'Large capital inflows are exacerbating tensions in the monetary policy framework among exchange rate management, monetary independence, and financial openness,' the IMF said in an annual review of Asia's fourth-largest economy.

'Resolving these tensions will require an evolution of monetary policy, further exchange rate flexibility, and deeper and broader capital markets.' The Washington-based IMF warned in the report that capital controls could 'dampen investment, raise doubts about the government's commitment to fuller capital account convertibility, and pose questions about the exit strategy from new controls.'

The Securities and Exchange Board of India, which regulates the country's markets, tightened offshore investment norms last year to help stem a tide of foreign money.

The Indian central bank, the Reserve Bank of India, has indicated it might impose restrictions on capital flowing into certain sectors of the economy.

India, whose rupee is largely managed, has longstanding capital controls but has pledged to gradually ease them.

The IMF said 'the temporary space provided by existing controls should be used to prepare for a more open capital account.

'One point of view is temporary controls might have some influence in buying some space. We are a little bit sceptical about that view,' said Charles Kramer, division chief in IMF's Asia and Pacific Department.

'Our view based on the international experience is that temporary controls haven't worked very well and the only kind of controls that really buy much space are ones that are fairly Draconian and may actually cut off capital that's needed,' he told reporters.

Kalpana Kochhar, IMF's mission chief for India, said the Fund 'would prefer to see somewhat more exchange rate flexibility,' possibly with the rupee appreciating over time, 'rather than trying to control inflows.' Capital inflows, crucial to fuel India's economic growth, especially infrastructure development, reached a record 45 billion dollars in the fiscal year ending March 2007 and continue accelerating.

They are putting upward pressure on the rupee and raising concerns about competitiveness and prompting the authorities to intervene in the foreign exchange market.

The rupee gained 12.3 percent against the dollar last year, as funds abroad snapped up local shares and bonds amid buoyant economic growth.

The IMF said allowing greater exchange rate flexibility could lead to more effective monetary policy and deal with global financial market chaos.

The Fund also called for 'broader and deeper' financial markets to channel capital to its most productive use, accommodate higher exchange rate volatility, and support financial stability.

In a bid to limit any inflationary impact of the capital inflows, the IMF also proposed tightening the country's fiscal policy.

GNP
India's economy expanded by a higher than expected 9.6 per cent in the last fiscal year, the fastest pace since 1989 and second only to China, according to Indian data released last week.

Growth averaged about 8.5 per cent in the past four years, and is set to record 8.75 per cent this year, making India one of the world's fastest-growing economies, the IMF said. -- AFP