RBI’s success on dollar flows raises stakes in inflation fight & clamour for rate hike

Just months ago, India’s central bank pulled out all the stops to draw in dollars to bolster its foreign-exchange reserves and defend the rupee. The stronger-than-expected deluge of cash is now adding to the case for a more hawkish monetary policy stance.

The record $133 billion inflow from the Indian diaspora left banks awash with cash and pushed overnight rates below the Reserve Bank’s 5.25% policy rate, effectively making borrowing cheaper than policymakers intend.

Also Read: RBI may face two hikes, one dilemma as repo rate is seen hitting 5.75% soon


Keen to prevent the excess liquidity from adding to price pressures, the RBI has already drained more than 1 trillion rupees ($10.4 billion) through bond sales and other measures. Market participants expect it to announce further action in coming days.

At the same time, calls for an interest-rate hike next week are getting louder as rising food costs and elevated oil prices add to inflation pressures.

The prospect of a more hawkish RBI, alongside rising global bond yields, has driven Indian yields sharply higher and unsettled investors.

The liquidity surge came at a time when credit growth is accelerating, domestic demand is proving resilient while inflation is picking up.

If the headline figure climbs further toward the top of the RBI’s 2%-6% target band while surplus cash remains high, draining liquidity may not be enough, said Sneha Pandey, fixed income fund manager at Quantum AMC.

Also Read: RBI revises FCNR(B) inflows upwards to USD 133 billion

“In that scenario, a rate hike would no longer be merely a signaling tool - it would become a necessary policy response,” she added.

Economists at Nomura Holdings Inc., Deutsche Bank AG, and Australia and New Zealand Banking Group are among those predicting the RBI’s first hike since early 2023 next week, with some bringing forward calls that previously anticipated a move in December.

The market is pricing in four hikes over a one-year period compared to three at the end of June, according to Abhishek Upadhyay, an economist at ICICI Securities Primary Dealership.

In September, surplus banking-system liquidity swelled to as much as 11 trillion rupees ($115 billion) as commercial banks swapped dollars for rupees with the RBI. The move also pushed the RBI’s foreign-exchange reserves close to $800 billion, the world’s fourth largest.

Leaving that money unchecked could have a “credibility cost”, impede monetary-policy transmission and fuel mispricing of risk in asset markets, Citigroup Inc. economists including Samiran Chakraborty and Baqar Zaidi wrote in a note.

Citi expects the RBI to gradually steer overnight rates toward the repo rate, mainly through short-term FX swaps and other interventions that can temporarily drain liquidity. It sees up to 1 trillion rupees of bond sales as an additional option, according to a research note on Sept. 25.

While such interventions have helped the RBI’s cash drain efforts, they have also driven up the cost to guard against future rupee weakness, reflecting the market fallout of its attempts to counter easy financial conditions. Deutsche Bank’s Kaushik Das said the RBI may raise the cash reserve ratio “as a last resort” if other measures fail to absorb enough liquidity.

Read more: Traders Brace for Prolonged India Bond Slump as RBI Mops Up Cash

Meanwhile, surging oil prices — Brent crude rose for a third month in September — is making matters worse. The rupee is now trading near the levels seen prior to the RBI’s Foreign Currency Non Resident deposit plan, or FCNR (B), despite a steady stream of dollar-selling interventions by the central bank. Down more than 6% year-to-date, it remains one of the worst-performing Asian currencies.

The RBI’s measures have put pressure on the bond market too. Benchmark 10-year yields have climbed nearly 20 basis points last month, hovering around a two-year high. The jump comes as the government prepares to borrow nearly 8 trillion rupees through March.

The predicament echoes what economists call the “impossible trinity” — the constraints countries face in simultaneously managing capital flows and the currency while pursuing an independent monetary policy.

“The FCNR(B) experiment has brought the trilemma uncomfortably close to home,” said R. Gurumurthy, a former regional director at the Reserve Bank of India. “The question now is if the central bank can judiciously leverage the liquidity situation to ensure the smooth passage of the government’s borrowing program, especially when pressures are building up on the RBI to raise rates.”