Problems of surplus

Balancing rupee, interest rate movement, a tough ask

s India’s financial markets begin the new fiscal year, the overhang of record foreign portfolio inflows in equity and debt instruments in 202324 will be weighing heavily on the minds of regulators. FPIs purchased (in net terms) ₹3.39lakh crore of equity and debt instruments last fiscal year, the highest since 199293. They purchased stocks worth ₹2.08lakh crore, and debt instruments worth ₹1.21lakh crore. If such inflows continue this fiscal year, they will support stock prices, lower bond yields, boost the rupee and have a beneficial impact on the balance of payments.

AHowever, the Reserve Bank of India (RBI) will have a problem on its hands. The challenge will be in managing the currency, liquidity and interest rates as a result of the high flows. The alltime high foreign portfolio inflows have come despite elevated interest rates and tight monetary conditions globally and are influenced by a variety of factors. First, is the superior growth and potential of India’s economy, healthy profitability of domestic companies thanks to falling commodity prices, and rising demand fuelled by urban consumption. Second, with China falling out of favour with foreign investors given the weakness in its economy, emerging market equity funds seem to be diverting more money into India. Third, inclusion of Indian government bonds in JP Morgan and Bloomberg bond indices has resulted in additional inflows of ₹80,000 crore in debt securities. Fourth, is the stability of the rupee, which has largely fluctuated around the 83 mark against the dollar.

In the last fiscal year, the RBI managed, or decided, to keep the rupee stable, despite these inflows, by buying dollars, and in the process taking the foreign exchange reserves to a record high of $642 billion. But dollar purchases increased system liquidity and the RBI had to absorb some liquidity under the LAF window and also conduct variable reverse repo rate auctions in February and March to absorb the surplus. Of concern is the fact that the money market rates have begun moving lower due to higher liquidity. Managing the exchange rate and interest rate simultaneously will become a challenge if this fiscal too sees high FPI inflows, as expected. With the US Federal Reserve expected to cut the Fed Funds rate by 100 basis points by the end of 2024, the relative attractiveness of Indian government bonds is likely to increase. The equity market is likely to attract foreign funds investing in emerging economies.

The central bank will have to use all tools in its arsenal to sanitise the surplus liquidity flows. As the Chief Economic Advisor, V Anantha Nageswaran, said at an event organised by this newspaper on Tuesday, the current size of the Indian economy is much larger than in the 200408 period, and therefore these flows will be more easily absorbed. But the government will also have to create opportunities for public and private entities to absorb these flows.