The huge inflow of money in India is likely to pose some problems over the next few months. For starters, the surge in inflows have set the stockmarkets in India soaring. With the developed countries not showing signs of recovering anytime soon, foreign investors have rushed to India in their quest for greener pastures. This has already sent the valuations of many companies beyond unjustifiable levels.
But there is more. As Morgan Stanley reports, the RBI will have a challenging time controlling these inflows going forward. Interest rates in the US and Europe are at an all time low as the governments there are trying to revive economies. And would continue to remain low next year too. More so, when there is the possibility of the Fed announcing additional quantitative easing, in other words QE2, which would involve US$ 1.2 trillion of asset purchases.
In India meanwhile, interest rates have been rising as the government is struggling to bring high levels of inflation down. Thus, the big differential in interest rates will continue to attract foreign money to Indian shores. And it is not just investors who are bringing in the money. Indian corporates themselves are going in for foreign loans given the cheaper interest rates overseas.
So far, the RBI has not really been too concerned about these inflows. It has mostly stayed on the sidelines while making sporadic attempts to intervene in the currency market. But if the flows exceed beyond acceptable levels, then the central bank will be compelled to do something. For instance, a substantial appreciation in the rupee could be halted by the RBI. Largely because this could lead to the widening of the current account deficit due to more imports and less exports.
Managing monetary policy could also become a challenging task for the central bank. It has been tightening policy measures to rein inflation. That said, although inflation has been easing a tad bit, it still remains high. However, if the central bank chooses to raise rates aggressively, it would only lead to more inflows as the gap between interest rates of the developed world and India widens.
Meanwhile, the Indian government on its part also needs to spruce up its act. Fiscal deficit has risen significantly in recent times due to wage hikes, stimulus measures and a cut in indirect taxes. Some respite has been provided by license fees from 3G and broadband wireless access (BWA) services and money mopped from divestments. But the government needs to bring its spending down since demand from the private sector is already heating up. Otherwise, excess demand will only spur prices and thereby inflation. This will induce RBI to sustain its tightening measures which in turn will only attract more inflows.