FCNR(B): Has RBI bought forex stability at too high a cost?

The Economic Times September 29, 2026

The RBI’s FCNR(B) [Foreign Currency Non-Resident (Bank)] scheme has been widely lauded for attracting $132 billion. But is the amount attracted the right measure of success? A proper assessment should balance the benefits against the costs. When we do so, it is not clear that the benefits of the scheme outweigh the costs.

Without doubt, the scheme has had two positive outcomes. It has bolstered the RBI’s foreign exchange reserves, which rose from USD 682 billion when the scheme was launched on June 5, to USD 785 billion on September 4. It has also helped strengthen the rupee. In May, the rupee appeared headed towards Rs 100 to the dollar. Since then, it has stabilised in a range of Rs 94–96 to the dollar.

Those are clear results. But the deeper question is: what benefits did these outcomes bring to the economy? The answer to this however is less clear. For a start, it is not obvious why the RBI needed more reserves. USD 682 billion was already a sizeable kitty, more than sufficient to finance any prospective balance of payments deficit for this year, or even the next five years.

As for the exchange rate, there is no obvious reason why Rs 95 to the dollar is better for the economy than Rs 100 to the dollar. A more depreciated rupee does hurt importers by making foreign goods and services such as education, more expensive. But it also gives domestic producers some breathing space as they compete with cheap imports from China. Depreciation also helps exporters by making their products cheaper for foreign buyers and helping them find new markets.

In other words, the economic benefits of higher reserves and a stronger rupee are unclear. What about the costs?

First, consider the financial burden. When Indian banks gave dollars to the RBI, the RBI gave them rupees in return, creating more than Rs 10 lakh crore of liquidity. This surplus liquidity is now pushing interbank interest rates below the RBI’s policy rate. That is a problem because with inflation going up, the RBI may need to raise the policy rate in October. But to do so, it will first have to “mop up” the surplus liquidity to bring interbank interest rates back in line with the policy rate. Otherwise, the rate hike will not be effective.

However, absorbing the excess rupee liquidity would be expensive. For example, if the RBI were to sell the banks, Rs 10 lakh crore of 10-year government securities carrying a market interest rate of roughly 7 per cent, the interest cost would be about Rs 70,000 crore a year. This is a sizeable sum.

There are other options. The RBI could ask the government to bear the cost by issuing new government securities, or share part of the cost with the government. The RBI’s additional foreign exchange reserves would generate some income, for example from US Treasury securities, but even after accounting for this, the net cost to the public sector would remain large.

Alternatively, the RBI could make banks bear the cost by raising the Cash Reserve Ratio (CRR). This has two problems. First, banks that have not received the dollar deposits would also be penalised. Second, banks have to pay 6-7 percent interest rate on the NRI deposits but receive nothing on the surplus liquidity deposited with the RBI as a result of any CRR hike. This would undermine banks’ profitability.

The potential costs do not end there. The second problem is that the RBI has assumed considerable exchange rate risk. For every dollar that banks gave the RBI, they received around Rs 95 in return, assuming this to be the prevailing exchange rate. When the deposits mature in roughly five years, the RBI will have to reverse the transaction at the same exchange rate. But what happens if the rupee depreciates in the meantime? Let's say if the exchange rate is Rs 105 when the deposits mature, the RBI would lose Rs 10 for every dollar swapped.

This is only an illustration, since the future exchange rate is unknown. But even a small depreciation could impose a large cost because the amount involved is enormous. Put simply, returning $127 billion after five years could prove costly for the RBI, over and above the cost of absorbing the surplus liquidity. Future dividends from the RBI to the government would consequently suffer.

Perhaps these costs would have been worth incurring if the scheme had been used to buy time to strengthen India’s balance of payments. But no such measures have been announced either to attract more foreign direct investment or more foreign portfolio investment into Indian equities. Partly for this reason, and also because the war in West Asia has intensified, the rupee has begun to fall again.

In summary, the benefits to the economy of the FCNR(B) scheme are unclear, while its costs are significant. In the end, it has left the system weaker than before. This raises a basic question: was the scheme really needed?

Making India attractive to foreign capital: Beyond the RBI's June measures

Business Standard July 14, 2026

Last month, the Reserve Bank of India (RBI) announced a series of measures to support the rupee by encouraging foreign borrowing. So far, they seem to have worked. The rupee has stabilised. But the important question now is whether this stability will last.

The answer depends on whether the problem is temporary or permanent. If it is temporary, the RBI's strategy makes sense. Borrowing can bridge the gap in dollar supply until conditions improve. But if the problem is permanent, borrowing only postpones the adjustment. Eventually, the same problem will return and the country will have to deal with it from a weaker position, since it will have accumulated debts in the meantime.

So, is the problem temporary? Only partly. The war in West Asia has pushed up oil prices, increasing India’s import bill and putting pressure on the balance of payments. But this factor is only a small part of the problem. Even if the war continues for a few more months and oil prices rise back towards $100 a barrel, India's current account deficit should remain within its traditional “safe limit” of 2 per cent of gross domestic product (GDP).

The bigger problem lies in the capital account. For much of the period since the 1991 reforms, India attracted substantial foreign capital. During the investment boom of the mid-2000s, inflows were more than sufficient to finance the current account deficit (CAD) and still allowed the RBI to accumulate foreign exchange reserves. That is why a CAD of around 2 per cent of GDP came to be seen as safe. Over the last couple of years, however, capital inflows have weakened steadily and, at current levels, they are no longer sufficient to finance even a modest CAD.

There is another reason why foreign capital matters. The government’s goal of making India a "Viksit Bharat" by 2047 will require the economy to grow at around 8 per cent a year, in real terms, for the next two decades. Achieving that will require much higher investment. Domestic savings alone are unlikely to be enough. Foreign capital will, therefore, have to fill part of the gap.

Consider the incremental capital output ratio (ICOR). It measures how many rupees of investment are needed to generate one additional rupee of GDP. India's ICOR has historically ranged between 4.5 and 5. At that rate, sustaining a real GDP growth rate of 8 per cent requires investment of 36-40 per cent of GDP every year.

Today, India's gross savings and investment are both around 30 per cent of GDP. Raising investment to the level needed for sustained high growth would, therefore, require an additional 6-10 per cent of GDP every year. At today's GDP of around $4 trillion, even the lower end of that range amounts to roughly $240 billion a year in investment. Unless domestic savings increase substantially, India will need foreign capital to bridge this gap.

The obvious question, then, is how India can attract more foreign capital. The RBI's June 5 package, especially the elimination of capital gains tax on foreign investors’ bond purchases, is a step in the right direction. But much more needs to be done. For example, nothing has been announced so far to encourage foreign direct investment (FDI). This matters because FDI is not only more stable than portfolio investment, but also brings technology and access to global production networks that India needs to build a competitive manufacturing sector.

To encourage FDI inflows, three policy actions are crucial. The first step is to liberalise India's trade regime. Import tariffs need to come down. The Customs duty structure should be simplified. Quantity control orders (QCOs) that make it harder for manufacturers to source imported inputs also need to be phased out.

Second, policymakers need to rebuild the bilateral investment treaties (BITs) network that was dismantled entirely between 2016 and 2024. Setting up a factory requires a large, long-term investment. Foreign investors are more likely to make such commitments when they are confident that any disputes will be resolved through a credible and predictable legal process.

Third, policy certainty matters. Investors making long-term commitments need confidence that the rules will not change after their investments are made. The retrospective tax dispute involving Vodafone damaged that confidence. Although the government has since ruled out such taxation, more recent policy reversals have kept those concerns alive. The RBI's decision in March requiring banks to unwind their offshore forward positions, at an estimated cost of hundreds of millions of dollars, is one example. Whether or not the policy was justified, unexpected changes of this kind increase the perceived risk of investing in India.

The RBI’s June measures have bought India some time. The challenge now is to use that time wisely. India needs a permanent strategy to attract foreign capital, especially foreign direct investment. That means making it easier to invest, protecting investors through predictable rules, and avoiding policy reversals after investments have been made. 

Indian policymakers cannot guarantee that foreign capital will come. But they can ensure that there are no avoidable reasons for it to stay away.

The Rupee's problems runs deeper

Business Standard June 15, 2026

On June 5, the Indian authorities took out a bazooka to rescue the rupee. The RBI announced a series of measures, providing subsidies to state-owned companies taking overseas loans, introducing a new version of the dollar-deposit scheme for NRIs, last seen in 2013, and removing restrictions on foreign investment in bonds and equities. At the same time, the government exempted foreign investments in government bonds from tax on interest and capital gains. The announcements are ambitious in scope. But will they be effective? There are reasons to be sceptical.

