The rupee has been appreciating owing to these huge influx of FII.

The huge inflow of dollar

makes it cheaper in the forex market and hence causing appreciation of the rupee.This
appreciation has got the potential to hurt India's export.RBI may have to intervene in the forex
market to stem the appreciation of the rupee against dollar.But,India faces a very high degree of
inflation for several reasons.When India was hit by the financial crisis the Government responded
with fiscal stimulas and RBI key policy rates.Given India's economic structure demand recovered
rather quickly while the stimulus remained quite high.Also India faced food supply shortages
owing to bad monsoon and drought in 2009 leading to food inflation.In the mean time
corporations were not very eager in adding capacity after the crisis.All of this was reflected in
current account deficit.Now intervening in the forex market to curb rupee appreciation would
mean infusion of liquidity in the system leading to softening of the interest rate.This can frustrate
RBI's effort to contain inflation.Inflation in september has risen to uncomfortably high level of
8.62%.The rupee has appreciated by around 8% in the last 5 months from around Rs. 47.60/$ in
May to Rs. 44.03/$ on 15th october 2010 as FII poured in $ 22 billion in Indian stocks.More
money can flow in to buy Coal India shares in India's largest IPO next week.The sale of 10%
stake in World's largest coal mining company could fetch upto $ 3.4 billion.But increasing short
term interest rates beyond a certain point to contain inflation is a difficult proposition for RBI as it
would provide arbitrage opportunities in the currency markets.As rate of return is higher in
India,investment would be more attractive in Indian assets along with cheaper borrowing rate of
dollar leading to further increase in return.However there is a view that due to tight liquidity banks
may increase lending rate soon. As a whole the banking sector is borrowing Rs. 100000 crore
from RBI at 6% under the liquidity adjustment facility.Therefore it's possible at the present
moment for RBI to intervene without creating excess liquidity.But,at the same time policymakers
may be forced to resort to selective measures to restrain capital flow that has begun to influence
India's current account deficit.India is the only major emerging economy that has not yet
imposed restrictions despite concerns of declining exports and increasing imports.The current
account deficit is heading 3% of the GDP,the first in nearly two decades.Thailand has joined
Brazil and South Korea in imposing restrictions on overseas flows which have been distorting
trade as USA is set to continue its stimulus to avoid double dip recession and China sticks firm to
near fixed Yuan exchange rates,there is a possibility of currency war brewing in the
horizon.Thiland has ended a 15% tax exemption for foreigners on income from domestic
bonds.Brazil has doubled its tax rate on capital inflows to save its export competitiveness from
being eroded.Japan is caught in the middle as it's been facing sluggish economy along with rapid
rise of Yen against weakening dollar hitting a 15 year high.Japan has tried to thwart this by
decreasing policy interest rate close to 0 and intervening in the forex market though these
measures have not yet paid the dividend for Japan.One major difference between India and
countries like Korea,Brazil,Japan is while India have an ever increasing deficit of external
earnings and expenditure these countries run on surplus and can afford an appreciating currency
better than India.As long as capital flows are in excess of current account deficit the pressure on
rupee to appreciate will continue.The Indian policymakers' views do not seem to be concerned
about the deflationary impact of rising rupee on growth,employment or about the SMEs
competing with manufacturing imports.The key macroeconomic concern is funding available for
current account deficit has been exceptionally volatile.There are two kinds of risk that India
remains exposed to.First, a sharp recovery in overall risk appetite could increase commodity
prices and oil prices.Considering India's current inflation level, India would be in a highly
vulnerable position if it has to absorb a high degree of commodity price inflation at this
stage.Second,if the talk of decoupling between emerging and developed economies doesn't
come out to be of true significance and US fiscal expansion doesn't turn out as per expectation
we can possibly see sudden withdrawal of capital threatening financial stability as happened in
2008.Also given the decline in the growth of Index of Industrial production (5.6% in August
compared to 13.8% in July and 10.6% in August 2009) dizzying heights of the Indian stock
indices may not be justified even in the light of country's high growth rate.So, stock indices are
expected to slow somewhat in the coming months.Currency appreciation according to RBI annual
reports quotes research worsens trade balance significantly.The estimated coefficient shows that
1% currency appreciation invokes around 0.7% deterioration in trade balance.Over the last 18
months rupee has appreciated more than 25% in real terms against dollar which the invoicing
currency for 80% of India's cross-border trade.As US seems to follow a policy of passive
devaluation of dollar to come out of the economic sluggishness in the long term economies that
are driving global growth particularly those in emerging Asia will see sustained inflows of capital
and a secular trend of appreciating emerging economy currencies against dollar,euro and pound-
sterling.There will be political pressure on emerging economies from the developed countries not
to intervene in forex market and distort it.The competitiveness of emerging economies export will
then depend upon their ability to enhance domestic productivity.Capital control will give the
emerging economies temporary breathing space.This will be a challenge for Asian
countries.Therefore it's important to strengthen the financial market and manage the macro
economic policy better.