The predominant issue that continues to confront the RBI in 2007-08 has been the steady increase of forex flows. These large and volatile inflows have resulted in rapid appreciation of rupee—almost by 12% against the dollar along with high interest rate in the economy.

1. The first phase of rupee appreciation--due to RBI stepping back from market: Active intervention by RBI in the forex market prevented the rupee from strengthening fully in response to the dollar global weakness. Indeed, increase in foreign currency reserves by USD 86 bn between 2004 to March 2007 indicates the scale of intervention. However the obvious consequence of this was an increase in money supply and inflation. Inflation as measured by WPI ran as high as 6-6.8% from January to April 2007 while M3 continued to hover above RBI’s comfort zone. Concerns over rising inflation ultimately forced RBI to step away from the forex market in April 2007. As a result rupee appreciated at a rapid pace between April and May approximately by 10%. Besides impacting the pace of appreciation, the decision to step away from the market led to change in expectation for rupee. The market expected the currency to move in only in one direction namely appreciate, appreciate and appreciate.

Was RBI’s decision to step away from the market correct? I think the decision need to be viewed in the backdrop of high inflation rates prevailing in the beginning of the year. While a stronger rupee can have a negative impact on export growth, but a sustained up move in inflation could have triggered an increase in inputs costs for exports and would have ultimately made the exports non competitive despite a stable exchange rate. Though it cannot be contested that if RBI had allowed appreciation on a gradual basis over a period of time instead of side stepping for a complete month, the pain would have been much less. This would have enabled companies to adjust their costing and expectations on a continuous basis, rather than having to deal with it in one fell swoop.

Perhaps this is a classical “Dutch Disease” situation where non-tradeables become over-priced and erode the competitiveness of the economy in the tradeable sector. Which emphasize the “need” to restrain these capital flows and enhanced the absorptive capacity in the economy.

However to summarize, the first phase of appreciation was caused by RBI’s action or to say inaction in the forex market-- an exogenous factor rather than a market force say increase in inflows.

2. The second phase of rupee appreciation: Rupee was once again under strong appreciation pressure as Fed cut it’s rate by half-percentage point to 4.75% on Sept 18, 2007, followed by a quarter percentage point cut to 4.5% on Oct 31, 2007. The reason for the Fed’s decision was fears of recession following the sub-prime credit crisis. Impressive growth rates and appreciating rupee resulted in large inflows especially portfolio investment. As the move was driven more by market exuberance rather than any change in fundamentals, RBI intervened aggressively to protect the pace if not the level of rupee. The extent of RBI’s dollar purchases is reflected in the USD 3.7 bn increase in its foreign exchange reserves during the week ended Sept 21. Besides direct market intervention, RBI also liberalized overseas investment norms for Indian companies and mutual funds raised the prepayment limit for ECB’s and doubled the foreign remittance limit for individuals. Modifications were also introduced on participatory notes to make investment flows transparent apart from easing of FII registration norms with SEBI. For ECB the amount that could be brought in was capped at USD 20mn per corporate per year. The consequence of this active intervention was that rupee has stayed ranged despite strong inflows.

This second phase of rupee appreciation has pushed liquidity management as a top priority: In order to ensure that the intervention does not erase the success gained in terms of control in inflation and non-food credit growth, RBI continued with the simultaneous sterlisation policy. Basically combination of three tools has been used: (i) Absorption of liquidity through its reverse repo window at a cost of 6%. (ii) Raising CRR, which is currently at 7.5% (iii) Issuance of MSS bonds to manage the issue of injected liquidity. Though there were associated costs with these sterilization tools (refer note 1 below for more details), RBI continued with it for the above-mentioned reasons as well as to manage export competitiveness. Withdrawal of the ceiling on daily reverse repos under the LAF in August and hike in CRR by 50 basis points in August to 7% and again in November to 7.5% helped absorbing excess liquidity during this period. Also ceiling for outstanding MSS bonds was raised to Rs. 2,50,000 cr on November 7, 2007 in a phased manner.

3. Going Forward - Will the rupee continue to appreciate in 2008 also?

A look at inflows from supply and demand perspective in 2008:

Supply side - Will the inflows continue to come in the system at the same pace?

Most probably not, as the biggest chunk of inflows, which was pumped in by FII’s—aggregated to USD 26.8 bn during April 2007- January 11, 2008 was due of market exuberance rather than fundamental change. Therefore we can expect these flows to resume to normal levels. Infact there have been significant outflow of funds on account of FII’s aggregating to USD 3.2 bn since January 10, 2008 despite Fed cutting it’s rate to 3%. Rapid escalation of risk aversion could be a possible reason for such outflows.

