Rupee Weakness Tests RBI, but Rate Action May Wait

Renewed pressure on the rupee and recent bold regulatory interventions in the forex market by the Reserve Bank of India have cemented expectations that the central bank won’t hesitate to act decisively to protect the currency, if needed. The big question: will the Monetary Policy Committee hike rates to defend the rupee to keep inflation in check? With inflation set to jump over the next couple of quarters and crude hovering near $100 per barrel, a rate hike of 25-50  basis points is a looming risk, but it is unlikely this week.

Rate hikes to shore up the currency are not new to the RBI’s playbook —  recall 2013, 2018 and 2022. It, however, has typically come along when inflation is running hot — 2013 and 2022—  or when risks of spillover effects are high.

India’s current headline and core CPI inflation are still below 4% —  the MPC is mandated to keep inflation in the 2-6% range with a 4% medium-term target. Even as inflation is poised to edge towards 5% later this year, it is likely to stay within the mandated band. We estimate CPI inflation at 4.7% assuming an average crude oil price of $90 in 2026-27. If the risks of currency weakness feeding into inflation and inflation expectations increase, the MPC’s hand may be forced, but we’re not at that stage yet in our view.

Another important consideration is that economic activity could take a bigger hit than inflation if energy prices stay elevated. History shows us that most global recessions since the 1950s have followed oil shocks. With the global outlook as murky as ever, a wait-and-watch strategy is the smarter play, in our view. We expect India’s 2026-27 GDP growth at 6.4%, down from estimated 7.4% in the preceding year; downside risks to our GDP growth forecast exist if supply disruptions persist.

Let’s not forget, these challenges – geopolitical tensions, soaring crude, a stronger US dollar – aren’t just pressure points for the rupee. Except for the Chinese yuan, most Asian currencies have weakened since the West Asia conflict began. Rupee weakness, thus, needs to be viewed as a pressure valve for mounting external uncertainty.

This is not to say that there are no sore points for the rupee. India’s current account deficit has been small and steady over the past couple of years. But thinning capital flows have weighed on the balance of payments. For the first time ever, India posted back-to-back balance of payments  deficits in 2024-25 and 2025-26, a sharp contrast to $100 billion in surpluses two years preceding the Russia-Ukraine war in 2022-23. In past decades, spikes in the current account deficit from soaring commodity prices were brief, thanks to robust capital inflows (read FDI flows); now, BoP deficits are sticking around as FDI flows have dwindled.  

Back-to-back BoP deficits are gradually eroding India’s go-to shield of external buffers for macro stability and resilience; we expect a third consecutive BoP deficit as the current account deficit appears set to widen to almost 1.25-1.8x of 2025-26 levels. India’s import cover,  after adjusting for the forward book, while still about 9.5 months—more than 3x the recommended levels by the IMF—faces further risks from valuation losses on softer gold prices and a stronger US dollar. We estimate that almost two-third of the fall in headline spot foreign exchange reserves in March was driven by valuation losses.  Thus, if push comes to shove, the need to resort to a rate hike to defend the currency is probably higher for India versus other Asian currencies. This is also evident as the rupee has weakened by about 7.8% since January 2025 while other Asian currencies have either weakened by 1-6% or have appreciated.

But before the MPC resorts to a hike to defend the currency, it has the option to potentially deploy other tools in its kitty.  The last two regulatory interventions by the RBI in the FX market were a good precursor to other alternatives which RBI possess. And we believe both the RBI and the government will continue to leverage tried-and-tested tools from previous episodes to ensure that the rupee weathers the storm while supporting the economy’s resilience.

Reintroducing the oil window for oil marketing companies to buy dollars directly from the RBI rather than the open market can prevent the massive daily dollar requirements of oil companies from weighing on the spot exchange rate. More measures to attract dollar inflows, such as a temporary waiver of the withholding tax on external commercial borrowings, incentivising domestic banks/oil companies to raise capital abroad in a cost-sharing-model with the government, disincentivising consumption of fuel products for less productive activities say by sharp price increases and disincentivising imports like gold, are a few of the tools from the past that can be deployed before rate hikes are considered in our view. In a nutshell, rate hikes can happen but we are not there yet.