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Indian equities have touched new highs. The rupee has traded at levels last seen in August 2015. Global capital is pouring in. Should we celebrate or worry?
There is no doubt that domestic demand has bounced back after the demonetization shock. The global economy is in the midst of a cyclical recovery. Crude oil prices remain low. But there is also no doubt that the rally in Indian equities and the sharp rupee appreciation are being driven by liquidity—both global as well domestic. The high valuations also suggest that prices have moved ahead of fundamentals.
The liquidity sloshing around could be drained out for two reasons. First, it is a matter of time before global central banks begin to shrink their balance sheets which remain bloated because of quantitative easing. Second, domestic inflation risks have already made the Reserve Bank of India switch from an accommodative to a neutral stance. Its next move could be a rate hike.
The key question now is whether the cyclical economic recovery consolidates to become a structural boom. The jury is still out on that one.