The sharpness of India?s economic rebound, its overall resilience, along with the lowering of global risk aversion has once again led to a surge in foreign capital inflows into the country. To be sure, India has continued to run a current account deficit that has been gradually rising and now stands at around 3% of GDP, something last seen in 1990-91. However, unlike 1990-91, India is running a much larger capital account surplus of about 3.8% of GDP, fuelled by both foreign direct investments and foreign portfolio investments, mainly foreign institutional investments or FIIs (Figure 1).
According to RBI data, net portfolio investments into India between April and December 2009 rose sharply to around $23.5 billion compared to a net outflow of just over $14 billion in 2008. This, in turn, has helped push the local stock market to a two-year high and has also been putting upward pressure on the Indian rupee (notwithstanding the retreat in May 2010 largely because of US dollar strength) (Figure 2). India thus finds itself in the pre-global financial crisis era of 2007-08 when it was faced with the ?problem of plenty?.
Large-scale capital inflows can be managed in a number of ways. One option is to limit the size of the capital account surplus through a combination of policies that promotes capital outflows while also moderating the size of capital inflows via capital controls.
Owing to the absence of any credible attempts to control net capital inflows, there have been sharp upward pressures on the Indian rupee since it reached Rs 52 per dollar level (in March 2009) at the height of the global financial crisis and is currently hovering at around Rs 47 to the dollar as of mid-May 2010.
Consistent with its policy of managed floating, RBI has, in the past, intervened in the foreign exchange market to control?rather than prevent?rupee appreciation. This was certainly the case between April 2009 and November 2009 when India?s reserves rose from $250 billion to around $290 billion during the corresponding period. However, since then the reserves have remained fairly stable, implying that RBI has eschewed any significant foreign exchange intervention and has, since December 2009, permitted the rupee to find its own level in the market.
Part of the appreciation of the rupee is consistent with the fact that the authorities had also let the currency move downwards during the global crisis, compared to the renminbi. However, given the extent of the rise of the rupee, the CII has called on RBI to intervene in the currency markets, arguing that failure to do so would derail the export recovery, which only began in November 2009 (having contracted in the last two years).There are also concerns that the rising rupee value may limit the extent of inward remittance flows from the Middle East and elsewhere, all of which further would widen India?s current account deficit.
As against this, the rupee appreciation has likely been tolerated by RBI as a means of countering the inflationary effects of a rebound in global commodity prices and other tradable prices. The overall inflation rate as measured by the wholesale price index rose to 9.6% in April from a year earlier (Figure 3). This near double-digit increase, which in turn is raising inflationary expectations, is a cause for concern and is certainly above the comfort zone of RBI. The central bank has attempted to manage these pressures by trying to rein in domestic credit creation via raising the cash reserve requirement. However, such policies are not without their costs, be it the fiscal costs of debt servicing or the banking costs of financial repression.
Overall, therefore, RBI policies can be generously described as one of pragmatic ad hocism. As inflationary pressures have become more intense with the pouring in of ?hot money?, RBI has started to rein in liquidity growth via hikes in the benchmark policy interest rate.
However, this, in turn, is likely to intensify capital inflows as investors look to gain from global international interest rate differentials. RBI is thus caught between a rock and a hard place.
Over the medium-term the ideal solution would probably be to rein in the large fiscal expenditures as a means of reducing domestic demand and the pressures on domestic non-tradable prices. Unfortunately, rampant fiscal expenditures continue to be India?s Achilles? heel.
The author is associate professor, School of Public Policy, George Mason University, Virginia and visiting senior research fellow, Institute of Southeast Asian Studies, Singapore
