Net capital inflows into India, on account of interest differentials and an appreciating rupee, have risen in the last two months. Investments by FIIs in the debt market, by Non-Resident Indians in NRE (Non-Resident External) accounts, and offshore borrowing by firms have increased sharply in May.

Today, it is possible for a foreigner to invest in an Indian treasury bill, be fully hedged and yet earn higher  than international returns. This is possible because the forward premium on the rupee- dollar rate has dropped to historic lows.

The demand for treasury bills has put a downward pressure on yields, pushing rates below the 5 per cent repo rate. In this turn of events RBI's exchange rate policy is clearly a major factor. This policy impacts expectations and thus the forward premium.

A key facet of this situation is the new constraints that our open capital account places upon macro policy. Countries with an open current account face a conflict between interest rate policy and exchange rate policy. For India, the dilemma is relatively recent.

As long as the capital account was closed, the RBI could conduct its monetary policy and exchange rate policy independently of each other. But since 1993, with the opening up of the economy, the two are no longer independent.

The conflict between the two policies is sharpest when a country tries to keep its exchange rate fixed. At a fixed exchange rate, net inflows or outflows have to be absorbed by the central bank so that they do not change the price of the domestic currency. Reserves go up and down in response to capital flows, and thus monetary policy is determined by the external sector.

While India does not have a fixed exchange rate, the exchange rate is actively managed by the RBI. But a central bank can only autonomously choose monetary and interest rate policy if it has no currency policy. An independent monetary policy, a fixed exchange rate and an open capital account have come to be known as the 'impossible trinity' or the 'open economy trilemma'.

Since few countries follow a policy of a fixed exchange rate, the impossible trinity can be interpreted as the relationship between the country's interest rate flexibility and exchange rate flexibility in an open capital account.

A country that seeks low volatility of the exchange rate is likely to end up with high volatility of interest rates, since interest rates have to move quite a bit in defence of currency policy. Cross country data thus shows a high correlation between low exchange rate volatility and high interest rate volatility.

Until now the RBI has been wedded to reducing currency volatility, as a policy goal. The INR-USD exchange rate appears to be a crawling peg. The rupee is allowed to move, but only by small amounts. Sharp movements in the rupee have, in general, been avoided.

Not only has the RBI intervened directly in foreign exchange markets, not only has it asked SBI to buy or sell dollars on its behalf, it has also changed interest rates, to prevent sharp volatility in the exchange rate of the rupee. The 200 bps move in interest rates on 16 January 1998 was such an example.

So while the pressure on the exchange rate in the recent two years initially came from the current account, the policy of letting the rupee move only by small amounts has created avenues for speculation and today the pressure is coming in from rising capital flows. Our currency regime has, ironically, converted a current account surplus into a capital surge.

If the RBI were to continue to target currency volatility, the impossible trinity of an open economy will not allow it to contain volatility in interest rates as well. The logical consequence of sustaining the existing currency policy, i.e. of trying to stem capital inflows, would be to cut the repo rate.

In the current situation, continuing with its exchange rate policy, and therefore cutting interest rates does not appear to be a very difficult decision.

Inflation rates are low and whatever inflation we have had in the recent months has been more on account of petroleum and edible oil prices, than excess money stock. RBI may hence find cutting the repo rate, and sustaining the status quo on the currency regime, to be an easy option.

The story may, however, not be a simple one. An important impact of any step taken by a central bank policy is the effect it has on expectations. And, in India expectations about the INR/USD rate determine the forward premium.

So, while cutting interest rates may be meant to reduce capital inflows by reducing the interest differential, the step may not impact capital inflows to a large extent because these also depend on rupee expectations which will not change immediately.

Cutting rates would give a signal that the RBI is wedded to the policy of low exchange rate volatility and keep the forward premium low. With low forward premiums an investor can be fully hedged and can choose to invest in India even when interest differentials are not very large.

When does this saga end? The rupee cannot appreciate indefinitely. When expectations change, there would be an outflow of capital. At that point, preserving the current currency regime would involve raising interest rates to defend the rupee, and keep rupee volatility low.

So it appears that we may be headed first for lower interest rates, and then for higher interest rates. Interest rates will have to bounce around in sustaining the present currency regime, which targets currency volatility.

It is clear that India can no longer behave as though our capital account is closed enough for us not to have to make a choice between exchange rate stability and independent monetary policy. Before a crisis arises we need to take a fresh look at the trade-offs posed by an open capital account.

What is the right choice for India? Is currency volatility harmful? Is currency volatility more harmful than interest rate volatility?

Can we just have a currency futures market, accessible to all, so that people can find private solutions to currency volatility? Should monetary policy be controlled by currency policy?

Is monetary policy useful for greater goals, like targeting prices and playing a counter-cyclical role, or should monetary policy be 'used up' for reducing currency volatility? These are key economic policy questions that need to be debated.

The author is at ICRIER. These are her personal views.