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Guesr column

Monday, November 29, 2010

Can India handle the huge FII inflow?

We have seen an inflow of $16 billion in Calendar Year (CY)’07, $18 billion in CY ’09 and $25 billion in CY ’10 so far. In CY ’09 there was an outflow. Hence, assuming a $60 billion inflow in a year would be an optimistic assumption.

FII flows reflect the positive perception of foreigners about the Indian economy but at the same time their investment has become more of a need for the Indian economy today. The so called comfort of RBI can best be explained by comparing today’s key macroeconomic numbers with those prevailing during the boom period about two years back.

India had a current account deficit of $23 billion (-1.8% of GDP) in FY ’08 and $23 billion in FY ’09 (-2.1% of GDP). This has ballooned to $38 billion (-3.0% of GDP) in 2010 and if trend of first quarter continues it is expected to touch $45 billion (-4.0% of GDP) in FY ’11. Hence, absorbing an incremental $15 billion (over and above $45 billion) in an economy growing at a rate of 8% plus and needing huge investments in its infrastructure, would not really be a big challenge. However, managing liquidity, interest rate, inflation and exchange rate becomes a challenge.

The foreign inflows lead to an appreciation of the domestic currency and this becomes a cause of concern for the RBI. RBI’s comfort emanates from the fact that the 36-Currency-REER (Real effective exchange rate) is currently at 100.87 indicating that the rupee has not strengthened despite $26 billion of FII inflows. During the boom period of Jan-March ’08, the 36-Currency-REER was at 103.43. Hence, current account deficit has prevented any excessive rupee appreciation.

Any intervention in the Forex market leads to a liquidity infusion in the economy and the RBI would be uncomfortable with the same due to high inflation rate. However, the MSS outstanding is nil and the system has a liquidity deficit of Rs. 1,00,000 crores. This position is much more comfortable for the RBI as compared to what we had seen during the boom phase of Jan-March ’08, when the MSS outstanding was Rs.1,68.956 crores (approx.$39 billion), despite that the system had an average surplus liquidity of Rs.4600 crores.

Even the current money supply growth is at a comfortable level of 16% as against 21% in Jan-March ’08. At present CRR, Repo & Reverse Repo rates are at 6%, 5.25%, 6.25% respectively, giving the RBI the flexibility to further tighten if the liquidity in the system increases substantially.

The ability of any country to absorb FII flows depends upon its requirements – which is determined by the Current Account Deficit and the required capital investment of the country. If foreign flows are much larger, then it impacts currency markets and leads to appreciation of the currency making its exports uncompetitive.

At the current rate of $14 billion deficit, India’s annual deficit would be $45billion and hence absorbing $60 billion would not difficult. However, the discomforting fact is that FII money is not stable money. Another problem is that the FII flows are not uniform and hence they create a lot of volatility in the Forex market forcing the central bank to intervene and hence making task of inflation and liquidity management more challenging.

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