Since the start of the year, the Reserve Bank of India [Get Quote] has had to contend with rising inflation and increased liquidity in the financial system causing it to raise the cash reserve ratio (CRR) ratio and the repo rate to reign in the excess money. And by not actively intervening in the forex market (an act, which would have further fuelled the release of rupees into the system), the rupee appreciated sharply to 40.58 levels.

However, what the RBI has not been able to control is the surge of inflows into the country, and, in this article, we shall take a look at the kind of inflows that have been aggravating the abundance of liquidity.

Capital inflows: Capital flows during 2006-07 were substantially higher than a year ago, led by foreign direct investment (FDI) flows, on the back of strong growth prospects and buoyant investment demand.

FDI inflows at $16.4 billion during April 2006 to January 2007 were substantially higher than the inflows in the corresponding period of the previous year ($5.8 billion). This FDI was channelled mainly into financial services, manufacturing, banking services, IT services and construction.

As far as the institutional activity is concerned, while FIIs continued to pour money into Indian equities, the activity on this front was lower than what it was last year. To put things into perspective, net FII inflows in FY07 stood at $3.2 billion as compared to $9.9 billion in FY06 (Source: RBI).

The fall was attributed to the global developments such as meltdown in the global commodities and equity markets (May-July 2006), fall in Asian equity markets subsequent to the tightening of capital controls by Thailand and on account of concerns of slowdown in the US economy.

External commercial borrowings (ECBs): Capex plans lined up by India Inc., and buoyant investment activity led to the demand for borrowings from abroad. This was substantiated by the fact that the amount of ECBs in the period between April 2006 and December 2006 stood at $9.3 billion as compared to $4.4 billion in the corresponding period last year (Source: RBI).

Besides funding capex, Indian companies resorted to the ECB route to fund acquisitions abroad. Thus, a rise in the recourse to ECBs has not only increased the flow of money into the economy but has also magnified India's external debt position. For instance, India's total external debt was placed at $142.7 billion at the end of December 2006, an increase of $16.2 billion over the end of March 2006 and thus accounting for 25% of the total external debt.

NRI deposits: NRI deposits increased to $3.7 billion in the period April 2006 to January 2007 from $1.7 billion during the same period last year. The same was attributed to higher interest rates on various deposit schemes upto January 2007.

Having said that, while the ceiling interest rate on these deposits was raised by 25 basis points each in November 2005 and April 2006, the same was scaled down by around 50 basis points in January 2007 probably in a move to make these deposits less attractive and to some extent control the quantum of inflows that these deposits were fuelling.

It must be noted that NRI deposits have also been instrumental in increasing India's external debt and accounted for 27% of the total external debt at the end of December 2006.

Summing up

The influx of inflows into India has led the Indian rupee to appreciate sharply, which is expected to hurt export oriented sectors such as software, textiles, pharma amongst others at least in the medium term. With the government laying more emphasis on containing inflation, its intervention in the forex market is likely to be a tad lower, which means that we could see a stronger rupee in the near term at least assuming that the inflows continue to remain strong.

These capital inflows have also acted as a cushion to India's BOP situation, which is in surplus despite the deficit that the country faces on the current account front. While the FDI money that is coming in is essential in terms of boosting economic development and generating returns, the government needs to make sure that it is not too liberal in making the scenario attractive for NRI deposits and ECBs if it wants to have some semblance of control over the problem of rising inflows.

Powered by Equitymaster.com, an independent equity research initiative. Equitymaster is currently celebrating its 10th Anniversary. To know more about the special offers on its equity research subscription services, please click here.