By Swati Bhat and Ira Dugal
MUMBAI (Reuters) – India’s central bank is prioritising currency stability over concerns about credit market tightness, defying wider market expectations it would need to let the rupee fall more if it is to free up funds for a faltering economy.
The Reserve Bank of India (RBI) cut its key interest rate for the first time in nearly five years in February, seeking to arrest the alarming slowdown in growth.
Analysts say India, like other emerging markets, is currently facing what is known as the “impossible trinity” – the principle that economies cannot simultaneously control monetary policy and the exchange rate while letting capital flow freely.
In India’s case, policymakers are struggling to provide an accommodative and open interest rate environment without risking a sharp and potentially destabilising fall in the rupee.
The central bank’s dollar selling intervention to prevent forex volatility has come at a cost: reduced rupee liquidity that is slowing bank lending and interest rate transmission.
The rupee is the worst performing Asian currency so far this year, hitting a series of record lows into mid-February.
Analysts believe the Reserve Bank of India, faced with this choice, may have to allow the rupee to slide further.
“The RBI has been facing the impossible trinity since October 2024. The dollar pressure is a little less now as the U.S. economic data is a bit weaker,” said Gaura Sengupta, an economist with IDFC First Bank.
“Since December RBI has been allowing a greater pace of rupee depreciation and has also started easing monetary policy. So they have chosen to focus on growth and allow rupee depreciation,” she added.
Three sources aware of the central bank’s thinking, however, said liquidity is not a constraint on forex intervention and the broader objective of the bank remains keeping rupee volatility in check.
Critically, the central bank does not want market speculation against the rupee to be widely out of line with fundamentals and will continue to intervene when there are one-way bets, one source said.
“The RBI doesn’t want to keep rupee as an outlier with respect to Asian currencies,” this person said. “When global macros are against emerging markets, RBI would prefer to keep rupee depreciation at around the median level.”
The RBI did not immediately respond to an email seeking comment.
MITIGATING THE CASH CRUNCH
While the RBI does not explicitly state reasons for mitigating rupee volatility, a stable currency ensures the smooth functioning of capital markets and foreign trade, which are essential for sustained India’s economic development.
“A relatively stable currency helps local importers and exporters better plan their foreign exchange strategies and also augurs well for investors who deploy money in the country’s assets, like equities or bonds,” said Dhiraj Nim, FX strategist and economist at ANZ.
The heightened trade uncertainty under the second Trump administration is also adding to global currency market volatility.
The central bank sold a net of nearly $40 billion between October and December, withdrawing an equivalent amount of rupees from the banking system. Dollar sales continued in January and February, traders said, although data for this is yet to be released.
The banking system liquidity deficit widened to a one-year high of 3.16 trillion rupees as of late-January before starting to ease on the back of RBI measures.
To balance the rupee shortage created by dollar sales, the RBI has since mid-January bought bonds and conducted long-term FX swaps worth a total 2.70 trillion rupees ($30.96 billion) and there are plans for similar operations worth 1.87 trillion rupees in March.
One of the sources Reuters spoke to said the central bank faces no constraints in buying bonds or conducting FX swaps to infuse rupee liquidity and prefers to use the latter when the cash shortage has been caused by currency market intervention.
Cash infusions also do not have any adverse impact in the current situation where inflation is moderating and growth is slowing, the source added.
Bank of America Global Research analysts Adarsh Sinha and Claudio Piron, co-heads of Asia FX, said while the RBI appears to be stepping in to stabilise the rupee, more recent actions suggest the “threshold for intervention has gone up”.
($1 = 87.2020 Indian rupees)
(Reporting by Swati Bhat and Ira Dugal, additional reporting by Siddhi Nayak and Jaspreet Kalra; Editing by Sam Holmes)
Comments