Is rising forex kitty fuelling inflation?

Analysts expect it to surpass $400-bn mark by first week of September

As the Reserve Bank keeps on shoring up the forex kitty, which is on course to hit the $400-billion-mark anytime now, it may leave Governor Urjit Patel with a piquant situation as rising liquidity may spoil the low-inflation party.

The country's forex reserves are marching towards the $400-billion mark, and many analysts expect it to cross the magic figure by the first week of September. While this will bring in greater macroeconomic stability, with import cover rising to over 12 months, it may also lead to some uptick in inflation, say treasury officials.

When Patel assumed the reins of the central bank, the forex kitty was at $367.766 billion (as of September 2, 2016). During the past 11 months, the net addition to the reserves was $25.846 billion, taking the reserves to $393.612 billion for the week to August 11 this year.

Patel assumed the office of the Governor on September 5, 2016.

"The forex reserves have been rising as the central bank is accumulating greenbacks by selling the rupee in the market which is already awash with liquidity. This excess liquidity may create some inflationary pressure," the treasury head of a state-run bank told PTI, requesting not to be named.

Also, going forward there will be more pressure on the RBI to contain the rupee as a strong local currency has been crimping exports, he pointed out. The rupee has for long been trading in the 64.50-64-10 range.

Concurring this view, the treasury head of another state-run bank said, "Rising liquidity may play spoilsport for the central bank's mandated inflation fight. Already after a dramatic dip in June to 1.54 per cent, CPI has almost doubled to 2.36 per cent in July and this does not augur well for the inflation fight."

Some analysts, on the other hand, feel the Reserve Bank may not allow inflation to harden and will try to manage excess liquidity through instruments such as open market operations and cash management, among others.

Recently, American brokerage Morgan Stanley had estimated that the reserves could hit the $400-billion-mark by the week to September 8.

"The surge in reserves is on account of higher capital inflows from foreign portfolio investors and other funds. The high reserves will bring in macroeconomic stability in the country," a treasury official of a private sector lender said, adding the rising foreign direct investment will also act as an enabler.

So far, this calendar year, foreign portfolio investors have pumped in nearly Rs 1.75 trillion into the equity and debt markets.

The Morgan Stanley report had said the buoyant capital inflows put appreciation pressures on the rupee which could leave the market awash with liquidity, creating challenges for the RBI to manage its monetary policy.

"The monetary policy will only take into account the impact of the rupee appreciation on inflation into its policy decision, rather than tackling currency rise per se," the report had said.