The government is exploring the option of capping incremental foreign institutional investor inflows to create monetary space for it to increase its deficit. This will help the government generate resources for infrastructure financing without any inflationary impact.

A section in the government feels since the cap on money supply growth cannot be breached, the only option is to reduce FII inflows.

Officials said the incremental money supply growth came entirely from FII inflows. The Reserve Bank of India has specified 14.5 per cent money supply growth as the acceptable target for a 5.5-6 per cent inflation rate.

Officials, however, said the proposal was still being internally debated and no final decision had yet been taken.

Without the cap of FII inflow, any monetisation would raise money supply and push up inflation, which was already quite high, they said. The wholesale price index based inflation was 7.76 per cent in the week ended November 6.

If the government monetises the deficit to the extent of $5 billion a year, it will increase money supply by about 1.5 percentage points from the current level of 14.5 per cent and result in inflation going up by about a single percentage point.

The officials said the government could step up fiscal deficit and invest in the economy. Investment of $5 billion a year would roughly increase gross domestic product by 2.5 per cent over a year and a half. The growth would lead to additional imports which could be absorbed by drawing down of forex reserves.

Under the current practice, if the government wants to raise resources, it has to place bonds in the market. Bonds result in creation of future liabilities for the government, which will raise fiscal deficit at a later stage.

The move would however be detrimental to corporates and could also stymie the government's plans to offload stake in public sector companies in the market. The FII investments, particularly in the case of fresh issues, reduce capital costs for blue chip companies.

Limiting their participation in the market would lead to a fall in premium on shares and raise capital costs for these companies. However, government sources argued that given the limited resources available, there was a greater case for providing subsidies for, say rural roads rather than for large corporates.

Also, FII inflows crowd out the domestic retail investor, forcing him to invest in relatively low quality stocks.