FUELLING CRISIS. Energy price rise is driving imported inflation | Photo Credit: RAO GN

The upcoming monetary policy meeting is timed at an unusually fraught juncture. The Reserve Bank of India faces a confluence of pressures that rarely materialise simultaneously: the rupee has touched successive record lows, bond yields have surged, growth headwinds are building, inflationary risks loom on the horizon, and the transmission of last year’s rate cuts is progressively compressing.

Markets are now pricing in not one, not two but four rate hikes over the next 12 months.

The policy committee, in short, faces “everything everywhere all at once”.

In such an environment, the RBI’s most urgent task is unambiguous: stabilise the currency.

No to passivity

The argument that the RBI should simply “let the rupee weaken” fundamentally misreads the current shock. India is facing an imported inflation episode driven by elevated energy prices, and in such circumstances a depreciating currency does not serve as an adjustment mechanism — it functions as an amplifier, compounding cost pressures for producers and consumers alike. Worse, a currency in prolonged free-fall can corrode investor confidence, accelerate capital outflows, and beget further weakness in a self-reinforcing loop. Exporters delay hedging in anticipation of further depreciation; importers rush to cover at every level.

The resulting demand-supply imbalance in the dollar market can drive the exchange rate well beyond what fundamentals justify — and once overshooting takes hold, the cost of correction rises sharply.

Pressure points

Breaking this currency loop requires a diagnosis of why the rupee is weakening? The pressure is from two directions simultaneously. On the current account, elevated energy prices are likely to push India’s goods and services trade deficit into the range of $70-80 billion this year. The capital account flows, under a more optimistic assumption — namely geopolitical tensions de-escalate in a timely fashion — are unlikely to top $30-40 billion.

These estimates carry material uncertainty and outcomes can prove worse under a more adverse scenario. The resulting $40-billion financing gap is not trivial and needs to be addressed even if the precise magnitude remains uncertain.

Critically, waiting for geopolitical tensions to resolve will not by itself close this gap.

The RBI’s 2013 taper tantrum experience offers a useful template. A concessional FCNR(B) deposit scheme, structured with an FX swap rate at or below 1 per cent, could attract meaningful non-resident inflows.

Sovereign dollar bonds and further relaxation of external commercial borrowing limits deserve consideration alongside. The precise timing of these instruments matters, given the sharp rise in global yields; the RBI would want to deploy them when conditions maximise uptake. That said, the mere signal that the central bank possesses a credible, well-stocked toolkit — and the resolve to use it — can exert a stabilising effect on the exchange rate well before any measure is formally activated.

Capital controls, by contrast, should be firmly set aside. These measures may offer superficial near-term relief, but they distort market functioning and directly contradict the RBI’s own efforts around regulatory predictability.

The third option — deploying interest rate hikes as a currency defence — deserves a more nuanced treatment.

On the narrow question of attracting capital flows, a modest rate increase is unlikely to meaningfully shift the calculus for foreign investors in Indian debt, particularly at a moment when US Treasury yields have surged to multi-year highs and the global search for yield is being fundamentally repriced. The carry differential alone will not do the trick.

The more substantive argument for a rate hike, however, is the signalling one: to demonstrate inflation-fighting resolve, anchor expectations, and reduce the risk premium embedded in the rupee even if the carry arithmetic is uncompelling. The difficulty is that deploying rate hikes as a signalling instrument is only credible when the underlying inflation dynamics justify them — and at present, they do not.

The RBI’s own adverse scenario estimate puts average inflation at around 5 per cent this year, a full percentage point below the upper bound of its 2–6 per cent tolerance band.

A rate hike in this environment would signal not inflation-fighting credibility but policy confusion and conflating of two objectives that require distinct instruments.

Household spending

There is a further cost to premature tightening. Raising rates at this juncture risks real damage to household balance sheets and consumption demand, at precisely the moment when a potentially below-normal monsoon is already clouding the outlook for rural spending. India’s consumption-led recoveries are historically slow to build, highly sensitive to policy conditions and, once disrupted, take years to fully reconstitute. The downstream consequences — weaker corporate revenues, delayed capital expenditure, and compressed tax collections — are neither trivial nor quickly reversible. The signalling benefit of a premature hike does not justify these costs.

The RBI’s optimal course is a three-part sequence: hold rates; signal the rupee toolkit forcefully; and deploy instruments in a calibrated fashion over the coming weeks, as global conditions allow.

Beyond the firefighting, the current episode also raises an uncomfortable question for policymakers — what can structurally make India’s capital account more resilient to external shocks?

One such reform that can be introduced is the reduction in the withholding tax on foreign debt investments. This could signal structural openness that no temporary swap scheme can replicate. A coordinated response from the government and the central bank could be considerably more powerful in the current environment.

It’s not about finding the best tactical fix but rather using this shock to create long-term strength and resilience.

(The writer is a Principal Economist at HDFC Bank)

Published on May 25, 2026