To begin with, it is important to recognise that the rupee’s weakness has not been caused solely by the war in West Asia. In fact, the rupee was the worst performing currency in Asia last year, depreciating by more than 6 percent against the dollar. This suggests that there is more to the story. The obvious question is: why have foreign investors been taking money out of an economy that, according to the latest official data, is growing at nearly 8 percent, faster than any major economy in the world?

The answer lies in two other shocks that India has been facing. These shocks have received relatively less attention but are likely to have a longer-lasting impact. What are these shocks and how should the economy adjust?

The first of these could be termed the China shock. Until recently, the dominant narrative among investors was that India would gain significantly from the shift of global manufacturing out of China. The logic seemed compelling: a vast pool of low-cost labour, the government’s incentive schemes for the manufacturing sector and a rapidly expanding domestic market. Since 2008, India’s GDP has risen fourfold, from about $1 trillion to $4 trillion, reinforcing the perception that the country offered both a production base and a sizeable consumer market.

However, things have not turned out as expected. For a start, the shift out of China has been smaller than anticipated. China continues to be the workshop of the world, even expanding into new sectors (such as automobiles) where it previously did not have any major international presence. Moreover, the manufacturing that has shifted out of China has generally not come to India. Gross FDI to India has in fact fallen as a percent of GDP, from 3.6 percent in 2008 to less than 1 percent in 2024. The major beneficiaries of the China+1 shift have been in East Asia, with Vietnam in particular seeing its FDI ratio surge to more than 5 percent.

While foreign firms have been reluctant to invest in India, Indian firms have been expanding their investments abroad. Outward FDI has doubled over the past two years from roughly USD 15 billion to more than USD 30 billion in 2025-26, even as domestic investment has remained sluggish. In other words, India has not been able to present itself as an attractive manufacturing location, either to foreign or to domestic firms.

In addition to this, the economy is facing a second major shock: AI, which is threatening the country’s flagship IT sector. Despite India’s software prowess, it is lagging well behind the US and China in developing AI platforms and shaping global AI development. The Nifty IT index has fallen roughly by 22 percent over the past year. This in turn has forced the IT firms to retrench. Hiring has fallen sharply, while anecdotal evidence suggests that the top IT firms have laid off around 40,000-50,000 employees since 2024.

Taken together, these two shocks have exposed the vulnerabilities in India’s growth narrative. If the twin drivers of manufacturing and IT services are under strain, where will sustained, high growth come from? New pillars can certainly emerge; they have in other Asian economies. China, South Korea, and Taiwan have proved their potential to move up the value chain and establish a global presence in frontier industries such as AI hardware and electric vehicles. The Indian manufacturing sector however, has yet to make a similar transition.

The takeaway is straightforward. As expectations of India’s growth prospects have moderated, both FDI and portfolio flows have weakened, to the point where they are no longer sufficient to finance even a modest current account deficit. This implies that short-term dollar inflows triggered by the recently announced measures are unlikely to solve the problem. Instead, the economy needs to adjust.

There are two ways this could play out. One way is for investors to mark down the prices they are willing to pay for Indian assets, to reflect the economy’s weaker growth prospects. Under this scenario, share prices would correct, pulling market valuation down from its lofty 20-23 price to earnings ratio to the 12-17 range more typical of emerging economies. Alongside this, the Indian rupee would depreciate further. As Indian assets become less expensive, foreign capital will eventually be enticed to return, in sufficient quantity to finance the current account deficit, now running around $100 billion a year.

Such a scenario would not be particularly appealing because those who have invested in Indian assets would lose considerable amounts of money.

The alternative is to restore confidence in the economy’s growth prospects. This is a better option but it is also harder to achieve. It would require decisive measures to address the factors holding back investment-both domestic and foreign. It would also require something that has so far been in short supply: a willingness to recognise that the concerns being expressed by investors may not be entirely misplaced.

Why RBI’s regulatory intervention is the wrong way to defend the rupee

Why RBI’s regulatory intervention is the wrong way to defend the rupee, The Print, June 1, 2026.

Words and deeds in the Indian exchange rate

Words and deeds in the Indian exchange rate, The Leap Blog, May 19, 2026.

The rupee’s decline is part of the solution, not the problem

The rupee’s decline is part of the solution, not the problem, The Print, May 18, 2026.

Let the rupee move freely: RBI intervention risks more harm than good

Business Standard April 21, 2026

The Indian rupee has been under intense scrutiny in recent weeks, with its depreciation against the US dollar attracting widespread attention. Much of the commentary has framed this decline as a sign of weakness, often applauding the central bank’s efforts to resist it. But this view overlooks a basic point: The exchange rate is a price. And like any price, it must adjust to shifts in demand and supply. Trying to hold it at an artificial level does not fix underlying imbalances — it only postpones the adjustment and risks making the eventual correction more disruptive.

Consider a familiar example. When the monsoon fails, the supply of vegetables falls short of demand. Prices rise, and this serves a purpose: Households cut back consumption, and farmers are encouraged to bring as much produce as possible to the market. The imbalance begins to correct itself.

Now imagine the government steps in to prevent prices from rising. The gap between demand and supply does not disappear—it simply persists. To manage it, the government would then have to impose restrictions, such as rationing or limits on sales. In the end, consumers would face shortages and reduced access, defeating the very purpose of the intervention. This is precisely why governments typically allow such prices to adjust rather than trying to control them.

The same logic applies to the foreign exchange market. When demand for dollars exceeds supply, the price of the dollar rises—and the rupee falls. What we are seeing today is simply this basic market adjustment at work.

So why is demand for dollars rising faster than supply? There are two main reasons.

First, India has been running a current account deficit, which was around $40 billion in 2025-26, but foreign capital inflows were insufficient to finance it. This imbalance helps explain why the rupee was already under pressure last year.

Second, the war in West Asia has made matters worse. By pushing up the prices of key imports, it is likely to widen the current account deficit further—potentially to around $80 billion this year.

As a result, India faces a difficult challenge: It needs to attract around $80 billion in foreign capital at a time when global investors are becoming more risk-averse and pulling money out of emerging markets into safer developed economies. In such a situation, the most practical way to restore balance is to allow the rupee to depreciate.

How does depreciation help? In much the same way that higher vegetable prices restore balance—by reducing demand and encouraging supply. The exchange rate works through two key channels.

First, a weaker rupee helps restore balance through trade. As it depreciates, Indian goods become cheaper for foreign buyers, boosting exports and bringing in more dollars. At the same time, imports become more expensive, which reduces domestic demand for foreign goods. Together, these effects help narrow the current account deficit.

Second, a weaker rupee makes Indian financial assets cheaper for foreign investors. In dollar terms, Indian stocks and bonds now cost less, which can make them more attractive. This can encourage foreign investment into Indian markets, bringing in dollars and helping to finance the current account deficit.

In contrast, if policymakers try to hold the exchange rate at an artificial level, the underlying imbalance does not disappear—it lingers, and can even intensify over time.

The main reason is that the market is aware of the $80 billion funding gap—and that the central bank cannot finance it indefinitely by selling dollars, since it will eventually run out of reserves. Unless this gap is expected to close on its own, some depreciation of the rupee becomes inevitable. Faced with this prospect, firms and households will naturally look for ways to safeguard their wealth, including shifting part of it abroad.

There is another concern. When the central bank tries to manage the exchange rate, the private sector shifts its focus from market signals to guessing the central bank’s next move. This uncertainty can itself be destabilising. If the currency is supported through restrictions—such as the recent curbs on gold and silver imports—it can unsettle the private sector and raise fears of further controls. Such fears can trigger precautionary behaviour, with firms and households pre-emptively moving money out of the country, adding to the pressure on the rupee.

In other words, attempts by the central bank to hold back the rupee risk doing more harm than good — by eroding confidence, fuelling uncertainty, and distorting market signals. This can widen the gap between dollar demand and supply, discourage investment, and complicate economic recovery. The exchange rate is not the problem; it is the mechanism through which the problem is corrected. Holding it back only delays the adjustment and makes the eventual cost higher.

In these circumstances, the most effective policy is also the simplest: Allow the rupee to move freely and do its job as the economy’s primary shock absorber.

RBI’s rupee defence may backfire

Business Standard April 14, 2026

Since the onset of the West Asia conflict, the Indian rupee has come under sustained pressure against the dollar. In response, the Reserve Bank of India (RBI) has stepped up its defence of the currency. However, the measures announced by it risk backfiring, disrupting the foreign exchange market, and intensifying the very pressures they seek to contain, with broader consequences for the economy.