Whereas ECB’s, another important source of inflows--amounted to USD 10.6 bn from April-September 2007-08, can also slow in future because of the global credit squeeze, which could be around USD 2 trillion because of sub prime crises.

Demand side—Active market intervention: RBI has continued to say that it will intervene, as India is a developing economy, with inflexible mechanism, therefore steps are needed to smoothen out volatility. However the challenges of intervention and management of expectations will be particularly daunting in case of financial contagion, because such events are characterised by suddenness, high speed and large magnitudes of unexpected flows, in either direction.

RBI sterlisation policy: Since inflation remains a concern, RBI will continue to sterlise these interventions. Currently the level of current account deficit is lower than the amount of capital inflows. Therefore the enlargement of absorptive capacity would be an appropriate approach, but only up to the limit of sustainable levels which is achievable over the medium term under normal circumstances.

There has also been growing concern about the use of appropriate mix of instruments for sterlisation. The LAF is used for very short period flows. The MSS handles the longer-term flows slightly better than the LAF, and the CRR is more appropriate for addressing fairly longer-term flows. However effectiveness of the MSS depends more on the initiatives of the market participants than on the decisions of the RBI.

Growing global uncertainties: There are worries about global slowdown impacting both our exports as well as capital flows. With the external sector now accounting for almost 40% of GDP, we cannot be fully immune to international developments. Therefore we need to redouble our efforts to maintain the domestic drivers of growth and ensure that policy facilitates even faster growth. However considerable sluggishness in the domestic industrial sector is a cause of concern. IIP in November declined to 5.3%, against 15.8% in the same month last year, which is lowest since October 2006. Although the cumulative growth for the period April-November 2007-08 was at 9.2% over the corresponding period of the pervious year. Consumer demand has taken a hit due to high interest rates while investment demand continues to be strong, as indicated by 11.2% growth in the machinery and equipment sector and 24.5% growth in capital goods production over 29.4 % a year ago.

Fiscal actions to be export competitive? Capital account openness is beneficial when it is appropriately teamed with other policies--monetary and fiscal. RBI will continue to use MSS, CRR and LAF to manage the challenges of monetary policy. However there are suggestions to use fiscal policy, as the main tool for countering appreciation of the currency. Which requires raising taxes and cutting public spending to control currency appreciation. This is politically challenging, but it is a necessary corollary of the decision to free capital flows.

Possibility of outflows liberalization: It is sometimes, suggested that encouraging outflows would be a good solution to manage surging inflows, because they help reducing the pressures on currency and inflation. However, liberalising outflows may not be of great help in the short run because a greater liberalised regime generally attracts more inflows, as also seen in second phase of rupee appreciation. However recourse to some encouragement to outflows such as the liberalisation of overseas investment by our corporates in the real sector is helpful, though it has to be combined with other measures to manage the flows depending on their intensity.

Possibility of more restriction on inflows if pace again become strong: An inescapable consequence of growth is greater capital inflows. The cautious approach to opening the capital account followed thus far as a conscious act of policy has given the government some leeway in limiting inflows of certain categories. However in order to control these flows it is important to recognise the relative attractiveness of different types of flows. In this regard FDI is the most preferred form of flow since it comes packaged with technological and organisational know-how. These benefits may be true of equity but not true of debt finance. But unlike most FDI, inflows through FII’s are inflationary. Investments in Indian firms through the stock market and by venture capital funds in unlisted companies are also potentially beneficial. While ECB’s and other short-term flows are areas where one can introduce an element of control to moderate sudden surges, as has been done in second phase of rupee appreciation.

Does this mean that no further rupee appreciation? Not really. RBI will continue to intervene to arrest any fast pace of appreciation. Hence will allow rupee to appreciate at a gradual level.

*Note 1: Issuance of MSS bonds has a fiscal cost as government has to pay interest on bonds. This represents an opportunity cost, since the same funds could have been used for development purpose. RBI bears the cost when it sucks out liquidity through its reverse repo window while the banking system bears the cost when CRR is raised. Also sustained absorption of liquidity through any or combination of the above measures sooner or later gets reflected in higher interest costs for borrowers, which adversely affect the growth in investments and consumption. Beside the direct fiscal cost mentioned above, there is the indirect cost to the economy of allowing ECB’s by companies at much higher interest rates than what the RBI receives for its reserves held as safe assets abroad.

流动资金及汇率管理（2007-08 ）