Sanjay Malhotra is right that markets can be irrational in the short run, as maxims go. But the RBI governor’s suggestion that the rupee might be undervalued does not settle whether buying dollars is sensible today. An importer with a bill due next month cannot pay it with a long-run valuation model. 

Just two days after those remarks, in a midnight press release, the RBI has tightened currency-derivative rules. It has prohibited rebooking cancelled rupee-linked contracts, cut the threshold for hedging without establishing underlying exposure from $100 million to $5 million, and tightened checks against duplicate hedging. Banks must also lodge a 20% cash reserve against qualifying derivatives above $2 million for customers buying foreign currency to hedge current-account exposures. 

It also decided to sell dollars on tap to Indian government-owned refiners so they can avoid the interbank market.

Separately, banks will have to maintain 99% of their required cash reserves daily, rather than 90%, while the fortnightly average requirement remains unchanged. A ₹250 billion bond sale will absorb liquidity. These are meaningful monetary measures: making rupee funding less abundant can reinforce a rate increase, making money dearer and making hedging protection harder to obtain.

There will be consternation over the imposition of a reserve requirement on genuine hedges. Banks may pass the funding cost to customers, encouraging some businesses to remain exposed to depreciation.  For businesses operating on thin margins, absorbing this expense eats heavily into profitability and could force them to either swallow the cost or pass it down to consumers.

A policy presented as improving risk management could be making prudent risk management more expensive.

The deeper question is whether the RBI has underestimated the interaction between easy domestic funding and a harsher external environment. Its own assessment describes an appreciating dollar, rising overseas bond yields and tighter global financial conditions. Against that backdrop, buying dollars need not reflect irrationality. Restricting transactions does not remove the reasons for undertaking them.

The inflation outlook makes the case for firmer policy more compelling than the exchange rate alone. The repo rate is now 5.50%, after a quarter-point increase, while the RBI expects inflation to average close to 6% over the next three quarters. This is not a complete measure of monetary tightness, but neither is it reassuring evidence of restraint. The central bank also acknowledges that overnight rates have traded below its policy rate. Announcing tightening while allowing funding conditions to dilute it risks confusing intention with effect.

The answer is not to match every American rate increase or defend an arbitrary rupee level. Monetary policy should respond to the domestic inflationary consequences of external pressures, while allowing the exchange rate to absorb part of the shock. Nor should government borrowing costs dictate the limits of that response. Fiscal convenience is not a substitute for price stability, and independence matters most when exercising it becomes uncomfortable.  Experts often talk of the impossible trinity in the context of monetary policy and exchange rates. Something will eventually give at some point.

The RBI should follow its first increase with further tightening, ensure that market rates transmit its decisions, and keep policy restrictive until inflation is credibly returning to target. Calibration should describe a readiness to adjust to evidence, not advertise reluctance to act. Higher funding costs can make speculation more expensive; a credible policy response can also make its expected rewards less attractive.

On the rupee itself, the governor would do better to promise orderly market conditions than to debate traders’ rationality. The latest restrictions may buy time, but they cannot purchase credibility. That must be earned through a monetary stance that leaves less reason to doubt the inflation fight.

There is another maxim that comes to mind: the markets can remain irrational a lot longer than one can remain solvent.