RBI’s rupee challenge should nudge it to tighten monetary policy—even the US Fed may have to

In fact, it may have worsened it by signalling that the central bank was scraping the bottom of its traditional toolkit for rupee defence.

So instead of sticks, authorities decided to go with a carrots-only approach, telling state-run firms and local banks to raise dollars overseas, bring them home and get a big discount on their hedging cost until 30 September. Although I was not expecting RBI to once again subsidize the cost of external borrowing—it was controversial even during the emerging-market selloff sparked by the US Federal Reserve’s 2013 taper tantrum—I guess the thinking was that if it worked then, it would work again.

Sure, borrowing overseas—and raising foreign-currency deposits from the diaspora—might buy the rupee a breather. Analysts expect the latest package to bring in $50 billion. Some funds may come in via the bond market, where foreigners have been given tax breaks and more freedom to invest.

But the bulk may be brought home by local borrowers scooping up three- to five-year money overseas, provided RBI gives them a similar concession on hedging cost as in 2013: roughly 3% a year. That is a burden that taxpayers will bear via reduced central-bank dividends to the government.

However, euphoria around short-term inflows will not fix the core weakness in India’s external accounts. An economy that topped all forecasts and grew 7.8% in the March quarter—when the Iran war had already begun—should not be struggling with just $3 billion in net annual foreign direct investment. Nor ought it be fighting so hard to bring back financial investors who have taken out $35 billion from the stock market over the past 12 months.

Telling them that any individual can park money with an Indian portfolio manager is not of much use when they can as easily enter via a foreign fund. The problem is, they do not want to. Not right now.

A part of the pessimism has to do with a paucity of imagination. Beyond building power-guzzling data centres, India lacks a compelling story for global capital hunting for AI innovation.

While a central bank cannot do much about that, it can at least give savers more remunerative interest rates. What is the point of near-8% growth in GDP that does not reward households financing the expansion, forcing them to chase risky returns beyond bank deposits?

It might have been acceptable if frothy stock prices were leading to new jobs or wage increases. But that is not the case, either. The net result of India’s supposedly pro-growth policies is that they keep valuations high—so foreign firms and private equity investors in startups can get profitable exits. Instead of being just another gauge for the economy, the market has become its proxy.

As part of the 2013 currency rescue, India raised benchmark interest rates to 8%. RBI’s then governor Raghuram Rajan had to leave them there for a year, even though the overnight US rate was near zero throughout. He was roundly criticized for keeping a tight lid on liquidity.

That playbook, which helped the central bank re-establish its inflation-fighting credibility, is not getting enough attention. Sanjay Malhotra, the current RBI chief, is sticking with borrowing costs that have fallen by 125 basis points since he took over in December 2024.

Last Friday, the monetary policy panel decided to keep its policy rate steady at 5.25%. That is too small a premium for investors when the Fed’s target range is 3.5% to 3.75% and expectations are growing that its next move will be a hike.

It is clear what authorities are trying to do—stabilize the currency, keep domestic rates low and avoid capital controls. Juggling all three objectives requires putting taxpayers on the hook, which is what an expected 3% concession on dollar borrowers’ hedging cost effectively means.

But ultimately, if capital controls are to be avoided and the rupee is to be saved, RBI has no real choice. The only path to lasting peace on India’s external accounts goes through higher rates. ©Bloomberg

The author is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia.