Capital inflows: Balancing market gains with economic risks

livemint.com:

The Economist while examining the Netherlands’ loss of export competitiveness and rise in unemployment subsequent to the discovery of oil and gas in the North Sea in 1959. The export of hydrocarbons brought in so much of foreign exchange that the Dutch guilder (this was before the EU was formed and most EU members adopted the euro as their currency) became overvalued, rendering non-gas Dutch exports less competitive.

Similarly, in resource-rich Africa, exports of minerals like copper, diamonds, oil, or gold have led to the Dutch Disease, as these exports bring in significant foreign exchange but don't necessarily promote broader economic activity, and can even make other exports less competitive, now that their self-same domestic price translates into a higher price in foreign currencies that have depreciated against the currency of the commodity exporter. Sure, the Reserve Bank of India (RBI) tries to manage the rupee's value to prevent it from becoming too strong due to financial inflows, which can be volatile and detached from the real economy's fundamentals.

Interest rate cuts elsewhere in the world, or quantitative easing, the creation of money by central banks, could suddenly lower the cost of capital for the rich world’s investment pools, as well as the rate of their domestic returns, incentivizing them to hunt for higher returns in a country like India. If the policy triggers behind the sudden influx of capital into India were to reverse, the money would flood out, as well.

To counter this resultant volatility, the RBI intervenes in the currency market, buying dollars to prevent the rupee from appreciating too much. The obverse of a cheaper dollar is, of course, a stronger rupee.