This should have strengthened the rupee further. That did not happen because of the RBI¹s decision to buy dollars, increase the demand for that currency and stabilise its value vis-à-vis the rupee. Net purchases of foreign currency from the market by the Reserve Bank of India amounted to $3.25 billion between end-March 1999 and end-March 2000. These purchases resulted, among other things, in an increase in the foreign currency assets of the central bank from $29.5 billion at the end of 1998-99 to $35.1 billion at the end of 1999-20000. The large demand for dollars that this intervention by the RBI in foreign exchange markets resulted in help keep the rupee relatively stable during financial year 199-2000. In fact, RBI figures show that the real effective exchange rate of the rupee remained more or less constant during 1999-2000, though, as argued earlier, some depreciation of the real effective rate could have helped.
 
It is this recent history which makes the recent downward movement in the value of the rupee and the RBI¹s knee-jerk reaction to it a bit surprising. It is indeed true that over the first two months of 1999-2000, for which we have information, while exports have staged a recovery, imports have grown even faster, resulting in an increase in the trade deficit relative to the corresponding period of the previous year.  But what has been a more depressing influence on the rupee are signs that portfolio investments are once again turning negative, and rapidly so. Net FII investments, which in April stood at $617 million, fell to $111 million in May, and turned negative as of June. Outflows are estimated at $218 million in June and around $300 million in July.
 
It must be noted that net outflows do not reflect a complete loss of FII interest in India. Rather FII purchases during 2000 have been fairly high. But so have sales. In the net, these institutional investors appear to be cashing in their past investments, making some new investments and diverting the rest to other markets. In particular the strengthening of interest rates in the US and the recovery of markets elsewhere in Asia have, according to insiders, resulted in a shift of FII focus away from India. The point is that this consequence of developments elsewhere has had a dampening effect on the value of the rupee, which is perceived as being "overvalued".

From the Reserve Bank¹s point of view this should have been fine, except that given the liberalised nature of financial markets, any perception that a currency is overvalued and that it is headed downwards sets off speculation in the currency. The typical form this would take would be the acquisition of rupees that are used to purchase dollars, which in turn are later sold for a much larger sum. So long as this difference is greater than the interest costs incurred on the original amount at prevailing interest rates, the transaction yields a profit.

The difficulty is that transactions  of this kind by increasing the demand for dollars, strengthens the dollar relative to the rupee to an even greater extent, ensuring that speculative expectations are realised. It is obvious that the RBI, based on past experience, expected at least some of those authorised to deal in foreign exchange to behave in this manner. This raises the possibility that a warranted and welcome depreciation of the rupee can soon turn into collapse, which can have a host of adverse implications. It is only that perception that can explain the heavy-handed response of the central bank.
 
The source of that perception could have been evidence that the RBI¹s strategy of Œplaying the market¹ was proving inadequate to stabilise the rupee. Figure on foreign exchange reserves reveal that the foreign currency assets of the RBI fell by $1.4 billion between end-March 2000 and mid-July 2000. Sensing a downward pressure on the rupee the RBI was clearly offloading dollars in the market with the aim of strengthening the rupee. It was possibly when this proved inadequate to halt an accelerated slide of the rupee that the decision to reverse the direction of monetary policy was taken.

It is to be expected that industry would be affected adversely by the hike in interest rates and the squeeze in liquidity, since it occurs at a time when industrial growth still remains sluggish and the demand for consumer durables has weakened. This only suggests once again that financial liberalisation, which makes monetary and fiscal policy the victim of the whims of highly mobile and speculative portfolio investors, is in the long run inimical to the development of the real, commodity producing sectors. But there is more to learn from these developments. It also makes clear that the defence of financial reform on the grounds that it would help create an autonomous central bank and increase the effectiveness of monetary policy is completely misplaced. The size of the foreign currency assets of the RBI, which is a crucial influence on money supply, is clearly determined by the whimsical behaviour of the foreign financial investor. And there are times when adjustments in the foreign assets position of the central bank is inadequate to realise an objective, necessitating changes in crucial parameters determining the central bank¹s monetary stance. This renders all talk of autonomy of the central bank meaningless. While the central bank in India may have won a degree of independence from the scrutiny and influence of the executive and, more crucially, of Parliament, it now appears to have subordinated itself to the requirements of international finance. It is not autonomy that has been won, but a new master.