High inflow by FIIs could create problems for the economy: RBI

"A potentially worrying feature of capital flows to India has been the dominance of portfolio flows which are prone to sudden stops and reversals," the RBI said in a report on assessment of the health of financial sector.

The second financial stability report by the central bank also warned that "at present, stressed liquidity conditions warrant caution and a watchful management in the coming months".

During April-October 2010-11, Foreign Institutional Investor (FII) inflows increased sharply to USD 27.5 billion, compared to 18.4 billion a year ago. FII, also called portfolio investment, go largely into stock and debt markets.

With both financial and real sectors still under stress in advanced economies, the report said, "India will have to guard against vulnerabilities arising from risks to global growth and financial stability."

It said that the other soft spots in the financial sector include widening current account deficit, deteriorating external sector ratios and tight liquidity position, in addition to inflationary pressures.

The report also said that recent concerns regarding microfinance institutions (MFIs) warrant closer examination.

"The current account deficit is widening while capital flows continue to be dominated by volatile components. External sector ratios have deteriorated, fiscal conditions are still under pressure and inflationary pressures persist," it said.

Liquidity conditions tightened beyond the RBI's comfort level and some policy measures have recently been taken to alleviate the stress. Earlier this month, RBI announced measures to pump in Rs 48,000 crore. It will purchase sovereign securities worth Rs 48,000 crore within a month, a move that is expected to ease the situation of cash-strapped system.

RBI also cut Statutory Liquidity Ratio (SLR), which is a requirement for banks to keep portion of their deposits in government securities, cash and gold, by one percentage point to 24 per cent from 25 per cent.

Referring to the non-performing assets of the banks, the report said, asset quality of banks and their asset-liability management position continue to warrant monitoring. It said, "Regulatory gaps in the non-banking financial sector will need to be plugged. A robust macro prudential framework for identification of systemic risks will need to be set up."