RBI’s MPC tightrope: How to keep repo rate unchanged, yet manage the USD-INR ride nimbly

Severe trade disruptions through the Strait of Hormuz have triggered broad spillovers across energy and related commodities. Although the direct supply shock disproportionately hits the heavy energy-importing Asian economies such as Korea, Japan, China, Thailand, the Philippines, and India, the larger concern is the second-order inflation impulse now threatening to disrupt global monetary policy trajectories.

Domestically, Indian economy entered the West Asia crisis with resilient activity indicators and still-supportive demand. Further, the inflation environment too has remained benign. February CPI and WPI inflation was 3.2% and 2.1% respectively.

However, persistent supply shocks are skewing the inflation distribution sharply higher, despite the government and oil marketing companies cushioning the impact for now. We expect the pass-through to consumers to begin in a month or two. Furthermore, inflation risks are increasing amid a weakening rupee, rising probability of sub-par monsoons, and risks of fertilizer shortage. On the positive side, heavy buffer food stocks should help cap some of the monsoon-led risks to food inflation.

While we do see risk of GDP growth falling towards 6.5% (from 7% pre-crisis period) and average inflation rising to 4.7% (from 4.1% earlier) with further upside risk in FY2027, we remain more wary on the increasing vulnerability to the external balance. Even before the recent crisis, the current account deficit (CAD) was being weighed down by higher goods trade deficit with services exports and remittances offering significant offsets.

In the current scenario, the import bill is expected to surge significantly not just from oil imports, but also gas, fertilizer and other inputs. Exports too will be impacted, especially to West Asia, worsening the CAD—we expect CAD/GDP at 2.2% compared to ~1% estimated prior to the crisis. Compounding this impact is the unrelenting capital outflows—foreign portfolio investors outflows in March surged to $15.5 billion following a brief inflow of $3.5 billion in February. If such risk-off sentiments continue, the balance of payments, or BoP, deficit is estimated to widen towards $75 billion, in the absence of RBI special measures.

The rupee has already been acting as a shock absorber, depreciating by about 11% in FY26 and 4.2% against the US dollar in March amid a sharp rise in crude oil prices, supply disruptions, and risk-off driven capital outflows reflecting uncertainty over the duration of the conflict. While currency depreciation is necessary to correct emerging external sector imbalances, excessively sharp moves risk triggering a self-reinforcing downward spiral. Beyond eroding confidence, a weaker rupee accentuates imported inflation, hardens inflation expectations, and complicates the RBI’s inflation-control mandate.

While the RBI has been defending the fall in the rupee, its ability to do so is increasingly getting constrained by declining foreign currency assets, valuation-loss risks to forex reserves, and a sizeable short-forward book. It is in this context, the central bank has already started taking aggressive measures like curbing speculative activity against the rupee through recent actions like capping the banks daily onshore currency open positions to $100 million, followed by prohibiting banks to offer non-deliverable derivative contracts to resident/non-resident users along with restricting rebooking any foreign exchange derivative contract involving the rupee.

Given that the fundamentals don’t remain supportive of the rupee in the near term, the persistence of the crisis will necessitate RBI to revisit elements of its 2013 toolkit—compressing dollar demand through tighter rules on its liberalised remittance scheme for investments abroad, overseas direct investments, and gold imports; exploring a dedicated dollar window for oil importers; and easing select norms to help banks mobilize foreign capital.

While memories of the RBI’s surprise 200 basis points MSF hike in 2013 to arrest rupee depreciation remain fresh, we believe the central bank should, for now, exhaust alternative tools to contain forex volatility and ease BoP pressures before resorting to rate hikes purely to defend the rupee. In case of a supply shock, rate hike tends to be a blunt tool. (MSF is short for marginal standing facility, which allows banks to borrow emergency overnight money when inter-bank lending markets are relatively illiquid.)

April’s policy, therefore, is more about how the RBI communicates on liquidity, growth-inflation scenarios, forex volatility management, and other prudential/control measures rather than the repo rate/LAF corridor itself. (LAF, or liquidity adjustment facility, is another RBI tool to manage short-term liquidity in the banking system.)

Status quo on rates and policy stance is the cleanest decision, with a more hawkish reaction contingent on data. RBI should highlight the upside risk to inflation from energy, currency weakness, and weaker monsoons.

For now, we expect RBI to focus more towards safeguarding macro/financial stability through adequate guidance. If the global risk-off continues to weigh on the rupee, the central bank will soon need to resort to tightening liquidity conditions (via VRRRs, CMB issuances, OMO sales) to anchor the overnight rates towards the MSF. Notably, the recent measures on INR is expected to keep Rupee supported in the near term, which in turn is expected to provide an opportune window for RBI to mop up FX reserves and cap the appreciation. The liquidity conditions are already comfortable and hence there will be a need to introduce liquidity tightening measures to avoid additional easing and ensure overnight hover between repo and MSF rate. This could be followed by a repo rate hike if market stress continues to intensify. Either way, monetary policy must stay steady, nimble, and operationally proactive. (VRRRs refers to variable reverse repo rate and CMB to cash management bills, both liquidity management tools to optimize liquidity.)

(The author is chief economist, Kotak Mahindra Bank. Views are personal.)