The point to note is that the lack of any fiscal stimulus is in large part the result of the effort to give the central bank greater independence. This, as discussed earlier, has required not just a curb on the fiscal deficit, but also the abolishment of the practice of financing it with low interest ad hoc Treasury Bills. Thus the curb on the deficit, during a period of shrinking revenues, has been accompanied by a rise in the interest burden on the government's budget. Not surprisingly, the role of government expenditure as a stimulus to industrial growth has been substantially eroded. What is appalling is that this has occurred at a time when the combination of burgeoning foodstocks that are proving to be an embarrassment, large foreign exchange reserves, low inflation and high unutilised capacity in industry, makes an obvious case for a major fiscal stimulus aimed at raising output and employment without stoking inflation. But that opportunity has been lost by the adherence to an orthodox monetary and fiscal policy regime that emphasises central bank autonomy.
 
What is more, even autonomy has proved to be limited, because of the role of volatile capital flows into the economy. As mentioned earlier, one area in which the RBI has been forced to be active in the wake of reform is the liberalised foreign exchange market. The supply and demand for dollars in that market does influence the level of the exchange rate. However, in the wake of financial reform the supply of dollars is no more determined by the inflow of foreign exchange due to current account transactions such as exports and remittances. Rather, inflows on the capital account in the form of private debt and foreign direct and portfolio investment, are a major determinant of supply at the margin.
 
Such inflows have increased significantly in the wake of the financial reform of the 1990s. But such increased inflows have not been matched by the demand for dollars from a not-too-buoyant economy. In the event, an excess supply of foreign exchange in the market has tended to push up the value of the rupee at a time when India has consistently recorded a deficit on its current account. To combat this, the central bank has had to regularly demand and purchase dollars, resulting in a substantial rise in the foreign currency assets of the central bank. Such a rise as we have mentioned earlier, by contributing to money supply increases, limits the autonomy of the central bank on the monetary policy front.
 
But that is not all. The volatility in foreign capital flows tends to further limit the manoeuvrability of the central bank even further. Consider for example the year 1999-2000, which was one in which foreign capital inflows into the country, having fallen from $12 billion in 1996-97 to $9.8 bilion in 1997-98 to $8.6 billion in 1998-999, rose once again to touch $10.2 billion (Chart 8). This should have strengthened the rupee. It did not because the RBI, as in the past, stepped in 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 1999-2000. Most of these purchases occurred between end-September 1999 and end-February 2000 (Chart 7). The large demand for dollars that this intervention by the RBI in foreign exchange markets resulted in, helped keep the rupee relatively stable during financial year 1999-2000. However, that stability concealed a new source of vulnerability. As Chart 9 indicates, the share of stable capital flows (or flows other than portfolio investments, short-term debt and NRI deposits), which had risen to account for almost 90 per cent of all flows by 1998/99, fell to 46 per cent of the total in 1999-2000.
Chart 7 >> Chart 8 >> Chart 9 >>
 
This vulnerability partly explains why things have changed suddenly this financial year. Thus over the first three months of 2000-01, 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 an even more depressing influence on the rupee are signs that portfolio investments have turned 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, with outflows estimated at $218 million in June and around $300 million in July.
 
Clearly, institutional investors are cashing in a part of their past investments and diverting funds to other markets. According to market sources, the strengthening of interest rates in the US and the recovery of markets elsewhere in Asia have encouraged 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 now perceived as being "overvalued".
 
This should not have mattered much, especially given the fact that the rupee has appreciated vis-a-vis a range of currencies other than the dollar. However, 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. And once such speculative activity is triggered, speculative expectations tend to realise themselves leading to a downward spiral in the currency's value. The RBI's "knee-jerk" reaction to the recent slide in the rupee's value suggests that it believed that some authorised dealers and exporters were acquiring and holding dollars for speculative purposes, so that an ostensibly warranted and welcome depreciation of the rupee could soon turn into collapse, with a host of adverse implications. It is only that perception that can explain the heavy-handed response of the central bank in the form of a squeeze in liquidity, hike in interest rates and a cap on dollar holdings in EEFC accounts.
 
Whatever the sequence of events that led up to that perception, it is clear that the whimsical behaviour of foreign investors and speculative activity in India's liberalised foreign exchange markets has forced the RBI to divert from its well planned monetary policy thrust aimed at stimulating growth. This substantially erodes the validity of the view that reform has rendered the central bank more autonomous and monetary policy more effective. Despite the accumulation of foreign currency assets in the hands of the RBI, it has found itself in a situation where it has had to make changes to the Bank Rate, the CRR and the ease of access to foreign exchange, in order to counter speculation in the market for foreign exchange. And yet, the evidence of success of the effort at stabilising the rupee is still ambiguous.