When the war broke out in late February 2026, the RBI, backed by foreign exchange reserves of nearly $730 billion, intervened aggressively. It sold over $30 billion in the spot market in March alone and built up a large short dollar position in the forward market. Despite these efforts, the rupee continued to weaken.

In late March, the RBI shifted strategy. It imposed regulatory restrictions —barring banks from taking positions in the offshore non-deliverable forward (NDF) market and capping their daily onshore FX exposure to $100 million each. These measures appeared to have some immediate effect, with the rupee stabilising briefly. But the key question is whether this strategy can hold.

There are strong reasons to doubt it.

The first concern is the sweeping and abrupt nature of the measures. The RBI did not merely restrict new positions; it required banks to unwind existing ones, reportedly at a cost of ₹4,000–5,000 crore. In effect, banks were penalised for actions that were fully legitimate at the time. Such retrospective costs risk undermining confidence and making banks more cautious in FX markets. Lower participation could reduce liquidity. And when liquidity dries up, currencies tend to become more volatile, not less.

This is particularly troubling because the activity being curtailed was neither illegal nor questionable. Much of it was simple arbitrage — buying dollars in the onshore market and selling them offshore and keeping exchange rates in the two markets aligned. These trades were perfectly normal and had been explicitly permitted by the RBI itself.

Indeed, for several years the RBI had encouraged offshore trading in the rupee as part of a broader push to internationalise the currency. A large offshore market has developed in centres such as Singapore, London, and Dubai, with an estimated $70 billion in daily turnover. By suddenly barring Indian banks from participating in this market, the RBI has reversed its earlier stance. While the central bank has described the move as temporary, such an abrupt policy shift raises concerns about consistency.

To the market, these measures send an uncomfortable signal — that the situation may be more serious than the RBI’s reserves alone can handle. Instead of reassuring investors, this risks eroding confidence. The opposite of what the intervention was meant to achieve.

There is also a broader concern. Banning legitimate market activity raises questions about what might come next. Investors may begin to worry about further restrictions — such as limits on outward remittances — and respond by moving funds out pre-emptively. Foreign investors may become wary of bringing capital into India if there is a risk that exit routes could later be constrained. If such fears take hold, the RBI’s actions could end up triggering the very capital outflows it is trying to prevent.

At the same time, these measures risk impairing the functioning of the FX market itself. In periods of heightened volatility such as the present, firms need to hedge their currency risk. By capping banks’ FX positions and limiting their participation, these measures are likely to raise hedging costs. Early reports suggest this is already happening. As Indian banks step back, hedging has become more expensive — precisely when foreign portfolio investors need certainty on exchange rates before committing capital. This makes India a less attractive destination for investment at a time when capital inflows are crucial.

This brings us to the fundamental problem: The pressure on the rupee is not merely cyclical but structural.

For some time now, capital inflows into India have not been sufficient to finance even a modest current account deficit of around 1 per cent of gross domestic product (GDP). This imbalance helps explain why the rupee was already among Asia’s weakest currencies in 2025, even before the war.

The West Asia conflict has only worsened this situation. Higher global oil and gas prices are widening the current account deficit, reflecting India’s heavy dependence on energy imports. At the same time, capital inflows are weakening due to global risk aversion and a decline in investor appetite for Indian assets. In such circumstances, some depreciation of the rupee is not only inevitable but necessary to restore external balance.

Against this backdrop, it is unclear what the RBI’s measures can realistically achieve. At best, they may delay the needed adjustment. At worst, they could exacerbate underlying pressures by undermining confidence and discouraging capital inflows.

The costs are already being felt beyond the FX market. Uncertainty around the FX strategy has pushed up market interest rates, amplifying the growth-dampening effects of the energy shock.

Perhaps the restrictions will be rolled back in due course. But even then, restoring confidence will take much longer. 

Why growth isn’t saving the rupee

Business Standard January 20, 2026

Last year was not a good one for the Indian rupee. It weakened steadily, even against a soft US dollar, ending 2025 as Asia’s worst-performing currency. Some argue that the rupee’s slide will be a blessing in disguise, giving long-struggling exporters a much-needed boost. Perhaps it will. But before taking comfort, it is worth asking a more fundamental question: Why is the rupee falling in the first place?

The puzzle is sharpened by the apparent strength of the Indian economy. Growth remains brisk, and inflation has fallen to multi-decade lows. It is true that exports have taken a hit from higher US tariffs, with merchandise shipments growing by less than 1 per cent year-on-year between August and December 2025. Yet gross domestic product (GDP) is still projected to expand by 6.5-7 per cent in 2026-27, keeping India firmly in place as the world's fastest-growing major economy.

Ordinarily, such performance would attract foreign capital, as investors chase returns, lifting the currency in the process. That was the pattern during the boom of 2004-08, when equity inflows averaged a little over 2 per cent of GDP and the rupee appreciated by around 2.5-3 per cent a year. This time, the script has flipped. Despite strong growth, the rupee has fallen by more than 5 per cent so far in 2025-26.

What makes the decline more striking is the modest current account deficit (CAD) — around 1 per cent of GDP in April-September 2025. A weakening rupee suggests that even financing so small a gap has become difficult.

The reason lies in a persistent imbalance: demand for rupees has lagged supply, reflecting pressures on both the trade and capital accounts. Merchandise imports averaged about $62 billion a month in 2025, far exceeding exports of roughly $37 billion and leaving a $25 billion trade deficit. Although services exports offset much of this gap, weak goods exports and a rising import bill — driven in part by higher gold and silver prices — have skewed demand towards dollars. Importers are buying more dollars than exporters are supplying, pushing the dollar up and the rupee down.

Normally, such a shortfall would be easy to finance — if capital inflows were behaving as they usually do. Last year, they were anything but normal. In 2025, foreign portfolio investors (FPIs) withdrew about $19 billion from Indian equities on a net basis — the worst outflow on record. This exodus occurred even as capital flows into the broader MSCI Emerging Markets index remained robust. India was a clear outlier.

Foreign direct investment (FDI) has been no more reassuring. This should have been a moment of opportunity, with multinationals diversifying away from China and India opening more sectors to foreign capital while offering incentives through production-linked schemes. Yet investors remain hesitant. Gross FDI inflows have been stuck at around 1.7 per cent of GDP since early 2023, well below the 3 per cent seen in the mid-2000s.

The graph tells the story starkly. Between January 2024 and October 2025, gross FDI inflows averaged about $7 billion a month, while withdrawals ran close to $4 billion, leaving net inflows of barely $3 billion — negligible for a $4 trillion economy. Once rising outward investment by Indian firms, averaging $2-3 billion a month, is taken into account, the picture worsens. In effect, India has received close to zero net FDI each month over the past 22 months.

The conclusion is hard to escape: India has failed to capitalise on the global shift in FDI in any meaningful way. This has in turn soured the mood among portfolio investors who now appear far less confident about India’s long-term growth prospects. Instead, capital is being redirected to East Asia, where economies are seen as better positioned to benefit from the China+1 strategy and the artificial intelligence (AI) boom. Delays to a US-India trade deal have only reinforced this perception. The rupee’s slide reflects this deeper malaise — India’s waning appeal as a destination for foreign capital. The Reserve Bank of India’s heavy interventions in the foreign-exchange market have offered only a temporary fix; a durable remedy lies in reforms that restore credibility and rekindle India’s appeal to global investors. 

All of this places the forthcoming Union Budget firmly in the spotlight. Strong headline numbers — rapid growth, low inflation and a modest current account deficit — have fostered the belief that little needs fixing. That would be a misjudgement. Both foreign investors and domestic firms are signalling that something is amiss, as evident in the prolonged weakness of private investment. The government has taken a few policy steps in recent months. One can only hope that more decisive measures will follow when the Budget is presented on February 1.

Internationalising the rupee: India's path must diverge from China

Business Standard October 20, 2025

At its last policy meeting, the Reserve Bank of India unveiled several measures to boost the Rupee’s use in cross-border trade—a step toward its gradual internationalisation. The notion that an emerging economy's currency can gain global traction took off after the IMF added China’s Renminbi (RMB) to its Special Drawing Rights basket in 2016. Now, amid renewed geopolitical tensions involving the US, Russia, and China, the question resurfaces: how can India meaningfully advance the Rupee’s journey toward international status?

For the Rupee to become an international currency, non-residents must both want and be able to trade and invest in it. A Russian importer, for instance, should be able to pay for South African goods in Rupees. Likewise, a UK investor should be able to buy Rupee-denominated bonds or shares with ease. In these cases, foreigners—not Indians—bear the currency risk. That shift is the essence of true currency power. It’s also the "exorbitant privilege" the US dollar has long enjoyed.

