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Emerging challenges due to surging capital inflows

LiveMint logoLiveMint 20-05-2014 Renu Kohli

Foreign capital is gushing into Indian markets. After a desultory April, inflows gathered pace in the first week of May. Net capital inflows already totaled $3.3 billion till Monday. It is anyone’s guess how soon the most recent peak of $5.2 billion, which came in March, will be crossed. In the last six trading sessions, daily inflow averaged $472 million. The pace accelerated further this week as nearly $650 million poured into both debt and equity markets. That’s a boom.

How long will this last? Neither magnitude nor persistence of such short-term capital is easy to predict, but here are a few pointers. Most investors have raised their targets for stock price indices, expecting at least a 15% over a 12-month horizon, even as growth projections are kept unchanged. Many market participants and analysts see the benchmark Sensex touching 40,000 points three years from now with gross domestic product growing anywhere between 6.75%-8%. Some others have predicted the beginning of a decade-long bull market. With political expectations of investors met, hopes of decisive action, reforms-push, investment revival, etc., are the big attraction. Could this be a prolonged boom?

For now, however, the boom is a budding economic problem. The rupee has risen 2.6% in value this month so far, with 1.2% appreciation in the first session of this week alone. The central bank has been reluctant to allow the currency stray too far from its Rs60 to a dollar range. Although external balances have improved, accreting reserves is a priority as vulnerability indicators like imports and short-term debt covers need strengthening. Then again, exports are the only stimulus for economic growth at this juncture, even though a stronger rupee helps lower imported inflation.

Brisk dollar purchases by the Reserve Bank of India (RBI) have been reported this month. In the fortnight to 9 May, foreign currency assets rose $4.5 billion, more than one-fourth of the $19.6 billion jump since March, a month in which the RBI bought $8 billion. A sustained surge of foreign capital inflow could force the central bank to quicken its pace of intervention in order to keep a lid upon the currency. This can become a headache very soon, making economic management quite difficult.

Foreign currency is bought by the central bank exchanging rupees, which results in expanding the domestic monetary base. A tighter monetary stance, as currently prevailing, pressures the central bank to remove the excess rupees and keep monetary conditions consistent. These actions are not sustainable or even too effective beyond a point. The policy choice between rupee appreciation and keeping the rupee competitive become difficult. Lobbies get active too. Exporters are already grumbling and it won’t be long before those who stand to gain from a stronger rupee will join in.

Markets are already forecasting the rupee at 57 to a dollar. If the boom sustains, voices will become shriller and choices more difficult.

Renu Kohli is a New Delhi-based macroeconomist.

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