was intended.

Again, the tighter money and higher interest rates in the domestic market over the last 12 months have also attracted further capital flows in the domestic market, but not in the way most commentators seem to assume. As far as India is concerned, higher interest rates attracting funds to the Indian market, at the initiative of the investor, does not seem very likely.

For one thing, there are restrictions on FII investments in the debt market; secondly, higher interest rates are, by definition, deflationary and a bear influence on both bond and equity prices. But the fact is that higher rupee interest rates do attract larger flows of short-term foreign capital for financing imports, at the initiative of the domestic importer.

The point is that the RBI's own monetary and exchange rate policies are responsible for attracting capital flows on a much larger scale than the case would be otherwise. In any case, one remains sceptical of the claim that "pre-emptive monetary measures since mid-2004 � have helped in containing inflation."

The errors of commission have been compounded by those of omission, by missing out on the timing of more effective intervention. As Abheek Barua wrote in this paper last week, when the curbs on P-notes were announced, a statement from the finance ministry and the RBI to the effect that "it expected the rupee to halt its uninterrupted climb against the dollar" would surely have influenced expectations.

As Barua notes, the RBI also missed the opportunity to buy dollars when there was a temporary shortage immediately after Sebi released its discussion paper on October 17. A shrewd market player has to take advantage of such opportunities to influence psychology, not intervene mechanically only when there is excess supply. This apart, the RBI's helplessness is difficult to appreciate given that other countries are managing much higher inflows without losing control of the exchange rate and that most Asian countries are comfortable with higher reserves than ours, as a proportion of their GDP.

Coming to Sebi and the issue of P-notes, while the positive thing is that firm and pragmatic decisions have been taken, one is confused about what the basic objective is. For instance, in the ET roundtable, reported on October 24, Sebi chief M Damodaran has been quoted as saying, "The government and central bank have expressed opinions to the effect that flow of capital into India has reached proportions that are somewhat difficult to manage."

But he says later that "there are elements that promote inflows rather than discourage them in the package." Incidentally, in that roundtable, only Uday Kotak made the point that we are "running the risk (of ignoring) that the key thing for building India is creating jobs. The situation is such that there is a risk of people losing jobs as a result of rupee appreciation." It was good to see a major player in financial markets making the point, which is often totally overlooked by most commentators.

Tailpiece: One wonders whether the Governor met Donald Rumsfeld during his recent visit to Washington. His reference to the "uncertain uncertainties" in this paper (interview, October 31) parallels Rumsfeld's famous reference to 'unknown unknowns'!