The Rupee's giddy ride

The Reserve Bank of India (RBI) now finds itself between a rock and a hard place. The torrent of inflows from foreign institutional investors, or FIIs, has sent the BSE Sensex soaring, and pushed up the value of the rupee. This year, the FIIs have so far pumped over $20 billion into the stock markets and as a result the rupee has appreciated over eight per cent. The central bank has followed a hands-off policy in the forex market recently but is fast running out of options.

The surge in the rupee could not possibly have come at a more inopportune time for North Block and the RBI. There seems to be an incipient recovery in exports but the appreciation of the rupee, some feel, could derail the process. The RBI's monetary actions in the last couple of months, where it has opted for a calibrated hike in repo rates to rein in inflation, could strengthen the rupee further given the growing interest rate differential between India and the United States.

Moreover, if it were not for a surge in imports, and the consequent widening of India's current account deficit in the June quarter to $13.7 billion, the rupee would have appreciated even further. Says D.K. Joshi, Chief Economist, Crisil: "The trade gap has actually checked the rupee appreciation."

Most emerging markets are grappling with the same problem. Like India, interest arbitrage possibilities and robust economic growth have made them a magnet for foreign capital flows. The Institute of International Finance, which represents more than 400 of the world's leading banks and finance houses, has revised its estimates of net capital flow into emerging markets in 2010 to $825 billion, from $709 billion earlier. Guido Mantega, Brazil's Finance Minister, recently observed that there was an ongoing "international currency war" and countries were seeking to boost export competitiveness by devaluing their currencies.

Brazil and Taiwan have introduced some capital controls, while China is resisting the US pressure to let its currency float on the open market. But experts feel that the RBI may have been wise not to intervene.

Ashima Goyal, professor at the Indira Gandhi Institute of Development Research, says: "Sometimes it is good to be a contrarian." An appreciating rupee eases inflation and makes import of investment goods cheaper, helping companies that are scaling up operations in a fastgrowing economy. Adds N.R.

Bhanumurthy, professor at NIPFP: "In recent times, there has been no correlation between exchange rates and exports." The RBI, though, is keeping a vigil on the rupee rise and Subir Gokarn, Deputy Governor has admitted that "the capital inflow is emerging as a potential threat." It is not a role that the RBI is unaccustomed to.

India's burgeoning foreign exchange reserves are a result of the RBI's proactive management of the rupee rate to check unbridled appreciation. Analysts feel the RBI may soon be forced to intervene by mopping up dollars from the market even if the mandarins refrain from imposing capital controls. It is going to be a tightrope walk for the central bank as it tries to combat inflation and check the rupee rise concurrently.

THE RUPEE GAINS HEFT...

• Surging FII infl ows into the equity markets
• Growing interest rate differential between India and the developed world

... AND RBI COULD BE FORCED TO INTERVENE

• By mopping up dollars from the forex market
• Imposing capital controls to further stem the rupee rise

- Additional reporting by Shalini S. Dagar