FX Firewall Buys the RBI Time

The government and the Reserve Bank of India have done a commendable job in the policy today, with the former announcing the withdrawal of capital gains tax and withholding tax on bonds and the latter announcing a swap window for deposits and commercial borrowings for public sector units, among other measures. This changes the narrative on the rupee, which was the need of the hour in the midst of persistent depreciation pressure over the last few months. In fact, BoP has been in deficit for the last two years, and a third year could have set in, raising expectations of further depreciation, thus requiring a monetary policy response. With the measures announced, the RBI now has time to adjust policy rates on the basis of growth-inflation dynamics rather than reacting to currency, as many Asian central banks have done.

In terms of inflows, a leverage facility on deposits, with the full swap cost to be absorbed by the RBI, along with concessional swap support for commercial borrowings for PSUs, should ensure around $50 billion of inflows, if not more. The tax changes on government securities should pave the way for Bloomberg bond index inclusion, with potential inflows of $25 billion. There could be far more debt inflows given the inclusion of longer-tenor maturities in the Fully Automatic Route segment — 15-year, 30-year and 40-year.

Apart from ensuring that BoP is now in neutral territory as against a large deficit this year, this should also ensure lower borrowing and lending rates.

The foreign liquidity with swap support should ensure adequate liquidity, which is positive for the cost of money. Banks getting dollars from abroad would require fewer domestic deposits. PSUs borrowing from abroad would borrow less in rupees.

Accordingly, yields saw a downward movement, with the maximum decline visible in the 5-year paper, which is the sweet spot for commercial borrowings.

Inflow Support
Apart from this, the RBI also took a number of measures for inflows, such as increasing the investment limit in equities for Indians abroad as well as reducing the timeline for bringing back export earnings from 15 months to 9 months. All of these measures should change the immediate narrative on the rupee.

However, FPI outflows in equities may still continue, given the trend seen across Asian markets as money is going back to the US for IPOs. For now, the immediate pressure on the rupee is relieved, and thus this gives time for the RBI to focus on growth-inflation dynamics.

Here, the RBI has revised its growth forecast lower to 6.6% from 6.9% earlier. While January-March GDP growth has surprised positively and even many high-frequency indicators are showing resilience, the impact of supply disruptions, including exports to West Asia, along with demand destruction due to elevated prices, should eventually lead to lower growth in the coming quarters. A possible subpar monsoon could also impact agricultural output. Lower growth also implies lower pricing power or demand-side pressure for the RBI to raise rates.

On the inflation front, the RBI has raised its inflation target to 5.1% from 4.6% earlier on the back of an upward revision to oil price to $95/bbl from $85/bbl earlier. Core inflation too has been revised higher to 4.7% from 4.4% earlier.

However, core inflation excluding gold ornaments is likely to be much more benign. While higher energy and food prices due to El Niño should be visible in CPI inflation and take the headline number higher to 5% in 2025-26, what matters more is how second-order effects play out. Here, we see a gradual increase in prices over the coming months as input costs are passed on. But pricing power could be limited when growth is coming down from last year’s high of 7.7%. Still, as headline inflation moves closer to the upper bound of 6%, the RBI is likely to raise the repo rate by 50-75 bps to bring core and headline inflation closer to target over the medium term.

What is more important here is that food inflation can go up on the back of a below-normal monsoon and much higher global food prices. The timing of lifting the repo rate would depend on when price pressures start getting generalised or energy prices move higher.

Policy Path

August policy is live; cumulative rate hikes of 50-75 bps may be required.

There are several moving factors that can affect the growth-inflation outlook during the year: West Asia peace negotiations, El Niño and its impact on food prices, and an inflation-led uptick in wage expectations, to name a few.

As per the MPC’s assessment, CPI inflation is seen at 4.2% in April-June 2026, 5.1% in July-September 2026, peaking at 5.9% in October-December 2026 and moderating to 5.4% in January-March 2027. Since inflation is likely to cross 5% in July-September 2026 and almost touch the upper bound of the MPC’s target range in October-December 2026, the ex-ante real rate in July-September 2026 is just 0.2% and is expected to be negative in October-December 2026.

Hence, we believe the MPC may start hiking rates sometime in the year, but timing is a bit uncertain. Given the projected inflation during the year, a cumulative three rate hikes (at most), or 75 bps, would be required during the year, potentially taking the terminal rate to ~6%.