The Reserve Bank of India (RBI) is managing inflation expectations by minimising intervention in the foreign exchange market and thereby controlling liquidity in the system. Even as foreign investors have brought in huge amounts, the funds have barely found their way to the central bank’s foreign exchange kitty.

Between August and October this year, foreign institutional investors have bought close to $8 bn into the country, according to the latest RBI data, but the central bank has absorbed only $336 million in the spot currency market and sold around the same amount in the forwards market.

Apart from FII inflows other major sources of dollars include FDI, ECBs, export earnings and remittances. However, there is huge dollar demand from importers and from investors to repatriate profits.

This is also helping the central bank contain inflation expectations as buying fewer dollars from the market results in less rupee funds being pumped into the system, while at the same time letting the rupee appreciate against the dollar in the process. RBI is already grappling with excess liquidity as banks are not lending much of the deposits they have mobilised. The system has excess liquidity of over Rs 50,000 crore these days.

According to Shubhada Rao, chief economist, Yes Bank, “The Reserve Bank has already indicated that it is comfortable with the current pace of capital inflows and has therefore not intervened much in the foreign currency markets. This also serves not to exacerbate inflation expectations.”

Spiralling food inflation in recent months has added to the central bank’s concerns as a section of the market feels that the easy monetary policy adopted to contain the impact of the global financial crisis is also in some way contributing to inflation, even though much of it is because of supply-side factors.

“India’s monetary exit will likely focus on first shrinking excess liquidity via multiple tools before normalising policy rates, probably from March/April 2010,” said Rajeev Malik of Macquarie Economic Research in a recent report.

Even though the country’s foreign exchange reserves have risen by around $13bn during Aug-Oct, much of this is believed to be due to revaluation of non-dollar assets in reserves such as euro, pound and the yuan. While some feel that the central bank could have also intervened by buying non-dollar currencies, these amounts are not reckoned to be significant.

The central bank’s policy of minimal intervention also helps it bring down the cost of managing foreign exchange, for if RBI continuously buys dollars from the market, it has to simultaneously infuse rupee liquidity into the system and later suck it out by selling bonds.

Source: The economic times.