Here is a article which i took from economic times clearly explaining about the effects of dollar inflows
Its raining dollars in India. Such a dollar deluge can be quite harmful. Here is how. When a foreigner Joe invests $100 into the Sensex,
he first needs to convert his dollars to rupees. So, let's say the exchange rate is 47, which means 100 dollars becomes Rs 4,700.
After a couple of months the Sensex rises by 10 per cent (it's hot right now, and that's why Joe is putting his money ). The investment of Rs 4,700 becomes Rs 4700 + Rs 470 = Rs 5,170. At this point, dollars coming into the Indian economy have made the rupee stronger, so that the exchange rate is now 46 instead of 47.
So, when Joe decides to collect his winning investment, he gets Rs 5,170 divided by 46, which when calculated is $112.4. In short, he put in $100, and got back $112.4, even though the Sensex went up only by 10 per cent. This 2.4 per cent advantage is simply an added icing on the cake, not available to a desi (rupee) investor. The inward pressure of dollar investors also makes the Sensex go up dizzily. That makes Joe even happier.
He tells his friends. They all start investing here. Dollars pour in, and the inward pressure gets even more intense. It soon becomes a feeding frenzy . This Sensex is a "sure thing" say the foreign punters. You know how this ends, don't you? One fine day, with a small rumour , the tide turns abruptly. The bubble is pricked.
There is a stampede to get out. The financial world is known for such herd mentality and abrupt reversals. Once the investors rush out, this whole model starts going in reverse.
Meanwhile, the sufferers are the desi rupee investors. This indeed happened in September 2008, when the Sensex crashed, because the foreign institutional investors pulled out funds from India due to the Wall Street collapse. All that the desi investors could do was hold a morcha on Dalal Street. They did not know what hit them.
Of course, all this stock market investment is risky business. So, investors should heed caveat emptor (buyer beware). If they are taking risks, it's their funeral. Why should the government or the Reserve Bank intervene?
Under normal circumstances, the investors should be left alone with their risk-taking . However, it is difficult to say what 'normal circumstances' are. Since a trickle can become a deluge very quickly, normal can turn abnormal almost overnight. Hence, the policymakers need to keep a constant vigil on this incoming deluge of dollars.
The dollar dilemma is also faced by other developing countries. Recently, Brazil started tightening the screws on inflows of dollars, since their local currency strengthened rather quickly and unhealthily. Taiwan, Indonesia and South Korea too, have imposed some controls on dollar inflows.
The controls are not so much on stock market inflows, rather on the money that flows into debt markets and banks. Since dollar deposits earn close to zero per cent in fixed deposits in American banks, the Joes are tempted to put that money into an Indian bank into rupee deposits, which gives them 10 per cent. It's safer than the stock market. In addition, you get an additional 2.4 per cent due to rupee getting stronger, remember?
Of course it's much easier to do this in Korea or Taiwan, thanks to India's restrictive laws for foreign deposits.
As long as interest rates in America are low, and economic outlook remains uncertain or bleak, the dollars will tend to flow to emerging economies.
Those economies, like India, will need to put up some barricades, lest the dollar deluge destroys the edifice of the economy.
Of course, the dollar monsoon has not quite begun, yet it's better to keep our umbrellas ready.