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 brought in huge amounts, the funds have barely found their way to the central banks foreign exchange kitty.

Between August and October this year, foreign institutional investors (FIIs) have bought close to $8 billion 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 the dollars include FDI, ECBs, export earnings and remittances. However, there is a 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: RBI 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 banks 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. Indias 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 countrys foreign exchange reserves have risen by around $13 billion during August-October, much of this is believed to be due to revaluation of non-dollar assets in reserves such as the euro, the 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 banks policy of minimal intervention also helps it bring down the cost of managing foreign exchange, if RBI continuously buys the dollars from the market, it has to simultaneously infuse the rupee liquidity into the system and later suck it out by selling bonds. This is at a cost, as the returns on deploying the dollars in the overseas markets is far less than the interest paid on domestic bonds.