Has The Market Overpriced India's Rate Risk?

When the Monetary Policy Committee met last week, it did so against one of the most uncertain macroeconomic backdrops in recent years. A weakening rupee, a triple balance-of-payments deficit and elevated bond yields meant policymakers were under significant pressure to respond to market pricing. Occasionally, however, markets get ahead of themselves, and June's decision to leave rates unchanged may prove to be one such example.

While there is little doubt that the RBI's inflation projections, with headline CPI inflation at 5.1% and core inflation at 4.7% in 2026-27, imply another 50-75 basis points of rate hikes at some point, June's policy decision was also a classic example of the Brainard principle. Developed by economist William Brainard in 1967, the principle argues that when policymakers are uncertain about the impact of their actions, caution and gradualism may be preferable to aggressive intervention.

Monetary policy works best when the other two legs of the so-called impossible trinity, namely the external account and the exchange rate, are relatively stable. Over the past few months, persistent equity outflows, high currency in circulation and delayed exporter repatriation have contributed to rupee weakness and a widening gap between credit growth and deposit growth.

Certificate of deposit yields, which form the foundation of money-market pricing, had moved sharply away from repo and Treasury bill anchors, trading at spreads of 200-250 basis points across various tenors. That, in turn, put pressure on the short end of the government bond, state development loan and corporate bond markets, with spreads widening steadily.

To hedge against that widening, traders increasingly paid one- and two-year OIS. 

Over time, the hedge gradually became the market's interest-rate expectation. In essence, a funding problem transmitted through the foreign-exchange market became an interest-rate projection. While a significant portion of the repricing in one- and two-year OIS reflects genuine macroeconomic concerns, including higher crude oil prices and elevated US interest rates, part of the move also reflects the hedging activity that has built up over recent months.

Funding Stress
So what does the future hold?

The detailed guidelines for the RBI's FCNR deposit, external commercial borrowing and overseas foreign-currency borrowing measures were announced earlier this week. At first glance, the central bank appears to have provided every possible incentive for banks and public-sector borrowers to raise dollars through multiple channels until the end of 2026 for ECBs and Overseas Foreign Currency Borrowings, and until mid-October 2026 for FCNR deposits.

The base estimate is that these measures could attract $75 billion-$100 billion over the next six months, with OFCBs contributing around $25 billion, FCNR deposits around $50 billion and ECBs another $25 billion. FCNR deposits will not attract CRR or SLR requirements, while the FCNR swap support operates on a gross basis, allowing both fresh deposits and leverage. In the case of ECBs, the RBI is effectively bearing a significant portion of the hedging cost.

These measures are unusually generous and should enable banks and public-sector borrowers to launch sizeable dollar borrowing programmes.

Sceptics may argue that global interest rates remain elevated, the dollar index remains strong and attracting flows on this scale will be difficult. Those concerns are valid. Yet it is equally true that issuance by strong Indian borrowers in global bond markets has remained relatively limited in recent years, as reflected in the 85-90 basis point spreads at which dollar bonds of blue-chip Indian issuers trade in secondary markets. The Indian diaspora is also substantially larger and wealthier than it was in 2013, and leveraged returns of 10-12% remain a compelling proposition for FCNR deposits.

For banks, the measures offer a large-scale deposit mobilisation and fund-raising programme that could ease pressure in certificate of deposit markets and support spread assets such as corporate bonds and state development loans. For public-sector borrowers, they provide an opportunity to borrow in size and reduce reliance on domestic credit and bond markets.

From a bond-market perspective, the most immediate beneficiaries are likely to be spread assets. Five-year government bonds have already rallied sharply since the announcement. Assuming FCNR deposit rates of around 6.5%, incremental demand may emerge less in government securities and more in three-to-five-year state development loans, corporate bonds, Treasury bills and five-year OIS receiving positions.

With the spread between five-year OIS and five-year government bonds already close to zero, banks mobilising FCNR deposits may find it attractive to receive five-year OIS while investing in one-year Treasury bills. Many may also prefer loans, corporate bonds and state development loans, which offer more attractive opportunities.

The spread between government securities and state development loans, as well as between government securities and corporate bonds, could narrow by 25-30 basis points in the three-to-five-year segment if funding conditions improve as expected.

Liquidity Relief
The implications extend beyond bond spreads.

These inflows could materially reduce the need for RBI liquidity injections through open market operations. Durable surplus liquidity could rise substantially and, over time, the RBI may even find itself draining liquidity through variable rate reverse repo auctions or sell-buy swaps. That conclusion would be premature today, but the possibility cannot be dismissed if inflows materialise at scale.

For now, the market may have a two-month window, extending into early August, during which corporate bonds and state development loans in the three-to-five-year segment could continue to outperform. Some of the deposit inflows may also find their way into liquid ten-year government bonds, particularly ahead of Bloomberg Global Aggregate Index inclusion, potentially putting further downward pressure on yields.

OIS has not reacted as strongly, particularly in the one- and two-year segment, largely because of recent developments in West Asia. Nevertheless, OIS could also participate in any broader bond-market rally, particularly because it remains an efficient way of expressing interest-rate views when bond-swap spreads are already close to zero.

Markets may continue to price around 100 basis points of future tightening because inflation and external-sector risks remain elevated. Even so, yields could become increasingly capped, particularly if some banks choose to convert fixed-rate FCNR liabilities into floating-rate exposures, as many have done in the past by receiving OIS against borrowings while holding predominantly floating-rate assets.

Durable rupee liquidity could rise from the current surplus of around ₹5.25 trillion to as much as ₹9 trillion by September if inflows reach $75 billion and the RBI continues to offset broader balance-of-payments pressures through spot intervention. Assuming the government maintains an average cash surplus of around ₹2.5 trillion, system liquidity could move to approximately ₹6.5 trillion.

The rupee remains central to this story. If inflows approach the author's estimates, the balance-of-payments deficit could narrow substantially from earlier projections. Over the past two years, hedging demand has become increasingly skewed towards importers, while foreign direct investment hedging has also risen, creating incremental demand for dollars beyond underlying balance-of-payments pressures.

The RBI's decision to absorb the full hedging cost on FCNR deposits has already triggered a sharp compression in forward premia and MIFOR, particularly in the five-year segment. The shorter end, which had become unusually elevated, could also normalise further, while the concentration of flows at longer maturities may contribute to additional flattening of the MIFOR curve.

None of this eliminates the inflation risk. August could still see a rate hike if crude oil remains in the $95-100 range and weather-related disruptions become a concern. Some market participants also argue that a weak response to the FCNR scheme could itself increase pressure for future rate hikes.

That possibility cannot be dismissed entirely. Yet one notable feature of the RBI's approach over recent months has been its willingness to maintain adequate liquidity even as the rupee weakened. Policymakers appear conscious of the need to preserve growth through ample liquidity, provided inflation expectations remain anchored.

The implication for markets is straightforward. The next signal may come less from the policy rate itself and more from the RBI's liquidity management. If liquidity-draining measures begin to appear more frequently, markets may be justified in concluding that rate hikes are drawing closer. Until then, the case for an immediate interest-rate defence appears considerably weaker than current market pricing suggests.