The article has tried to address some of the fundamental issues in monetary imbalances and their impact on long-term growth prospects of the Indian economy. After the Federal Reserve decreased Fed fund rate and the discount rate, there have been a huge Foreign Institutional Investment (FII) flows into the financial sector and dollar has been at a record low against all major currencies of the world.

On September 18, 2007, the Federal Reserve stunned the market by reducing the Fed fund rate and the discount rate by 0.5%. This was more than expected and all the markets started rallying and expected that a further rate cut would be announced in its October policy. Risk aversion due to sub-prime crisis was suddenly converted into higher bets for the emerging markets. So, it was expected that more dollars would be pumped into the Indian economy. But with active Reserve Bank of India (RBI) intervention, rupee has remained relatively capped at Rs. 39.50 to Rs. 40. The following is a pictorial depiction of the rally in Dow Jones index after the announcement on September 18, 2007.

The rally in the Sensex has been stupendous due to record FII flows. Practically everyday the Sensex has been rising at least by 200 points. Is it a matter of concern? Yes. Therefore, from the Charts 1, 2, 3 and 4, it is extremely clear that yen carry trade was primarily responsible for the northward movement in Sensex. Impact of FII Inflows on Rupee Movement and Capacity of Excess Liquidity Threatening to Pose an Indian Sub-prime Crisis When an Foriegn Institutional Investor (FII) purchases rupees by selling dollars, he is essentially asking the RBI to pump in more money. Now, this excess money has the ability to generate more credit due to money multiplier effect, our money multiplier being in the region of 4.50. So, if $1 is converted into rupees @ Rs. 40/$ then Rs. 40 is being pumped into the banking system by the RBI.

Now, this Rs. 40 has the capacity to create credit of Rs. 180 (i.e., 40 x 4.5). At the current Indian interest rates of 12-14% is there a demand for such credit/loans? The answer to this question is `no', since the corporate sector is getting cheap international finance @ 6-8%. Therefore, the banking system has to either reduce the rate of interest or lend to a much riskier sector. This much riskier sector is real estate and the whole lot of financial services sector. This has the capacity to turn into an Indian sub-prime crisis.

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