With the rupee under pressure, RBI should pay attention to financial stability at this juncture

Based on recent guidance from the Reserve Bank of India (RBI), inflation is forecast at 2.6% for 2025-26, undershooting its 4% target. Growth remains firm, with RBI projecting the Indian economy to expand 6.8% this fiscal year. For the first quarter of 2026-27, RBI has forecast inflation and growth at 4.5% and 6.4%, respectively. These projections indicate price pressures inching up while the economy continues to operate close to its potential.

Central banks rely on rule-based frameworks to guide monetary policy decisions. These frameworks link their policy rates to deviations in inflation and growth from their respective targets, providing a disciplined way of assessing whether monetary conditions are loose or tight.

Monetary policy operates with a lag and applying such a framework to RBI’s current forecasts suggests that its rate is appropriate as we approach a new fiscal year. A formula that uses deviations of RBI’s inflation and growth forecasts from its inflation target and the economy’s potential output shows that today’s repo rate of 5.5% implies a real rate of 0.8%, which seems fine.

Taking financial stability into account, particularly the risk of a weaker currency, reduces the scope for further policy easing. There is a 1.5-percentage-point rate differential between the US Fed funds rate of 4% and India’s repo rate; a narrower gap encourages capital outflows. Adding a financial stability rubric to a rule-based framework yields a real rate of 0.15%, given RBI’s growth and inflation forecasts for next year’s first quarter. This real rate buffer is too narrow. Any move to cut rates could impact India’s exchange rate stability.

Financial stability has emerged as a key determinant of policy flexibility. Despite a weaker US dollar in recent months, the rupee has been under pressure amid a thin policy rate differential, new US tariffs and 10-year US bond yields above 4%. So India’s weak net foreign direct investment flows and strong foreign portfolio outflows warrant caution.

Expectations of a weaker rupee and compressed forward premia have influenced hedging behaviour. Importers have stepped up hedging (creating ‘importer leads’) while exporters have delayed their currency-risk cover (resulting in ‘exporter lags’). This lends complexity to India’s currency challenges.

In September, as per data published by RBI, its forward book of foreign exchange contracts was short on the dollar to the tune of $39 billion (sum of dollars sold in advance) in the up-to-1 year maturity bucket. Positions added in October took its total short dollar position to an estimated $50-55 billion in that bucket.

This position gets created mostly through forward-selling dollars against the rupee in the deliverable and non-deliverable forwards market. When non-deliverable positions are rolled over by RBI, it shows up as fixing demand in the deliverable market.

While a prospective trade deal with the US could grant the rupee relief, the broader global context needs to be taken into consideration.

The dollar index fell from 110.17 in January to a low of 96.22 before rebounding to 99.57, leaving limited room for further dollar depreciation, unless the US economy tips into recession and the terminal Fed funds rate priced at 3% falls further. Additionally, higher term premia along the US interest-rate curve has reinforced a tailwind for the dollar.

Given the combination of a low-rate differential with the US and rupee weakness, RBI’s policy priority right now should be financial stability. A cautious stance would preserve confidence in the currency and provide flexibility in the event of renewed global volatility.

Against this backdrop, RBI may consider the following measures:

One, avoid market intervention and losing reserves should the dollar index break higher; demand and supply will set a clearing price for the rupee.

Two, RBI should retain its policy rate at 5.5% in next month’s meeting while preparing the market for a policy rate reversal ahead if the rupee weakens.

Three, review the hedging lead-lag behaviour of importers and exporters, and restrict the cancellation and rebooking of forward contracts.

Four, provide window guidance through moral suasion for net open positions in the banking system.

Five, weigh the costs and benefits of banks participating in the non-deliverable forwards market during a phase of rupee weakness.

Six, RBI could eliminate its short forward book up to 1-year maturity by taking delivery of maturing contracts. This will have an impact on durable (or structural) liquidity within the banking system. The current durable liquidity in the system is placed at about ₹3.4 trillion. RBI taking delivery of maturing forwards would imply a liquidity impact of ₹1.48 trillion.

In other words, as dollars get delivered in lieu of rupees, the system will be short of durable rupee liquidity to the extent of ₹1.48 trillion. This is about 0.5% of banks’ net demand and time liabilities.

If RBI unwinds its forward book, which is estimated at above $50 billion, it would tighten liquidity and serve as a useful step in defence of the Indian currency at a time of significant global flux.

These are the author’s personal views.

The author is managing director and head, global emerging markets, Deutsche Bank, India.