Two days ago, the RBI governor said that India was witnessing an avalanche of capital flows, but that high inflation was a deterrent to cutting rates. This morning he cut repo rates by 25 basis points to 7.50 per cent.

Foreign investors have been pouring money into what is now very likely the fastest growing economy in the world. The competitive rate cutting being done by various central banks to deal with financial crisis in their respective domains has led to foreign investors looking for arbitrage opportunities to deploy their surplus profitably. Nearly $10 billion worth of investments in equity and debt has come in from foreign investors during the past two months. That trend seems likely to accelerate on the back of what many see as a growth-oriented budget announced three days ago.

The problem of the rupee

The RBI might well have to deal with the problem of a sudden appreciation in the value of the rupee after a spell of relative placidity in the last couple of months. Given the need to keep volatility of the currency under control and also pacify pressures from the exporter lobby, the RBI could take the alternative route and buy the forex that comes in and build up its forex reserves buffer. But this course of action would also mean the RBI would have to pump in rupees into the system and live with the possibility that it might stoke inflation just when the inflation battle seems like getting under control.

In this backdrop, cutting interest rates is the best policy option for the RBI. It will help moderate the avalanche of capital flows to some extent. And also serve to keep the rising chorus of demands for rate cuts from India Inc at bay. That is two birds with one stone.

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