The year 2003 will go down in history as one in which the Indian economy witnessed three related and remarkable developments. First, a sharp rise in the inflow of foreign institutional investor capital that touched record levels and established India as a favourite among emerging markets. Second, an unusual strengthening of the rupee, especially vis-à-vis the dollar, leading to a situation where exporters and even the government have started worrying about the adverse impact this could have on the competitiveness of India's exports and the size of the balance of trade deficit. Third, the massive acquisition of reserves by India's central bank, the Reserve Bank of India, which resulted in the accumulation of record foreign currency reserves totalling close to $90 billion currently, despite large outflows on account of the redemption of the Resurgent India Bonds issued a few years earlier.

The factors underlying the initial inflows of foreign institutional investment into India's stockmarkets are now well known. India has, since 1993, set up a relatively liberal trading and tax regime for these investors, and allowed them to enter the debt (and not just equity) market since 1996. The returns on Indian equity are known to be reasonable. And the Indian rupee has not just weathered the wave of currency crises in the region since 1997, but has also shown no tendency to depreciate and erode the value of rupee incomes earned on equity and debt trading when calculated in foreign exchange.

This attractiveness of Indian markets to foreign investors has indeed been enhanced by a number of recent developments. US stockmarkets have lost their charm ever since a spate of accounting scandals, corporate fraud reports and instances of conflict of interest put an end to the stockmarket bubble of the late 1990s. Thus, for investors looking for an alternative avenue for investment, India offers a good opportunity. Next, government guidelines, upheld now by the Supreme Court of India, ensure that firms based in Mauritius with uncertain residential prerequisites are eligible for the benefits offered by the double-taxation treaty between India and Mauritius. This implies that taxation of stockmarket gains will be lower and the rates of return offered by Indian markets higher if investments occur through the 'Mauritius route'. Finally, the interest rates in India are much higher than international ones, despite the RBI's efforts to bring down these rates and impose ceilings on interest offered on NRI deposits. Hence, the opening up of the debt market since 1996 has seen substantial investment flows into that market, accounting for about a quarter of FII investments in 2003.

While these and other factors show why India has emerged a favourite among emerging markets over the last few years, they are inadequate to explain the mad rush to India in 2003. Even by 30 September this year's FII inflows, at $3.09 billion, had exceeded their previous full-year peak, of $3.058 billion, recorded in 1996. Further, the evidence suggests that the inflows have accelerated over the last three months, with $836 million in September being the highest for any single month since Indian markets were opened to foreign investors.

The explanation for this sudden surge lies in the balance of payments scenario resulting from liberalization and the consequences of India being chosen as a favoured destination by portfolio investors from abroad. It is widely accepted that despite the moderate recovery in industrial growth in 2002–03, the Indian economy has for the last few years been experiencing slow growth relative to the record of the mid-1990s. Liberalization seemed to be triggering a post-crisis boom after 1992, but has failed to sustain that growth since about 1998. One set of reasons for this is the contraction induced by the reduction in the tax–GDP ratio associated with liberalization, and the drag on the fiscal deficit associated with fiscal reform. As a consequence, despite trade liberalization, imports have not been as buoyant as expected. Combined with robust inflows of remittances from non-resident Indians, this has meant that the current account balance—or the excess of current foreign exchange expenditures over receipts—in India's balance of payments has reflected a small deficit or even a surplus.

One implication of this is that India does not require large capital inflows to finance the deficit on its current account. If,  despite this, inflows on the capital account in the form of foreign direct and portfolio investment have been large, the availability of foreign exchange in the country exceeds that required to meet its foreign exchange expenditures. In the more liberalized foreign-exchange management system introduced post-liberalization, wherein the availability or supply of foreign exchange relative to the demand for the same has a role in determining the exchange rate, this could lead to an appreciation of the value of the rupee relative to the currencies of its trading partners.

No government, let alone a developing country government, can accept such a tendency for long periods of time. An appreciation of the rupee (implying that fewer rupees exchange for a dollar) increases the dollar value of the country's exports (that is, makes them more expensive), and reduces the rupee value of imports (makes them cheaper). This could result in sluggishness in export growth and an increased demand for imports, leading to a widening of the balance of trade deficit, domestic deindustrialization and a subsequent weakening of the currency that may be difficult to halt because of panic withdrawal by foreign portfolio investors.

