Problem of plenty

The Reserve Bank of India (RBI) is trying its level best to stop the flood of dollars pouring into the country.

Hours after the release of data showing a jump in foreign exchange reserves by a staggering $3.37 billion in the week ended April 9, the central bank announced measures to further reduce interest rates for NRI deposits, in an attempt to further reduce arbitrage flows. This is the fourth time, since July last year, that the RBI has reduced the ceiling on NRI deposit rates.

In July, the central bank fixed the ceiling on Non-resident External (NRE) deposits at 250 basis points above the Libor/swap rate of corresponding maturity, bringing it down to 100 basis points above Libor in September, 25 basis points above Libor in October and now setting the maximum rate at Libor.

The restrictions have had an effect, with inflows into NRE deposits tapering off to a mere $154 million in January. With the maximum deposit rate already at a maximum of 25 basis points above Libor, lowering it by another 25 basis points will not make much of a difference.

The loophole, however, lay in the NRE savings bank accounts, which offered the domestic rate of interest that is, 3.5 per cent. That loophole has now been closed with the requirement that NRE savings bank accounts can now pay a maximum rate equivalent to the six-month Libor rate.

While the rationalisation of the NRE savings bank rate corrects an anomaly, it is doubtful if lowering interest rates will enable the RBI to stop the influx of dollars. That's because these inflows are no longer large enough to make much of a difference "" contrast the rise of $3.37 billion in reserves in one week to NRE inflows of only $154 million in one month.

The RBI's recent balance of payments data showed that the main sources of foreign exchange inflows into the country were FII investments, remittances and proceeds from services exports.

Nevertheless, if the rupee continues to appreciate at the 9 per cent rate seen in the last fiscal, that will be incentive enough to prefer rupee deposits to dollar deposits, irrespective of the interest rate offered.

There are no easy answers to the RBI's problem of plenty. If it tries to keep the value of the rupee down, it floods the domestic markets with liquidity, with the result that money supply growth could later lead to inflation.

In China, which faces a much bigger but similar problem, with money supply growing at over 20 per cent, the government is very worried about a credit-induced bubble.

On the other hand, if the RBI lets the rupee rise to market-determined levels, not only will exporters cry foul but the appreciating rupee itself will attract large dollar inflows, just as money has flowed into China, betting on a renminbi appreciation.

Thankfully, once corporates start implementing their investment plans, the demand for project imports could lead to some of the pressure being taken off the rupee.

That would also be the effect of a rise in interest rates in the United States, which may lead to lower FII inflows. So far as policy initiatives are concerned, while the RBI should continue with its measures towards full capital account convertibility, the new government after the elections must seize the opportunity to reduce customs duties.