The willingness and ability to use a currency globally rest on three key conditions. First, the issuing economy must have scale—measured by GDP, trade flows, and volume of international transactions. China, with an $18 trillion economy, meets this bar; India, at around $4 trillion, does not yet. To build that scale, India must sustain a growth rate of 7–8 percent annually over the coming years—a difficult but necessary condition for the Rupee's global ambitions.

Second, the value of the currency must be stable over time. A currency is considered stable when the general level of prices does not vary too much. Stability has multiple aspects: macroeconomic, financial and political. On the macroeconomic front, India has done well. CPI Inflation is at multi-year lows, and the RBI has built credibility in keeping it close to the 4 percent target. Financial stability, too, has strengthened: banks are better capitalised, balance sheets are cleaner, and the broader financial system appears sound.

Political stability is the third pillar. The fact that India is a democracy, like issuers of major international currencies in the 19th and 20th centuries, goes in its favour. Democracy, with its institutional checks and balances, reassures foreign investors about policy credibility and continuity. That confidence, in turn, lends long-term stability to the currency.

Currency stability is often mistaken for the absence of volatility—but the two are not the same. A stable currency reflects true market forces, not central bank management. Its value should be shaped by cross-border capital flows, much like the USD–EUR exchange rate, which stays broadly stable despite constant movement in global finance. Think of it like administered prices: India once controlled prices of essentials like steel and diesel, keeping them artificially steady. Today, those prices fluctuate with supply and demand—and that's a sign of a healthy market. Currency markets should work the same way.

Finally, a currency must be liquid—meaning investors can buy and sell large amounts of assets in it without moving prices. Liquidity depends on deep financial markets and an open capital account. India’s equity market is vibrant, but its debt market remains shallow. History shows that countries with capital controls tend to have thinner markets, while openness to foreign investors boosts liquidity. Yet, more than three decades after liberalisation began, India still maintains extensive controls—especially in its debt and derivatives markets—limiting the Rupee's global reach.

Studies of professional forecasters show the same pattern. Research by Bhanu Pratap and Kundan Kishor (2023) and by IMF (International Monetary Fund) economists Patrick Blagrave and Weicheng Lian (2020) finds that medium-term inflation forecasts have become more stable and less sensitive to short-term inflation surprises. In our own research (Vaishali Garga, Aeimit Lakdawal Lakdawala and Rajeswari Sengupta, 2022), we find that professional forecasters now expect the RBI to react more strongly to rising inflation than it did before the inflation-targeting regime. Their expectations have also become less responsive to shocks in oil prices. Together, this evidence suggests that India's recent inflation stability is not just the result of favourable global factors. It reflects a steady buildup of policy credibility.

This is where India's approach must differ sharply from China's. Beijing has sought to internationalise the RMB while retaining capital controls and a tightly managed exchange rate—a combination no currency has ever succeeded with. China’s advantage lies in scale: it commands over 12 percent of global trade, and in some products, more than half of world exports. That dominance allows it to partially offset the constraints of limited convertibility. India, with only about 3 percent of global trade, lacks that leverage. The contrast shows in the data—the RMB accounts for nearly 9 percent of global FX turnover, while the Rupee lags below 2 percent.

India's best path forward is to gradually ease its capital controls. The RBI and the government have taken meaningful steps since 2020, but more are needed. Alongside this, India should embrace a genuinely flexible exchange rate while ensuring ample hedging options for market participants. Encouragingly, progress is visible: from the near-pegged regime of 2022–24, when INR-USD volatility hit record lows, the RBI has since allowed the currency to move more freely with market forces.

Of course, India cannot liberalise the capital account or adopt a fully flexible exchange rate overnight. One promising approach is to use GIFT City, the International Financial Services Centre, as a controlled experiment. It could become India’s "Hong Kong," with an open capital account, flexible exchange rates, and robust hedging instruments. Over several years, the RBI could gain valuable experience managing such a system, gradually scaling it up to advance the Rupee's journey toward international status.

Making the Rupee an international currency aligns with India’s vision of becoming an advanced nation by 2047. But achieving this over the next two decades will demand sustained, deliberate action. Currency internationalisation is a long journey, requiring multiple building blocks. Indian policymakers must chart a path distinct from China’s, steadily dismantling the barriers that limit the Rupee's global role. Success will hinge on a steadfast commitment to economic reforms that inspire international confidence in the currency.

RBI’s costly experiments with the currency

RBI's costly experiments with the currency, Ideas for India, Feb 21, 2025.

Inflation vs Exchange Rate: RBI’s conflicting objectives

Business Standard February 18, 2025

Since November 2024, the Reserve Bank of India (RBI) has allowed the rupee to weaken against the US dollar, ending the effective peg that it had maintained for nearly two years. However, it has continued to intervene in the foreign exchange (FX) market to limit the rupee’s decline, keeping it the least volatile major currency in Emerging Asia with a modest 3 percent depreciation. This has, however, strained monetary policy and tightened liquidity at a time when the economy is weak and needs support.

To understand how this has happened, we must examine the link between monetary policy, currency management, and liquidity. The rupee weakens (or the dollar strengthens) when dollar supply in the FX market falls short of demand, such as when India's diminishing growth prospects discourage capital inflows. To counter this, the RBI can sell dollars from its FX reserves, preventing or even limiting rupee depreciation. However, it does not give dollars for free; it sells them for rupees. This absorbs rupees from the system, thereby tightening monetary conditions.

The RBI conducts this transaction with banks. When a person asks a bank to exchange Rs 1 lakh for dollars, the bank typically goes to the FX market, finds a seller, and matches the buyer with the seller. In this case, the bank acts as an intermediary, profiting from the spread between the buying and selling rates.

However, when a bank gets dollars from the RBI, the process changes. The bank must provide Rs 1 lakh to pay for the dollars, but its assets mostly consist of loans and government securities. Only a small portion of bank deposits is held at the central bank due to the CRR (cash reserve ratio) mandate. This is what the bank uses to pay the RBI when the latter sells dollars. This means when banks buy dollars from the RBI on a large scale, their balance at the RBI can fall short of requirements, causing their liquidity to tighten.

This is exactly what has been happening. For most of the past few years, the banking system had a healthy liquidity surplus. However, over the past few months, the RBI has sold large amounts of dollars, causing its FX reserves to drop sharply from USD 704 billion in September 2024 to USD 630 billion in January 2025. As a result, domestic banking system liquidity has shrunk, and the system is now in a large deficit, around Rs 1-2 lakh crores.

To address this, the RBI has taken two approaches. On a daily basis, it has been lending funds to the banks. It has also repeatedly engaged in open market purchase operations, buying government securities from banks to replenish their deposits at the RBI. These actions have ensured that banks have the necessary funds to conduct their business. However, this does not mean the RBI’s FX intervention has been without consequences.

This is evident in the graph below, which shows the difference between the weighted average call rate (WACR) and the RBI’s policy repo rate. The WACR reflects banks' borrowing costs in the overnight interbank market. When banks have a liquidity surplus, the WACR goes below the repo rate, resulting in a negative spread. However, as liquidity has tightened, particularly since November 2024, the spread has become positive, indicating that banks facing a cash shortfall have struggled to secure the necessary funds.

Figure 1: Spread between weighted average call rate (WACR) and repo rate (Source: RBI)

This matters because the RBI has now signalled its intention to ease monetary conditions. On February 7, the central bank lowered the repo rate, citing weaker inflationary pressures and slowing growth. However, just days after the cut, the RBI conducted a massive FX intervention to prevent the rupee’s depreciation. Though FX intervention data is released with a lag, anecdotal evidence suggests the RBI sold between USD 7 to 11 billion in only two days. This action tightened monetary conditions and raised the WACR.

In effect, the central bank has been sending mixed signals. Is the RBI truly committed to ease monetary conditions – or not? It is difficult to decipher from its actions.

For banks, the message is clear: as long as the RBI keeps liquidity tight and interbank lending conditions remain strained, they will be hesitant to lower their own interest rates. This reluctance means the RBI's repo rate cut will not get transmitted to the rest of the economy, and the monetary stimulus will fail to materialize. In short, the RBI's exchange rate management strategy is undermining the effectiveness of its monetary policy.

The law mandates that the RBI's primary objective is maintaining price stability, keeping an eye on growth. It does not mention managing the exchange rate. It is time for the central bank to focus on managing inflation and growth, allowing the exchange rate to adjust based on fundamental factors.

