The Reserve Bank of India (RBI) has hinted at possible action if faced with a surge in capital inflows through foreign institutional inves­tors (FIIs), who are expec­ted to flock to India for higher returns due to a superior growth outlook.

“Given the stronger gro­wth outlook of India and the probability of monetary exit being delayed by the advan­ced economies, ca­pital infl­ows could be expected to accelerate, which will have to be managed, as in the past,” RBI said in its annual report released on Tuesday.

India’s foreign exchange reserves, a cushion against volatile capital flows, have fallen to about $278 billion from a high of $315 billion in May 2008. Volatile capi­tal flows have been a potential source of instabi­lity for the emerging market economies.

Sterilised interventions (an intervention when RBI sucks out excess liquidity by issuing bonds) could limit the pressure on appreciation but may lead to a higher interest rate environment. Unsterilised intervention (RBI does not interfere with liquidity) could relieve the pressure on both the exchange rate and the interest rate, but would involve excess liqui­dity creation. In an enviro­n­ment of high inflation this option could only exacer­bate the situation further.

“FII flows are expected to increase further as the for­e­ign investors find India a hi­gh yield giving dest­inations specially when markets in the US and Europe are still to recover. Both Foreign dir­e­ct inve­stments and FII mo­ney into India will surge in the coming months,” said Sadanand Shetty, vice pres­ident and senior fund man­ager, Taurus Mutual Fund.

FIIs so far got in $10 billion into the Indian stock market during the year. After pulling out a record Rs 52,990 crore from the equity market in 2008, they put in Rs 83,420 crore in 2009, thereby helping an 81 per cent gain in the Sensex.

While stronger growth could help in absorbing higher magnitude of for­eign capital within the limits of sustainable cur­rent account deficit, excess inflows would entail the risk of exerting appre­ciation pres­sure on the exchange rate of the rupee, which in turn could wea­ken the comp­etitive adva­ntage of Indian exports.

Volatile capital mov­eme­n­ts have influenced the do­m­estic stock price move­ments, exchange rate and domestic liquidity condi­ti­ons significantly in the past. RBI has used a mix of fle­xible exchange rates, steri­li­sation of the impact of the in­flows on domestic liqui­di­ty, cautious approach to lib­e­ralisation of capital acc­ou­nt, and the cushion of for­eign exchange reserve to de­al with adverse rami­fic­ations.