The rise of the rupee was the key economic development of 2007. Two episodes of strong appreciation - from March to early May and to a lesser extent mid-August to mid-October stand out.'

What triggered it? The obvious culprit appears to be the foreign institutional investors. A careful analysis, however, suggests that the trigger for appreciation did not lie with foreign investors. It was more likely the outcome of the action of Indian corporates combined with the inaction on the part of the government (and not necessarily the RBI).

The analysis explores the dynamics of the relationship between the exchange rate, FII inflows and the stock market using the concept of rolling correlations. This is how we read the rolling correlations.

In the top part of the graphic, the first point denotes the correlation between the two series for the two months prior to the date shown on the horizontal axis. For instance, the graphic starts on April 3, the first working day of April, which means the first points plotted are the correlations for February and March.

As we move forward, the data for the first observation of the sample period is excluded and data for one more day is added at the end of the sample period. This is continued until the end of the period.

The first episode of a major appreciation lasted approximately two months from March 7 to May 7, when the currency appreciated from 44.56 to 40.56 a dollar (bottom part of the graphic).

The second phase again lasted for around a couple of months from August 16 to October 16 when the rupee strengthened from 41.09 to 39.31. Hence, the rolling correlations have been estimated to cover these time periods.

Apart from the exchange rate, three rolling correlations are depicted - first, the stock market movements and the exchange rate; second, the stock market movements and FII inflows; and third, FII inflows and the exchange rate.

A significant feature of the appreciaiton episodes is that as the currency was strengthening, the correlation between the exchange rate and the stock market increased significantly. What instigated such a drastic change in the correlation?

The obvious culprits here are the FIIs. If this is true, FII inflows should show a strong correlation individually with the stock market and with the rupee movements during this period.

However, interestingly these correlations are weak, at times close to zero during the periods in which the currency was appreciating. Does this seem contradictory?

Data on reserve accumulation by the RBI provide the answer. Over the period, increases in net FII inflows coincide with increases in absorption almost perfectly. This pattern of synchronisation of the two series suggests that other sources of inflow contributed to the exchange rate and market movements.

It is equally important to note that during the first and major appreciation period from March to May net FII inflows totalled only $ 1.4 billion - a relatively insignificant amount over a three-month period.

What other sources - other than FII inflows - can influence the stock market as well as the currency (since the correlation between these two series has been significant during both the episodes of appreciation)?

The other major types of inflows include FDI, ADR/GDRs, private transfers (NRI transfers and NRI funds withdrawn locally), export earnings and ECBs. The first two (FDI and ADR/GDR) were not significant during the episodes of appreciation.

The private transfers, though likely to be substantial, are unlikely to have found their way into the equity market (monthly data on private transfers is not available). As for export earnings, since data on services export are available on a monthly basis, it is not possible to scrutinise the hypothesis in detail.

In the first episode, during March-early May 2007, it appears that ECBs provided momentum to both the markets and the rupee. During March-May, foreign borrowings of $ 10.8 billion were raised - a considerably large amount when compared to net FII inflows of $ 1.4 billion.

More importantly, despite the restrictions imposed on external borrowings in August, the second episode of appreciation in October also seem to be related to an increase in flows other than from the FII channel. Is it possible that the cheaper funds raised abroad got diverted into the Indian equities in the short run, triggering both the currency and the equity market movements?

The inference that ECBs could be responsible for the appreciation during March-May raises another question - why did the RBI not intervene more aggressively and mop up any excess dollars?

The RBI's intervention in the foreign exchange market in the form of dollar purchases leads to greater domestic liquidity, and consequently, inflation expectations. To sterilise excess liquidity, the RBI issues government securities under the market stabilisation scheme.

The government places a ceiling on the securities that can be issued under the MSS; as and when this limit is about to be reached, the RBI notifies the government. The government then decides if and by how much it should further raise the MSS limit.

In March 2007, the ceiling for the MSS for 2007-08 was fixed at Rs 80,000 crore (Rs 800 billion).

In early April, the RBI had notified the government that the threshold limit of Rs 70,000 crore (Rs 700 billion) had been reached. However, the revision of the ceiling to Rs 95,000 crore (Rs 950 billion) took place only on April 24.

Within the next three days, on April 27, the government had to revise the ceiling further to Rs 1,10,000 crore {Rs 1,100 billion (at present, the limit stands at Rs 2,50,000 crore Rs 2,500 billion) - more than three times the original MSS limit for the current fiscal).

It is clear that the central bank would have found it difficult to sterilise the expansionary impact of any possible foreign market intervention from mid-March to third week of April. As a result, it may have abstained from substantial intervention in the market during this period and had to let the rupee appreciate.

In sum, our analysis suggests that it was the actions of domestic borrowers and not FIIs that drove the currency appreciation. An appreciating currency enhances returns being provided by a buoyant market and this is clearly an attractive arbitrage opportunity for anyone who can borrow in dollars.

The RBI and the government have been taking steps, and are expected to take further action, to control excessive inflows in an effort to limit short-term capital. For instance, in August, the government placed restrictions on bringing external borrowings back into the country.

Now, funds raised overseas in excess of $20 million can only be used abroad. ECBs of up to $20 million intended for use in India must obtain the approval of the RBI. It is striking, therefore, that, during the second episode of appreciation from mid-August to mid-October, the same pattern - that is, funds other than from FIIs driving up both the market and the rupee - appears to have repeated itself. This suggests that the limits did not work very effectively to restrict inflows.

Clearly, as long as the macroeconomic outlook and the India growth story remain intact, quantitative controls on inflows are not going to be adequate to address the issue of capital inflows and the exchange rate. It is, however, a different matter altogether whether or not the currency appreciation needs to be fought.