The US Federal Reserve decided to cut interest rates once again in its meeting this week. Last month, when the Fed cut rates, it led to a surge of capital flows into India. In the six weeks since the last Fed rate cut, portfolio investment of USD 8.7 billion flowed into the Indian stock market. A higher interest rate differential combined with India’s growth story will mean that India will remain an attractive investment destination for global investors.

A major concern arising from the surge in capital flows is the pressure on the rupee to appreciate. There has been immense pressure on the government to keep the rupee cheap. The government has tried to do three things: buying dollars in the foreign exchange market, imposing restrictions on capital inflows and liberalising capital outflows. If we look on a day-to-day basis, it may seem that the policy has had some success, but a longer term perspective suggests that it may have actually exacerbated the problem of the capital surge that we face today.

The last five years have seen a global decline of the dollar. Major currencies of countries where central banks do not trade in currency markets have shown an appreciation against the US dollar. The index of major currencies tracked by the US Federal Reserve shows that from mid-April 2002 to date, there has been a 34 per cent depreciation of the US dollar. Over this period, the dollar has seen a comparable depreciation against the Indian rupee of 20 per cent. However, the appreciation of the rupee has not been a normal market process. The rupee has rarely witnessed the two-way movement on a day-to-day basis in the manner that other currencies have. The appreciation of the rupee has been fought hard all the way by the RBI. As a result, there have been long periods when the rupee has appreciated slowly with the RBI actively intervening to prevent sharp movements. This slow appreciation has been truncated by periods of sharp volatility when the RBI let go and the rupee saw sharp appreciation.

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