The weakening of the American dollar in international markets and stronger foreign capital flows to India in recent weeks suggest that in the coming year the rupee could witness pressure to appreciate. Allowing the rupee to appreciate could be a way out of the policy dilemma of the Reserve Bank of India concerned with low growth and rising inflation. Preventing appreciation could, on the other hand, lead to either higher liquidity, if intervention is unsterilised, or to the familiar difficulties of sterilisation.

Despite the US being the epicentre of the global financial crisis, the dollar strengthened in the immediate aftermath of the financial crisis. This somewhat surprising development has been explained by the increase in risk aversion of investors from around the world who preferred the relative safety of US treasury bills. In the last six months the dollar has weakened. It moved from $1.26 to the euro in early March to $1.47 in the last week of September. This weakening is being seen as the end of the phenomenon of the “flight to safety”, or the “dollar as a safe haven”.

As the risk appetite of global investors has increased in recent months, India has witnessed a return of foreign inflows. Both FDI and foreign portfolio flows have been strong. As the Indian economy grows at a relatively faster pace than the world economy and as the long-run growth prospects of the Indian economy remain strong, India can be expected to attract capital inflows.

The global weakening of the dollar and continued capital inflows can put pressure on the rupee to appreciate. What should be the RBI’s response?

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