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Economic Times Case Analysis

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Economic times article and reflective note

Should RBI check rupee's rise?
Posted on October 20, 2010 | View 124

We expect the Reserve Bank of India (RBI) to intervene in the foreign exchange market to mop up surplus capital flows. This means that the RBI will buy dollars and inject rupee liquidity into the economy. This, of course, is different from imposing controls to turn capital flows away, which we do not expect. Why? Well, the RBI must generate more money to fund growth at reasonable interest rates. Its 100-basis-point hike in cash reserve ratio has pulled money growth down to a tight 15% level. This is clearly insufficient to fund loan demand growing at 20%. Won’t this fuel inflation? Not really. Some monetary expansion is necessary for growth; it is only excessive money supply that is inflationary — the difference between eating and overeating. Second, the RBI needs to inject liquidity to fund government borrowing. Although the Centre and states plan to borrow around Rs 2,000 billion (net) in October-March 2011, it is difficult to see how banks and insurers can put in more than Rs 1,400 billion. This means that the RBI will have to plug the gap either by directly buying government bonds through open market purchase or indirectly by injecting rupees through forex intervention. Third, the RBI needs to recoup the $35 billion of forex reserves sold during the 2008 credit crisis to arrest the deterioration in vulnerability indicators. Short-term external debt of one-year residual maturity has gone up to 42% of forex reserves from 26.5% in March 2008. Fourth, the RBI needs to shore up forex reserves to cover for the rising debt-to-equity ratio of external liabilities. The bond investment limit for foreign institutional investors has been hiked over five-fold to $30 billion. In a downturn, bond investors gain from falling interest rates

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