Falling $ an inflation worry; can create a bubble in the economy

MUMBAI: The linkages of the weakness in the dollar on the back of rising US current account deficit — which is running at all-time highs of over 6% of US GDP — and the performance of asset classes globally — equities, commodities, real estate, bonds and credit spreads — are well documented.

Indian asset classes have also been major beneficiaries. A depleted dollar has meant large portfolio flows into Indian equities, which, in turn, has added substantially to the foreign exchange reserves of the country.

The liquidity owing to dollar inflows has found its way into equity, credit spreads, real estate and commodities.

The downside to this liquidity flow is inflation caused by high money supply growth. So controlling prices makes monetary policy setting more complicated.

The Reserve Bank of India has tried sterilising the liquidity through market stabilisation scheme bonds, encouraging dollar outflows on account of acquisitions and investments, raising the cash reserve ratio (CRR) and through other money supply tightening policies. However, the flow of dollars has been too strong for the RBI to stem the rise of inflation and it has been forced to raise interest rates.

The dollar’s weakness is one the biggest worries for global central banks. Rakesh Mohan, the RBI deputy governor, has said that the impact of global imbalances on the Indian economy would not be as much as on export-driven economies.

However, such imbalances will have repercussions on Indian financial markets given its globalised nature.