Unshackling the Indian Rupee

Indian Express November 9, 2024

Recently, there have been several reports about the stability of the rupee against the US dollar. This is typically described as a positive development. But the central bank’s decision to control the exchange rate is in fact deeply problematic.

Admittedly, the Reserve Bank of India (RBI) has always intervened in the foreign exchange market to smooth out fluctuations of the rupee. However, since 1991, the intervention has never been as great as it is today. The data speaks for itself. Over the two decades through 2020, the average annual volatility (that is to say, the movement) of the rupee-dollar (INR-USD) rate typically ran around 5 percent. But between April 2023 and August 2024, the average volatility collapsed to only 1.9 percent, a level that is extraordinarily low not only compared to India’s own past but also to all of its emerging economy peers.

To be clear, if exchange rate stability comes about as a natural outcome of market forces, then it is welcome. For example, the euro-dollar exchange rate is one of the most stable in the world, not because their central banks regularly intervene in the market—they do not—but because a vast number of players are freely able to take money in and out of these financial markets, creating huge but roughly balanced cross-border movements of capital which in turn keep the exchange rate stable.

The rupee's recent stability, however, has not been driven by market forces. On the contrary, it has come about due to an apparent change in the RBI’s currency policy. Since late 2022, the RBI has decided to actively intervene on both sides of the foreign exchange market, on some days buying dollars to prevent the rupee from appreciating and on other days selling dollars to prevent the rupee from depreciating. It is only a small exaggeration to say that without any announcement or public debate, the rupee has become pegged to the dollar.

There are several fundamental problems with this change in currency policy.

To begin with, it goes against basic economic principles. In any country that aspires to reach the ranks of the developed economies, the price of any good, service or asset should not be determined by the State. Just as we do not want the price of tomatoes or computers or restaurant meals to be fixed by the State, it is not a good idea to fix the price of the rupee either. The price should instead be left to the market.

This is because the price system in a market economy performs a crucial function: it conveys information about demand and supply to buyers and sellers, who can then adjust their behaviour accordingly. For example, a high price signals to sellers that they should supply more, while telling buyers that they should hold off on their purchases. As each group responds to this signal, demand is gradually brought into balance with supply.

In contrast, when the State sets the price, the information system gets distorted. One only needs to look at India’s own history to see what can go wrong. In the pre-1991 era, controlled prices led to shortages of nearly every major good that people wanted to buy, such as cars or telephones. Most scarce of all were imports, which people could not obtain easily because the pegged exchange rate led to shortages of foreign exchange. Ultimately, these problems led to the crisis of 1991, when the entire system broke down.

This is not a uniquely Indian story. The list of countries that got into serious trouble after pegging their exchange rate is a long one, including major economies such as Argentina, Brazil, Mexico, Russia, South Korea, Thailand, and Turkey. That is why nearly all emerging economies have decided in recent years to free their exchange rates.

So much for theoretical principles. What about practice? After all, sometimes the practical problems of a theoretically-best policy can be so large that it simply needs to be abandoned. But that was not the case here, which brings us to the next problem with the new currency policy: it did away with a long-standing system that was working perfectly well.

The previous flexible exchange rate policy had two practical advantages. First, the exchange rate moved up or down over the business cycle which in turn helped smooth out output fluctuations. During periods of high growth when exports were growing and foreign capital was flowing in, the rupee appreciated which prevented the economy from overheating. And when the economy was in a downturn, the rupee depreciated, making Indian goods and services more attractive to foreigners, thereby promoting an export-led recovery.

Second, because these ups and downs balanced each other out, over long periods there was stability in the real exchange rate, that is the exchange rate adjusted for the difference in inflation between India and its trading partners. In contrast, the new inflexible system has already led to a significant real exchange rate appreciation, thereby making India’s exports more costly to foreigners, and potentially undermining the Make in India drive.

All these bring us to the final problem, namely the lack of transparency. The central bank seldom communicates about its currency policy. As a result, it is not well understood why the RBI felt the need to break with a long-standing practice and bind the rupee so tightly to the dollar. It is also not clear whether this is a temporary policy or a more long-lasting change.

Consequently, private sector participants in the foreign exchange market are confused. They need to guess when they see imbalances in the market, such as capital flows exerting pressure on the exchange rate. Will the central bank intervene to prevent the exchange rate from moving? If so, when or by how much or in which direction? No one knows. So, they do not know how to respond.

The exchange rate is the most important price in a market economy. If India wants to become a high- income economy, the exchange rate needs to be able to respond freely to market forces, sending appropriate signals to market participants. If instead the market gets distorted merely to stabilise the currency, this may prove costly in the long-run.

Why RBI’s attempts to control the Rupee can have adverse consequences

Indian Express August 24, 2024

The Indian rupee follows a managed floating exchange rate regime. This means that the central bank intervenes in the foreign exchange market to buy or sell dollars in order to stabilise the value of the rupee. In recent times, however, the RBI seems to be using its regulatory powers to gain greater control over the rupee. We argue that currency management must not entail the use of regulations. The purpose of regulations is to address market failures. Currency volatility is not a market failure — it is the fluctuation of the currency in response to demand and supply forces. The use of regulatory powers for currency management introduces uncertainty in the central bank's currency policy, and also increases the cost of doing business in RBI-regulated sectors. We discuss three such regulatory measures and the problems associated with them.

First, prohibiting speculative trades on exchanges. This exacerbates the difficulties of taking rupee exposure in India. In 2008, the RBI allowed Indian exchanges to launch a currency derivatives segment. At that time, the RBI’s guidelines on currency Futures and Options allowed Indian residents to participate in this market "to hedge an exposure to foreign exchange rate risk or otherwise". While the RBI continued to prescribe the product design, position limits, and trading hours, the general trend was towards opening up this market. The idea was that as India became more globally integrated, the demand for such instruments and for liquidity in the derivatives market would increase. At some point, the 2008 guidelines were overtaken by several circulars, with the last version issued in 2016 having been amended at least 11 times. These regulations explicitly allowed taking positions in rupee-linked currency derivatives up to $100 million across all exchanges, ``without having to establish existence of underlying exposure".

Earlier this year, however, the RBI explicitly mandated exchanges to inform users that they "should be in a position to establish the existence of a valid underlying contracted exposure, if required". This warning compelled the bulk of retail traders to wind up their positions as a result of which trading volumes collapsed by about 80 per cent across all exchanges. This regulatory measure essentially restricts speculators from trading in the onshore rupee market. It overlooks the fact that a liquid market requires all kinds of traders, including speculators, who act as de facto market makers. This move is an irreversible blow to a reasonably liquid market, which allowed hedgers to take positions on the rupee at low costs. It is likely to drive away volumes to the offshore currency derivatives market.

Second, regulating offshore trading platforms. The RBI proposed to regulate offshore electronic trading platforms (ETPs), which facilitate rupee-linked derivative transactions. Published on its website in April 2024, this proposal seeks to empower the RBI to oversee the offshore currency forwards market, commonly called the non-deliverable forwards (NDF) market. The NDF market allows people to trade in the rupee without undertaking any physical delivery of the currency, thereby reducing the cost of trading. In the last few years, the rupee NDF market has grown substantially in size, and is now reported to be almost thrice as large as the onshore market. This has led to concerns in the RBI that the offshore market, over which it has no direct oversight or control, could be playing a significant role in determining the rupee’s value. The recent regulatory proposal requires ETPs to register themselves with the RBI, and confers fairly extensive powers on the central bank, such as the power to refuse registration, seek information, specify "eligible instruments" that Indian residents may trade in, and impose additional terms and conditions.

Legally, the RBI can restrict Indian entities’ rights to deal with non-residents or to transact in foreign currencies, but it is a jurisdictional leap to regulate offshore platforms on which Indian residents trade. This is akin to Sebi asking the New York Stock Exchange to register with itself, simply because Indian residents trade at these venues. Instead of expanding its regulatory powers, the RBI must make it easier for people to trade the rupee in India. This will help bring back rupee linked trading volumes and allied businesses onshore.

Third, the RBI's instructions to banks. Earlier this month, when the rupee-dollar exchange rate depreciated close to the 84 mark in the spot market, the RBI is reported to have orally instructed some large commercial banks to not add to their existing trading positions against the rupee. This step seems to have been taken to stem further rupee depreciation. On August 16, the RBI similarly instructed banks that handle trade with the United Arab Emirates to partially settle their trade payments using rupee instead of the dollar. This means that banks should directly convert rupees into dirhams and vice versa without first converting them into dollars. One objective of this move seems to be to reduce dollar dependence in international trade. But settling trade in rupee also helps insulate the currency from the impact of dollar outflows, that is, lower the extent of rupee depreciation against the dollar. In other words, this is yet another regulatory measure that helps to manage the currency.

