Expectations are growing that Reserve Bank of India (RBI) will continue to intervene in currency markets after its suspected dollar-buying last week to ease upward pressure on the rupee.
A surge of capital inflows have pushed the rupee up 6% since the start of September and close to 5% on the year, threatening to slow export growth.
The suspected dollar-buying by the RBI, which traders believe was its first such move this year, came days before Coal India kicked-off a USD 3.5 billion IPO, the country's largest, that is expected to draw billions of additional dollars into India.
More governments around the world are moving to keep their currencies from appreciating or weighing capital controls as investors pour money into higher-yielding markets.
Below are some question and answers on the RBI and intervention in the currency market.
Will RBI intervene again?
Possibly. The partially convertible rupee rose to a more-than two-year high beyond 44 per dollar last week.
Persistent U.S. dollar weakness and ultra-low interest rates in developed markets have prompted a surge in flows into faster-growing emerging economies that could prolong the upward pressure.
Asia's third-largest economy has attracted a record $33 billion this year from overseas into stocks and bonds, which are helpful to the extent that they can help fund a current account deficit forecast to reach $42 billion by the end of March.
More US quantitative easing could unleash further flows into emerging markets like India.
Exporters, which are a powerful lobby, have argued for intervention. Margins in key industries including technology services and textiles are being squeezed by a strong rupee.
RBI Deputy Governor Subir Gokarn said India must manage inflows so it can fund its current account deficit while at the same time not harming exports.
Export competitiveness is more than a function of a straight two-way quote between the rupee and the dollar. The Real Effective Exchange Rate takes into account the inflation differential between two trading economies and is a better gauge of the effective exchange rate between them.
The rupee's REER based on a trade-weighed basis of six of its major trading partners provisionally moved up to 111.73 on September 9, above 102.45 at the end of 2009. A level of 100 is neutral.
The central bank maintains that it will step in to curb volatility but will not try to protect any particular level in the currency.
How will RBI manage added liquidity if it intervenes again?
If the central bank keeps intervening in the market it would result in more rupees entering the banking system, adding to the challenge of inflation management. Headline inflation at 8.6% in September is well above the central bank's comfort zone of 5-6%.
Right now, liquidity in the Indian banking system is relatively tight, due in part to funds flowing into IPO applications as well as slower-than-expected government spending of the proceeds from telecoms spectrum auctions earlier this year, making it an easier time to intervene.
The RBI can also sterilise additional rupees resulting from its dollar purchases something it did three years ago through the issuance of market stabilisation scheme bonds (MSS).
However, doing so is expensive given high market yields, and would add to the government's already high fiscal burden.
For 2010/11, the central bank fixed an upper limit of Rs 50000 crore (USD 11.3 billion) for bond sales under MSS.
What other measures can India take it to manage inflows?
Indian policymakers say they do not favour capital controls for now, but Finance Minister Pranab Mukherjee last week said he was on the lookout for "toxic assets".
India imposed controls in 2007 when it tightened rules for unregistered foreign investors by clamping down on the issuance of participatory notes, or P-notes, which were a popular vehicle for foreign investors in stocks.
RBI Governor Duvvuri Subbarao said recently that capital controls can be skirted and making frequent policy changes can send the wrong signal to investors.
India occasionally adjusts limits on flows into debt.
For example, it recently increased limits in government and corporate bonds by USD 5 billion each, to USD 10 billion and USD 20 billion, respectively.
The increase came with the caveat that the added limit can only be used to invest in at least 5-year paper. That encourages flows into long-term investments such as infrastructure and discourages a flood of hot money looking for short-end arbitrage.
India could also clamp down on external commercial borrowings (ECBs) by Indian companies looking to access cheaper funds from abroad, especially in a rising domestic interest rate scenario.
India could tighten the ECB tap by reducing sectoral ceilings, more stringently specifying end-uses for ECB funds and perhaps auctioning ECB entitlements.