The Reserve Bank of India is reluctant to intervene in currency markets but may be forced to in coming weeks as foreign investors pour in billions of dollars to buy shares in the country's largest ever IPO.
Foreign investment in Indian stocks stands at a record $21.8 billion and more than a third of that flowed in since the start of September, pushing the rupee to a two-year high last week.
Coal India's $3.5 billion share sale next week could prove the tipping point for intervention if, as expected, it generates heavy demand, although Reserve Bank of India sources downplayed any intention to manage inflows and ease pressure on the rupee.
"We are not traders. We don't buy dollars and sell dollars alternately. The volatility will be temporary and exporters and importers will take care of the levels," said an official, who is directly involved in currency management.
The Reserve Bank won't entirely dismiss intervention though. Officials said the RBI, as always, stands ready to manage any currency volatility and Governor Duvvuri Subbarao indicated in Washington over the weekend that the central bank will intervene if inflows are "lumpy and volatile".
That's exactly what India may get from the Coal India IPO, which is expected to be popular given the company's dominant market position and because a lower-then-expected price band for the share offer could result in heavy oversubscription.
"As of now, we don't intend to intervene as this is just a temporary issue of flows coming in and going out," the RBI official said, declining to be identified.
"The governor's statement was a weapon to calm down markets and ensure there is no panic. It doesn't necessarily mean we will intervene. Intervention by us is a big thing," the source said.
Half the Coal India shares will be sold to institutions, with the majority of such demand expected to come from overseas.
Under new rules introduced this year, institutional investors must prefund in full the IPO shares they want to buy. Previously, they had to provide 10 percent up front.
If the institutional part of the IPO is five times subscribed and foreign funds account for 70 percent of such demand, it would draw more than $6 billion in additional funds into India -- or the equivalent of more than a quarter of the record overseas funds that have already invested in stocks this year.
The Coal India offer will open to institutions from Oct 18-20 and shares will be allocated within 12 working days of the closing. Refunds of unallocated funds are expected to head back out of India, while IPO proceeds will go into government coffers.
"Given we will likely see lumpy U.S. dollar inflows first, followed by a part of that going back, we should have RBI watching the market very carefully. Will not be surprised if RBI does come in to smooth the flows out," said Ananth Narayan G, head of fixed income, currencies, commodities-South Asia at Standard Chartered.
Sluggish economies and ultra-low interest rates in developed countries have sent a flood of return-hungry funds to emerging markets, putting upward pressure on currencies and prompting many central banks to step in to brake the appreciation.
Brazil's Petrobras last month raised $70 billion in the world's largest share sale, adding to inflows already chasing double-digit interest rates and pushing the real to two year peaks.
Last week, Brazil doubled a tax on foreign investment in bonds to 4 percent, and the central bank has been stepping up buying of dollars.
Subbarao indicated in Washington, where he attended a meeting of the International Monetary Fund, that he did not support capital controls.
"Capital controls can be gamed or circumvented. Also stop-go policies send wrong signals to potential investors," he said.
In 2009, the RBI sold a net $5.8 billion to prevent the rupee from falling below a record low of 52.2, but traders believe it has refrained from intervening this year.
"There are costs associated with intervention, because we will have to also sterilise the money," the RBI source said.
The rupee is up 5.3 percent since September. Last year, record inflows of $17.5 billion pushed it up by 4.7 percent.
More state share sales will further test India's tolerance for inflows. Power Grid Corp and Hindustan Copper aim to raise a combined $2.8 billion by year-end.
On the face of it, India would welcome inflows -- if they are stable. The April-June current account showed a record deficit and on the capital account, foreign direct investment is down this year.
"Our absorptive capacity for inflows has risen as our current account deficit is growing," a second central bank official, who declined to be identified, told Reuters.