Abstract:
Since the liberalization of the Indian economy in 1991, the country has experienced sustained current account deficits as domestic savings rates, while rising, were still exceeded by domestic investment rates. However, these deficits were serviced by a massive influx of capital inflows, made possible by the removal or reduction of restrictions on foreign investments. These inflows also generated significant net demand for the Indian rupee, which in turn increased the pressures for an exchange rate appreciation. A natural consequence of such currency appreciation would have been a loss of export competitiveness and a widening of the country's trade deficit but for the active foreign exchange intervention of India's central bank, the Reserve Bank of India (RBI). This in turn led to a substantial build-up of India's foreign exchange reserves, which also created excess liquidity in the system. The resulting excess liquidity was absorbed by the RBI (so-called monetary sterilization) in order to prevent the rise of inflationary pressures. This absorption of excess liquidity went on until the Global Financial Crisis (GFC) of 2008-09 when there was a sudden reversal of capital flow.