To prevent such developments, in countries that have liberalized exchange rate systems and are subject to autonomous capital flows, the central bank has to make exchange-rate management an important objective, and intervene in foreign exchange markets (through purchases and sales) to manage and stabilize the currency. This is precisely what the central bank in India, as in many other developing countries, has been doing. Faced with an excess supply of dollars for the reasons noted earlier, the Reserve Bank of India has been forced to purchase dollars from the market and add them to its reserves in order to prevent the rupee from appreciating.

Central bank intervention of this kind is not without problems. An increase in the foreign currency assets of the central bank entails as its counterpart the release of equivalent local currency funds or an increase in money supply. This reduces the autonomy of the central bank when it comes to monetary policy and the control of money supply. Further, while foreign exchange inflows into the country are rewarded by relatively high returns, investment of foreign currency reserves in safe and liquid government securities offers a relatively low returns. This implies a cost which somebody has to bear.

In these circumstances, beyond a point, even the central bank finds it difficult to continue purchasing dollars and accumulating dollar reserves in order to prevent appreciation of the rupee. This sets off a process of creeping appreciation of the rupee, which India has been experiencing for some time now. At the beginning of October 2003, the rupee ruled at Rs 45.40 to the dollar, which reflected a 38-month high in the value of the currency. Yet, the signs were that the rupee would only get stronger.

Recent FII inflows, besides encashing the returns implicit in the interest rate differentials between India and international debt markets, are driven by expectations of  further appreciation of the rupee. Purchases made when the rupee's value rules lower yield, when sold, not just the capital gains or interest income differential associated with the asset, but also the difference in dollar incomes resulting from the appreciation of the rupee during the life of the investment. That such speculative gains have played a role in recent flows is indicated by the high level of trading associated with FII investments. After the initial period of stock acquisition by the FIIs in the early 1990s, sales of FIIs have amounted to anywhere between 70 and 100 per cent of purchases in value terms, pointing to a high turnover of the assets held by these institutions. Intense trading is a way to realize speculative profits.

The problem is that when investments are attracted to the Indian market with expectations of speculative gains from rupee appreciation, these expectations have a tendency to get realized. To begin with, the larger the inflow, the greater the buoyancy of the market, since, at the margin, stockmarket values are substantially influenced by the volume of FII investments. Thus, at the end of the first week of October, the Bombay Stock Exchange 30-share index, the Sensex, crossed the so-called 'psychological barrier' of 4600, to touch a high that has not been seen since June 2000. Second, the larger the inflow, the larger the excess of dollar supply relative to demand, and, therefore, the greater the upward pressure on the rupee. Also, the greater the pressure for rupee appreciation, the greater the stimulus to speculative investment flows. The stockmarket becomes a casino in which players bet on the value of the rupee. This could continue till the bubble becomes unstable. But when the speculative run unravels, there is no saying when and where the market and the rupee will stop its decline. Those who rush in to gain from the speculative run, rush out to cut their losses.

These dangers are the greater today because financial liberalization has more recently allowed for the introduction of instruments like futures and options that attract the speculative investor. The Securities and Exchange Board of India (SEBI) has also implicitly ratified the issue of participatory notes by registered FIIs, which are quoted and held abroad and whose values are linked to the prices of a bundle of Indian financial assets. It now only requires fortnightly reporting of the volume and holding of such participatory notes. Information has it that unregistered hedge funds are making speculative investments in these p-notes, introducing into the Indian market the most speculative of institutions in the world of international finance.

Seen in this light, the current 'comfortable' level of India's foreign currency reserves, the strength of its currency and the buoyancy of its stockmarket are not just indicators of a resurgent Indian economy that does not need to even blink when $5.5 billion worth of resurgent Indian bonds are redeemed. They are also indicators of a speculative wave that increases the vulnerability created by financial and currency market liberalization. Vulnerability of this kind in the past has ravaged even the miracle economies of Southeast Asia. Managing this vulnerability will be the first priority for the new Governor of India's central bank.