Notwithstanding the debate on the costs and benefits of a "managed" currency for an emerging economy like India, the RBI must not seek to manage the rupee’s volatility through an indiscriminate expansion of its regulatory powers. Regulations are the rules of the game. Unlike market operations that involve central banks buying or selling the currency in the foreign exchange markets, changes to the rules of the game can have a more permanent, damaging effect on the incentives and the costs of doing business in the country.

Don’t hit pause in the battle to contain inflation

Hindustan Times April 8, 2023

On April 6, the Reserve Bank of India (RBI) announced its first monetary policy decision of the financial year 2023-24. Going against widespread market expectations, it decided to hold the repo rate at 6.5%, pausing the rate hike cycle that began in May 2022. Unfortunately, the Monetary Policy Committee (MPC) statement does not fully explain why. All we can, therefore, do is speculate about the possible reasons behind this pause and discuss what MPC may need to do going forward.

Let's start by understanding what has changed since the last MPC meeting of February 8. There have been three main developments.

First, inflation pressures have arguably increased. Back in February, when MPC raised the repo (or policy) rate by 25 basis points, the latest data (for December 2022) showed that headline inflation had moderated to 5.7%, whereas going into the latest meeting headline, consumer price index (CPI) inflation had gone up to 6.4% in February 2023. In the run-up to both meetings, core inflation (non-food, non-fuel) remained elevated above 6%, the upper-limit of RBI’s tolerance band.

Second, the global economic environment has become significantly more uncertain compared to February, because of the turmoil in the financial markets in the US and European Union. With the collapse of a few mid-sized banks in the US and the forced take-over of the systemically important Credit Suisse by UBS, financial stability concerns resurfaced, which in turn, complicated the tasks of central bankers.

Third, the rupee-to-dollar exchange rate stabilised in recent weeks, after depreciating chronically in 2022, largely because markets now expect the US Federal Reserve to be less aggressive. The Fed has been tightening monetary policy since the start of 2022, increasing its policy rate from essentially zero to 5%, to rein in inflation which shot up to 9%, the highest in four decades. Arguably, this aggressive tightening triggered the financial instability in the US. The ensuing chaos prompted analysts to expect that the Fed will now slow down the pace of rate hikes in order to balance financial stability concerns with inflation control.

Which of these factors can help explain MPC's latest pause?

Clearly, it was not the first factor, given that inflation is still far from under control. RBI is legally mandated to bring headline CPI inflation down to 4%. Its inflation forecast for 2023-24 is 5.2%, implying that the central bank expects that inflation will remain well above target for the second consecutive year. What is more worrisome is that underlying (core) inflation is likely to be even higher, persistently hovering around 6% for several years now. The MPC statement recognises these problems, stressing the “importance of low and stable prices” and “not letting the guard down on price stability”, while pointing out that work needs to be done to “[anchor] inflation expectations” and “rein in generalisation of price pressures”. Yet, despite such a hawkish assessment, it did not vote in favour of a rate hike.

Why not? One possibility could be that the previous repo rate increases have not been fully passed on by banks to their lending and borrowing rates. So the central bank might have decided that the priority should now shift to ensuring that monetary transmission improves, either by tightening bank liquidity or exhorting banks to raise their rates. But there was no sign of any such initiative in the MPC statement.

So maybe the second factor, global uncertainty, played a key role? Perhaps RBI was worried that problems abroad could weigh on India’s growth? Apparently not. The central bank actually increased its 2023-24 GDP growth forecast, albeit marginally, to 6.5%, indicating that growth worries were likely not the major factor driving its decision.

Perhaps, then, exchange rate factors played the key role. It is certainly striking that RBI’s actions over the past year seem to have been mirroring those of the Fed. When the Fed was aggressively raising rates during 2022, RBI kept increasing its repo rate. And when the Fed decided in 2023 to slow down the pace of rate hikes, RBI responded by pausing. Hence, it is possible that there is some link between US and Indian monetary policy, perhaps motivated by a desire to protect the exchange rate by ensuring that rupee interest rates remain significantly higher than those in the US.

If indeed the pause was driven more by exchange rate factors than by domestic inflation – though RBI governor Shaktikanta Das said that monetary policy was driven by domestic factors, not international – then it needs some reflection. External considerations should not distract RBI from its primary objective of restoring price stability in the domestic economy. Traditionally, ensuring that the exchange rate remained stable against the US dollar could aid in this task, as US inflation used to be low. But times have changed. As long as inflation in developed economies remains elevated, India runs the risk of importing this high inflation.

Consequently, achieving the inflation target will require RBI to focus on exerting downward pressure on domestic inflation, especially now that high core inflation has become entrenched in the system. In particular, MPC needs to ensure that the real interest rate (the difference between the repo rate and core inflation) is firmly in positive territory if there is to be any chance of breaking the persistence of core inflation. Currently, the real rate is barely there.

Persistently high inflation hurts the poor the most. Volatile inflation can be inimical to growth, a troubling possibility given that India’s medium-term growth prospects look uncertain. Therefore, inflation control remains crucial to India’s future. Unfortunately the monetary policy decision did not throw much light on RBI’s plan to bring inflation down.

3 potential problems for India's economy

Times of India, March 21, 2023

If 2022 was the year of “heightened global uncertainty”, this year is proving to be no different. Until last week, the US financial system seemed resilient to the aggressive interest rate hikes of the Federal Reserve. That perception has now been shattered. With the collapse of as many as three banks, including the Silicon Valley Bank (SVB) which was the 16th largest bank in the country, cracks have started showing in the US banking system, triggering fears of a possible financial contagion. The macroeconomic repercussions will be felt far away in India, even if our banking system does not immediately face the same kind of problems. How might the US situation play out, and what does it imply for the Indian economy?

The genesis of the SVB episode can be traced to the decisions of the US Federal Reserve during the pandemic period. The Fed lowered interest rates close to zero and injected vast amounts of liquidity. Banks consequently received large volumes of deposits and, invested them in treasury bonds. This meant that many banks, like SVB, whose loans books are much smaller in comparison to their deposits, became dependent on the treasury bonds for earning returns.

This became a problem when the Fed started aggressively raising rates in 2022 in its fight against inflation. As interest rates go up, bond prices fall. As a result, SVB began incurring losses on its bond portfolio. Sensing problems, depositors began withdrawing money from SVB—a classic case of a bank run, which led to its eventual collapse.

The problem, however, is far broader than just SVB. Any bank which has a smaller loan book, a bigger deposit base, and a large portfolio of treasury bonds now faces similar risk. In fact, US banks are currently sitting on an estimated $600 billion in potential losses owing to the erosion of their bond portfolios, on a capital base of $2 trillion. In other words, interest rate risk has eroded about 30 percent of the capital base. Within this aggregate, the distribution varies considerably, with midsize banks facing significantly higher capital erosion, which is why they have been facing runs in recent days.

This has put the Fed on the horns of a dilemma. If it sticks to its current strategy of raising interest rates to curtail inflation, bond losses will only increase, putting more stress on vulnerable banks. Alternatively, the Fed could pause or even start reducing rates, thereby relieving the stress on the banks, but at the cost of worsening the inflation problem. In other words, the important question for the US economy now is: will growing concerns of financial stability deter the Fed from pursuing its goal of price stability?

Irrespective of what the Fed decides, there will still be difficulties for India.

In particular, investors will remain very cautious, and will continue to doubt the financial stability of the midsize US banks – as we have seen over the past week. Things may get even more complicated if there are bank failures in the European Union. EU banks are vulnerable to similar risks given that the ECB has been tightening monetary policy as well. Already, fears of a contagion were running high when Credit Suisse, one of the systemically important banks at a global level, began witnessing rapid fall in its share prices last week. This eventually led to a takeover of the bank by rival UBS, a move orchestrated to calm the financial markets.

Any further bank failure could trigger a system-wide panic, and push depositors away from smaller banks to bigger, more diversified banks thereby precipitating more bank-runs. The resultant uncertainty would lead to heightened risk aversion.

In such an environment of risk aversion, there is typically a flight to safety. This will have important implications for India. There will be a surge in demand for “safe” assets such as gold etc., while the currencies of emerging economies like the Indian rupee will come under pressure as foreign investors flee these markets. The rupee has depreciated a fair bit in the last one year and, this trend may continue.

