The RBI has raised the repo rate by 25 basis points (bps), as widely expected, and, to the surprise of some, changed its stance by guiding that further hikes are down the road. While much of the policy spoke about rising inflation and the need to counter it amidst a healthy economic growth, there is an underlying iceberg called “currency”, which has been stealing the slow.
Yes, inflation pressures are rising and probably getting closer to, or beyond the upper band of the tolerance level of 6 per cent and could stay there for two to three quarters. And, not to forget, inflation expectations are now around 10 per cent up to one year. Yes, a bulk of this is food, led by poor monsoon, and, needless to say, geo-politics but the argument that the central bank cannot control supply-side factors is only up to the point when it is first-order inflation or direct inflation.
When the impact from rising prices starts getting embedded into second order or finished goods and then wages, risking wage price spiral, the central banks have to step in.
But is it only inflation and growth? Why currency matters? India’s annual merchandise imports (last 12 months) are $830 billion and exports $476 billion. As we import more of finished goods and non-discretionary items including oil, the pass through from a depreciating currency can be much faster. And that links the inflation to the currency. In addition, stability of currency is a key barometer to attract capital flows.
In a scenario of large currency depreciation — like in the case of India’s 4.7 per cent in 2025, 7 per cent YTD (year-to-date) — foreign portfolio investments can remain elusive, as their return is eroded to the extent of rupee depreciation. Since India has a structural current account deficit (net dollar inflows, including exports and remittances, are lower than the outflows from imports and outward payments), which has been funded by capital flows, an eroding capital flow is a fundamental challenge.
Temporary liquidity
The RBI in its policy did highlight that the external risks are an area of concern and has been doing so since its April 2026 policy. But the policy measures from the RBI have not convinced the currency market yet. Why?
First, a foreign currency non-resident (bank) — or FCNR (B) — deposit is a borrowing, And this borrowing comes with an equivalent liability in terms of a large outstanding short-forward book. The RBI already had a short-forward book of $103 billion prior to the FCNR. Therefore, FCNR accretion to reserves is only a temporary liquidity, which has only ballooned the repayment obligations. As of August the forward book swelled to $200 billion. The adjusted forward book for FCNR has only declined. Notably, the very premise of currency depreciation to be contained via FCNR has been short-lived. The rupee is closer to May 2026 lows (96.96 per dollar).
Second, if it worked in 2013 (through 6-7 per cent appreciation in currency), why may it not have performed similarly? Capital flows were not a challenge then. Global rates were very low, making the proposition easier. Liquidity was in deficit and the RBI could raise the marginal standing facility (MSF) rate prior to FCNR.
Capital flows were already a challenge for two years prior to the FCNR deposit mobilisation by banks under the RBI’s special dollar-rupee forex swap facility. This time the RBI must bear the entire swap cost. Preceded by surplus liquidity, the FCNR has created a problem of liquidity deluge.
This deluge can given banks a welcome breather and they need not rush to raise deposit rates during repo hikes while enjoying the rise in lending rates. But there could be some distortions. The RBI governor’s statement did note that surplus liquidity led to distortion in rates: “Transmission in the credit market reflected dissimilar movements in deposit and lending rates during July-August.” Noting that short-term rates have eased while government securities yields hardened, the RBI is most likely uncomfortable with high system liquidity. If we observe YTD credit growth (April to August) 4.8 per cent, an annualised growth of 11-12 per cent for the full year emerges.
The wave of 19-20 per cent growth was led by a bout of inflationary working capital demand in May, which is since normalising. Beyond FCNR, structural deposit growth could once again come to test at elevated credit-deposit (CD) ratios.
Buying time
Then why did the RBI not announce any liquidity measures? Probably after testing most of the measures on the table — namely longer variable rate reverse repo (VRRR) , open market operation (OMO) sales and sell-buy swaps, none of which have been frictionless — the RBI is probably buying time for liquidity to run its course. Incremental hike in the cash reserve ratio (CRR) is the option they have not explored yet.
Is that why it stopped short at 25, when perhaps 50 bps was needed? In a surplus liquidity scenario, when transmission could be slow, a larger hike will only further distort the lending and borrowing markets. But what other options are on the table when the external risks are high, driving currency volatility further.
Note that RBI reserves are not in significant surplus — in comparison with $133 billion of FCNR, reserve accretion from June 12 to October 2 is $63 billion. The gap of $80 billion was spent in unwinding the existing forward book, sell-buy swaps, and valuation adjustments. Liabilities are building.
Global central banks are hiking — Indonesia hiked 100 bps (May-June) for its currency defence. South Korea 50 bps, Philippines 75 bps, South Africa 50 bps, Australia 100 bps, New Zealand 50 bps — either for currency, inflation or both.
Therefore, the call is for more. External yields and rates give better cues. Currency defence is about not just interest rate differential, but also getting entrenched in inflation and impacting financial stability. Currency is the mirror that reflects fundamentals and a credibility valve that stabilises imbalances.
The RBI may have to hike at the pace of 50 bps and not necessarily wait for eight more weeks. There is many a slip twixt the cup and the lip. May 4, 2022 (off-cycle monetary policy committee meeting), may be in the calling.
Anitha Rangan, Chief Economist, RBL Bank
(The writer is Chief Economist, RBL Bank)
Published on October 12, 2026
