New data has come out which validates this analysis. In January, the INR was basically unchanged: starting at 39.41 on 2 January and ending at 39.3 on 31st January. How did this come about? It required an unprecedented scale of purchase by RBI, both on the spot and the forward market. They purchased $13.6 billion on the spot, and the forward position grew by $8.4 billion!
In January, net FII flows were negative. Why, then, did it take $22 billion of USD purchase to maintain a flat exchange rate, even after capital controls have been brought back on ECBs and PNs in 2007, thus drastically curtailing these? The answer lies in India's deepening de facto convertibility. Capital controls that target any one element of capital flows might seem to work, but money will come through by other channels.
This links up to the case for a rate cut. The deep case for a rate cut is that India's 500 basis point interest rate differential against the US cannot be supported when India pegs the rupee to the US dollar. RBI is in an extremely uncomfortable position with the implementation of the pegged exchange rate, as long as this large interest rate differential is in place. The only way to reduce the discomfort of pegging is to lower interest rates. This is all about the loss of monetary policy autonomy that pegging induces, and has nothing to do with whether or not there is a business cycle slowdown.
This data about January trading by RBI was released today, i.e. 13 March. This big lag is part of the larger problem of RBI transparency; the delay helps to impede thinking and policy discussion about the difficulties of implementation of the exchange rate regime. Play the thought experiment in your mind: Suppose this shocker of January data was in the newspapers on 1 February. Or even better, suppose RBI was as transparent as FIIs are: suppose that RBI trading is disclosed every day. The process of policy analysis, policy discussion, and the external constraints that would come upon decision making at RBI would kick in much faster. Instead, with the present environment of non-transparency, information comes out with a huge lag, by which time the decisions are already made, and public policy discussion is stifled.