In addition, risk aversion is likely to dampen sentiments in the US, at a time when concerns about an impending slowdown have already persisted for a while. This may lead to a decline in credit growth and hence consumption, given that a large part of the US consumption is credit-fueled. Simply put, financial market turmoil might cause people to hold back spending. If this takes too severe a shape, then the US economy could fall into a recession, thereby hampering India’s growth prospects through the exports channel. Exports bailed out the Indian economy during the pandemic, but they have now stopped growing and, the situation is likely to worsen if the US goes into a recession.

Finally, if the Fed abandons its fight against inflation, this too will be problematic for India because we end up importing high inflation from the countries we trade with. This would aggravate domestic inflation, at a time when it is already running at 6.5 percent, well above the Reserve Bank of India’s 4 percent target.

The Indian economy has experienced a stuttering recovery from the pandemic. Its medium- term growth outlook remains weak, because private investment continues to be sluggish, exports are declining, consumption demand is lackluster and, the fiscal situation is overstretched. Now, the shockwaves from the banking crisis in the developed world are likely to create further headwinds for India’s growth.

We should consequently gear up for another year of volatility, amidst growing global uncertainty.

India's CAD reveals the need to increase exports

Indian Express, December 17, 2022

There seems to be a considerable amount of optimism about India’s near-term growth prospects, now that the major global energy and commodity shocks have subsided. But how will this growth be sustained? And even if these shocks have subsided, India still faces one big problem—its large current account deficit (CAD). How will this be managed? It turns out that the answer to both questions lies in one word: exports.

Let’s start with the second problem. Over the past year, the post-pandemic normalisation has caused the current account deficit to swell to exceptional proportions. At home, normalisation has spurred a renewed demand for imported inputs. But abroad it has had the opposite effect, leading to a decline in demand. Foreign households are no longer demanding so many goods now that the lockdowns that kept them in their houses and the fiscal stimuli that gave them the money to spend, have both ended. So, India’s imports have soared just at a time when its merchandise exports have started to fall.

Looking ahead, the situation seems set to worsen. Foreign demand will slow further as advanced countries slip into what now seems like inevitable recessions. In that case, India’s CAD could widen even further, possibly to 4 percent of GDP in 2022-23, double the level that the Reserve Bank of India (RBI) traditionally regards as “safe”. How should India respond?

One possibility would be to attract foreign capital inflows worth at least 4 percent of GDP. But is this realistic? The world is currently facing unprecedented levels of uncertainty. Following two years of a pandemic, we are now witnessing a land war in Europe, the highest inflation in the developed world in the last four decades, the fastest pace of interest rate hikes in the history of the US Federal Reserve, an energy crisis in Europe, and a slowdown in China that continues to struggle with Covid-19. In such an uncertain environment, foreign investors prefer to invest in safe assets such as US government bonds rather than emerging markets like India. This trend has become all the more acute now, since the persistent rate hikes by the Fed have made US financial assets even more attractive. As a result, India has witnessed large outflows of foreign capital in 2022-23.

If India cannot attract the required amount of capital inflows, the RBI’s foreign exchange reserves could be deployed to pay for imports. But this strategy is neither appropriate nor sustainable. The country’s reserves are meant to tide the country over short-term problems, such as commodity price spikes. The large CAD, however, is not a short-term problem: it is a long-term problem requiring a long-term solution. In particular, India’s merchandise exports have been structurally weak, stagnating for the past decade, until the pandemic induced a short-lived boom.

This means that something fundamental needs to change. Ultimately, India’s CAD reflects a mismatch between the demand and supply of foreign exchange; we are demanding more dollars than we have access to because we are importing more than we are exporting. To restore balance, first and foremost, the price needs to adjust, i.e. the rupee needs to depreciate. When this happens, exporting becomes more profitable, inducing more and more firms to explore foreign markets. Meanwhile, foreign demand improves, because the rupee depreciation makes India’s products more price-competitive. As a result, exports increase—and the CAD falls.

Exchange rate depreciation is helpful for another reason: it can help sustain growth.

The recovery of the Indian economy from the pandemic was largely fuelled by exports. In the April-January period of 2021-22, India’s merchandise exports grew at a staggering rate of 46 percent compared to the same period in the previous year. But with exports now declining, this crucial source of growth has now become uncertain for India.

This is deeply worrisome, since prospects for the other drivers of long-term growth seem cloudy. Private sector investment continues to be sluggish and is unlikely to pick up in an uncertain economic environment. Nor is there room for fiscal stimulus, since the high levels of government deficits and debt need to be reduced. And even though the Indian economy is regarded as consumption-driven, private consumption by itself cannot sustain a growth rate of 7 percent, especially when all other sources of growth are underperforming.

Strengthening the export sector is therefore critical for sustaining growth. True, the task will be difficult, since the global economy slowing down. But it is still feasible, since India’s share in global exports is very small and there is ample scope to expand this share.

Over and above a rupee depreciation, this will require structural policies—indeed, a fundamental shift in India’s economic strategy. Policy needs to become significantly more export-oriented and less protectionist. Over the last few years, average import tariffs have gone up. In a world where manufacturers are dependent on global supply chains, levying stiff import duties hampers exports. And this obstacle cannot be overcome by providing subsidies to a selected few producers.

In sum, the need of the hour is four-fold: allow the rupee to depreciate, encourage foreign firms to produce in India by letting them access their supply chains, encourage domestic firms to step up to the competition, and create a level playing field for all players.

By adopting this strategy, India could potentially solve its two most important macroeconomic problems—reducing the large CAD and securing rapid, sustained growth. Will this change come about? Unfortunately, there are no such indications so far.

Below 6% but 5 problems

Times of India, December 13, 2022

The latest data release for November 2022 shows that inflation is now within the RBI’s target range. This is undoubtedly good news. However, some major issues persist. Inflation remains much too high. And there is no clarity yet on how the central bank plans to bring it down to the target level.

Headline CPI (consumer price index) inflation came out to be 5.9 percent in November, down from 6.8 percent in October. This is the lowest inflation since December 2021. At the same time, global commodity prices have been falling, softening inflationary pressures. But that is pretty much where the good news ends. There remain at least five major concerns.

First, while it is true that inflation has slipped below the upper threshold of the RBI’s inflation targeting band, it is important to remember that 6 percent is not the RBI’s target. The RBI is legally mandated to aim for 4 percent inflation. This implies that there is still some way to go before CPI inflation reaches its target level.

Secondly, the decline in headline inflation did not reflect any fundamental change, but a steep fall in the price of vegetables. If one excludes vegetables, CPI inflation would infact have increased, to 7.2 percent.

Third, measures of underlying inflation indicate that price pressures remain stubbornly strong. Core (i.e., non-food, non-fuel) CPI inflation continues to be around 6 percent—the same level that it has been at for nearly three years now. This signifies that high inflation is deeply embedded in the system.

Why is core inflation so persistent, despite the easing of commodity price pressures? Most likely, because the economy is locked into a wage-price spiral. As the economy has opened up after two years of pandemic-induced restrictions, firms have had to pay higher wages to workers to bring them back, to compensate them for the price increases (for example, in fuel and transport prices) that occurred while they were away. Also, the depreciation of the rupee would have made it costlier for firms to import inputs. In both cases, firms seem to be passing these increases in costs on to the consumers in the form of higher prices.

Fourth, global inflation is still quite high. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, while that in the European Union has increased to 11.5 percent. As a result, India is importing high global inflation. This problem could intensify, if the rupee depreciates further, as advanced country central banks continue to tighten monetary conditions by raising interest rates.

Finally, cereal inflation remains exceptionally high, at 13 percent. It is difficult to understand why this is happening, since the government has been augmenting supplies by providing grains under its free food scheme (PM Garib Kalyan Anna Yojana) to all families holding a ration card. One possibility could be that traders are worried that the government’s buffer stocks are running low and that the winter harvest might prove disappointing.

Adding up all these factors makes it clear that it is way too early to declare victory on inflation. So, what is the strategy to bring inflation down?

It is true that the RBI has been consistently raising the policy repo rate since May 2022. The repo rate has gone up from 4 percent to 6.25 percent. The RBI has also been withdrawing surplus liquidity from the system to restrain the money supply. The Monetary Policy Committee (MPC) also seems more focused on inflation now compared to 2021-22. These are all steps in the right direction. But to break the persistence of the core inflation and bring inflation down to the target level of 4 percent, more effort might be required.

The RBI has predicted inflation to fall to 5.4 percent in the second quarter of 2023-24. But it has not yet indicated when it expects inflation to reach 4 percent—or what it plans to do to ensure that this target is achieved in a reasonable timeframe. Does it think that the current level of interest rate—which is only marginally higher than the underlying inflation rate—is sufficient to deliver the target in the next one year or so, implying that the RBI will continue to soften the pace of rate hikes or even end the tightening cycle soon? Or will further and steeper rate increases be necessary to ensure that monetary policy exerts sufficient downward pressure on inflation? It may help to provide some clarity on these issues.

