Does it have an option? We expect the Reserve Bank of India (RBI) to intervene in the foreign exchange market to mop up surplus capital flows. This means that the RBI will buy dollars and inject rupee liquidity into the economy. This, of course, is different from imposing controls to turn capital flows away, which we do not expect. Why? Well, the RBI must generate more money to fund growth at reasonable interest rates. Its 100-basis-point hike in cash reserve ratio has pulled money growth down to a tight 15% level. This is clearly insufficient to fund loan demand growing at 20%. Won’t this fuel inflation? Not really. Some monetary expansion is necessary for growth; it is only excessive money supply that is inflationary — the difference between eating and overeating. Second, the RBI needs to inject liquidity to fund government borrowing. Although the Centre and states plan to borrow around Rs 2,000 billion (net) in October-March 2011, it is difficult to see how banks and insurers can put in more than Rs 1,400 billion. This means that the RBI will have to plug the gap either by directly buying government bonds through open market purchase or indirectly by injecting rupees through forex intervention. Third, the RBI needs to recoup the $35 billion of forex reserves sold during the 2008 credit crisis to arrest the deterioration in vulnerability indicators. Short-term external debt of one-year residual maturity has gone up to 42% of forex reserves from 26.5% in March 2008. Fourth, the RBI needs to shore up forex reserves to cover for the rising debt-to-equity ratio of external liabilities. The bond investment limit for foreign institutional investors has been hiked over five-fold to $30 billion. In a downturn, bond investors gain from falling interest rates unlike equity investors who lose badly in a stock market correction. Finally, the RBI will have to contain appreciation to protect exports when the G3 slows down. The Indian rupee’s six-country real effective exchange rate, after all, has risen to 116.60 on September 9 that is far above usual 105-110 mid-cycle levels. Even with RBI’s forex intervention, the rupee should trade strong with capital flows coming in.
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roblem is the speed of appreciation The country’s rapid economic growth and rising interest differentials with the West, which continue to follow easy monetary policy, have attracted huge capital inflows in pursuit of higher returns. This has precipitated a sharp rupee appreciation, making exporters voice their concerns. Faced with a similar situation, some Asian central banks have actively intervened in the forex markets to protect the competitiveness of their currency, with South Korea and Indonesia resorting to selective capital controls to check short-term foreign inflows. Arising currency is not detrimental to everyone’s interest. It benefits entities borrowing abroad as well as importers and consumers of imported goods. Exporters with high import intensity would not be affected much as the lower cost of imports offsets the negative impact of appreciating currency on exports. But exporters of price-sensitive items and those that source their raw materials locally are adversely impacted. In the last decade, the country’s burgeoning economy has led to a general trend of rupee appreciation, and this scenario is likely to continue over the long run. Therefore, exporters will have to increasingly rely on productivity improvement and currency hedging to protect their competitiveness and margins. Right now, the problem is not so much the trend of currency appreciation but the speed. While gradual movements in the currency can be absorbed, any sharp swings in the rupee take the stakeholders by surprise, are disruptive and, hence, call for intervention. When the RBI intervenes, which in the current context means buying dollars, it increases money supply in the process. This is in conflict with the central bank’s current stance of tightening monetary policy and, therefore, would necessitate sterilisation operations. The extent of sterilisation depends on the stock of securities available for intervention and entails a fiscal cost. In the last few years, the RBI’s actions have been aimed at curbing potentially-disruptive swings, and not towards steering the currency in a given direction. Accordingly, if the foreign capital inflows continue unabated, the rupee will continue to appreciate, albeit at a slower rate due to RBI intervention.
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