With the Indian economy churning out magnificent growth figures, capital flows are flooding the country.

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Indian bourses received foreign institutional investments worth $4.7 billion, a figure that was never previously reached in history.

All in all, however, India stands to lose if the rupee appreciates further. The backlash in exports has started to hurt; trade deficit for April-June 2007-08 has widened to $21.58 billion, as compared to $16.94 billion in the corresponding period of the previous year. The trade deficit for August 2007 touched $6.88 billion, as against $4.08 billion in August 2006, a monstrous increase of 70%. Merchandise exports posted a moderate growth of 17.8% in Q1 2007-08, while the figure was 23.7% a year earlier. The situation will get worse as the effect of rupee percolates through the rest of the year and also with higher interest rates.

Now that the consequences are wide open in front of us, let’s take a look at why the rupee has suddenly started taking the course that’s breaching the comfort levels of many. One might term it as ‘growth pangs.’ With the Indian economy churning out magnificent growth figures, capital flows are flooding the country. In the month of September itself, Indian bourses received foreign institutional investments worth $4.7 billion, a figure that was never previously reached in history. All of it is quite substantiated by the fact that the benchmark indices are scaling new highs by the day. Capital inflows of such proportions bulldoze the domestic currency as demand for rupee shoots up in the international markets. Believe it or not, the proportions of capital inflows have been so epic that even the monetary authorities are finding it quite arduous to bring under control.

This brings us to the famous ‘Unholy Trinity’ mentioned earlier. The model put forth by Marcus Fleming and Robert Mundell suggests that it’s impossible to maintain an autonomous monetary policy, free flow of capital and a fixed exchange rate. Let’s see how it works. Taking into consideration the Indian context, capital inflows push the rupee up against the dollar and the central bank – the Reserve Bank of India, which has a clear mandate of sticking to a fixed exchange regime intervenes by buying dollars in the forex markets and selling rupee in order to maintain the requisite exchange rate and stem the rupee appreciation. This is quite in line with the mammoth forex reserve that the RBI has amassed up in the recent past (Reserve Bank of India made net market purchases worth $26.8 billion from the foreign exchange market in 2006-07, significantly higher than $8.1 billion as compared to the previous year).


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Source : IIPM Editorial, 2008

An Initiative of IIPM, Malay Chaudhuri and Arindam Chaudhuri (Renowned Management Guru and Economist).


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