Once the sanctity of a rule-based system is ignored for a while, it becomes more difficult to restore the credibility of that system. In India, a glaring example of this is the Fiscal Responsibility and Budget Management (FRBM) Act. After persistent deviations from the fiscal target for years, this institution has now ceased to be relevant and we may have normalised a high level of fiscal deficit. Inflation targeting should not suffer the same fate.

It is reassuring that the RBI has recently said that it has an “Arjuna’s eye” on inflation. It should now follow up by spelling out a strategy to ensure that Arjuna’s arrow hits its target.

On inflation, we are not out of the woods

Hindustan Times, December 5, 2022

The macroeconomic landscape in India seems to have suddenly changed. For most of this year, the main problem was surging prices, which had pushed consumer price index inflation far above the Reserve Bank of India’s target of 4 percent. In recent months however, inflation seems to have subsided. And now there is a new problem, as India’s export-led recovery is being threatened by weaking demand in the advanced countries, which seem to be slipping into recession. As a result of this shift in the landscape, some analysts have urged the central bank to shift its priorities, declaring victory over inflation, and focusing instead on the task of reviving growth.

At first blush, this shift seems reasonable. But we need to ask two questions. Is the inflation problem really over? And if not, what are the costs and benefits of shifting the policy stance?

Let’s understand the first question. It is true that inflationary pressures are softening. CPI inflation came out to be 6.8 percent in October, down from 7.4 percent in September. Alongside this, wholesale price index (WPI) inflation fell to 8.4 percent from an average of 14.9 percent in the previous nine months. It remains unclear though, whether these developments represent the start of a new trend or a temporary low. After all, core (i.e., non-food, non-fuel) CPI inflation has been running around 6 percent for the past three years, implying that inflation has become deeply ingrained at a level higher than the RBI’s target of 4 percent.

Moreover, there are still significant risks to the inflation outlook.

First, there has been a big spurt in the prices of cereals. Cereal inflation has gone up from 11.5 percent in September to 12.1 percent in October. In particular, the price of rice has gone up by 10 percent and that of wheat by more than 17 percent on a year-on-year basis. These developments are puzzling, considering that the government has been flooding the market, for some time, with cheap grains under both the PDS (Public Distribution System) and the PMGKAY (PM Garib Kalyan Anna Yojana) free food scheme that was launched in March 2020 as a Covid-relief measure. The latter scheme provides 5 kg of free foodgrains (wheat or rice) per person, per month for a family holding a ration card, and covers a significant portion of the population.

Why are cereal prices going up despite this massive free provision? One possibility could be that the government has used up much of the grains in its stock, and now the stocks are running low. If, on top of this, the winter wheat crop suffers, say due to the unseasonal October rains, then high cereal inflation could persist, thereby feeding a demand for higher wages, which would then translate into high general inflation.

Second, global inflation is still not under control. While inflation in the US has receded to 7.7 percent in October from 8.2 percent in September, inflation in the UK is 11 percent and rising, and that in the European Union has increased to 11.5 percent.

Third, the rupee may well remain under pressure in the coming months. As long as advanced country inflation remains high, their central banks will need to continue to raise interest rates from their historically low levels. Economists are currently expecting the US Federal Reserve to raise its policy rate by 100-150 basis points. The Organization of Economic Cooperation and Development (OECD) has recently indicated that rate hikes in the European Union would need to be even larger. These higher rates abroad will discourage capital inflows into India, which will be problematic for the rupee since India needs the inflows to fund its large and growing current account deficit.

For all these reasons, international and domestic, we can’t be sure yet that inflation in India is headed back to 4 percent. And this leads us to our next big question: should the RBI stay focussed on the inflation problem or should monetary policy instead focus on reviving growth? Consider the benefits and drawbacks of shifting its stance.

In principle, the main benefit of lowering interest rates is that it would encourage domestic investment. But it is far from clear that investment is being held back by high interest rates. In fact, private sector investment has been sluggish for the past decade, regardless of whether RBI policy has been tight or stimulative. As a result, it is difficult to believe that another shift in the RBI’s policy stance will make much of a difference.

Consider now the potential costs of such a shift. The most obvious cost is that stimulating the economy could worsen the inflation problem. However the biggest cost is perhaps much more subtle: when analysts urge the RBI to try to revive growth, they distract attention from the deeper policy actions that are required on the part of the government, namely the task of creating an economic framework that encourages firms to take risks and expand capacity. As a result, the reforms needed to revive investment are not undertaken.

In summary, we are still not out of the woods as far as inflation is concerned. Hence, we should let the central bank do its job, its legally mandated task of bringing inflation down to 4 percent. And we should encourage the government to focus on its mandate, of creating a supportive environment for investment and growth.

Breathe easy when the rupee falls

Times of India, October 13, 2022

While the Indian economy has started recovering from the pandemic, the global economy has begun to decelerate. This has complicated the task of finding an appropriate policy mix that can deliver growth amidst multiple global headwinds. Existing domestic imbalances such as high inflation and a large stock of government debt have already imposed constraints on the authorities’ ability to manouver. Now the constraints are likely to worsen as India’s export prospects have dimmed and current account deficit seems set to widen. In such a situation, is there any policy space left to support growth? It seems there is a powerful arrow in the RBI’s quiver: the exchange rate.

There are widespread concerns about an impending recession in developed economies, as they struggle to deal with the worst streak of inflation in four decades. The US Fed has already raised its policy rate by 3 percentage points since March 2022, the most aggressive monetary contraction since the 1980s. It has now signalled that this tightening cycle will last longer than previously expected. The European Central Bank and the Bank of England have also embarked on monetary contraction in order to bring inflation down to their target levels of 2%.

As if this sudden shift in the monetary environment were not enough, Europe is currently facing an energy crisis as Russian supplies of natural gas dwindle, while China’s economy is dealing with an abrupt end to the real estate boom that had been powering that country’s economy for the past decade. Owing to these developments, the IMF has lowered its forecast of global growth for 2022 to only 3.2 percent, far below the 4.4 percent it predicted at the start of the year. As a spillover effect, already India’s pandemic-time export boom has ended. In fact, September 2022 witnessed a fall in exports, with declines being particularly sharp for apparel and engineering goods.

This situation has put domestic policymakers in a bind. Ideally, they would react to the fall in external demand by stimulating domestic demand. But the policy space available to do so is highly limited. The fiscal deficit in 2022-23 is budgeted to be around 6.4 percent of GDP and the debt to GDP ratio continues to be very high, close to 90 percent. This restricts the fiscal space available to the government to provide any kind of stimulus.

On the monetary side, the RBI has now begun tightening policy to bring inflation back to the target level. The RBI’s medium term inflation target is 4 percent, whereas the CPI inflation has been averaging at 6-7 percent in 2022 so far. While oil and commodity prices have been softening, erratic monsoon is pushing up food inflation leaving no room for the RBI to go easy on the rate hikes.

This implies that using fiscal or monetary policy to support growth at this juncture will only worsen the existing macro imbalances: the high levels of inflation, government debt, and the current account deficit (CAD).

The CAD is especially a problem now. On current trends it could reach the exceptionally high level of 4 percent of GDP in 2022-23. Such a high CAD would be very difficult to finance. In fact, capital is flowing the other way, with rising US interest rates encouraging investors to take money out of Indian capital markets and deploy it instead in the US.

Given the circumstances what can the RBI do? The most obvious strategy would be to try to bridge the gap between rising CAD and falling capital flows by using its foreign exchange reserves. Indeed, that is exactly what it has been doing. However, there are limits to what the RBI can or should do. Bridging this gap using reserves makes sense only if the gap is small and temporary. It has turned out to be neither.

Reserves have now been falling for an entire year, by a staggering $110 billion between September 2021 and early October 2022. The pace of reserve loss seems set to accelerate as India’s CAD widens and the US continues to increase interest rates.

Clearly, other strategies are needed. The RBI could try to stem capital outflows by raising rates to reduce the interest differential with the US. But given that the US Fed has signaled that it will increase rates by another 125 basis points (and might do more), this strategy might require much more aggressive rate hikes on the part of the RBI than what is warranted by domestic inflation. Such a strategy could end up hurting the nascent economic recovery even more.

That leaves the exchange rate. The RBI could allow the rupee to respond to market forces, and depreciate. Such a strategy would have a number of advantages. Most obviously, it would reduce the need to spend so much of the foreign exchange reserves; these can be preserved for situations when the country is faced with temporary and unforeseen external shocks, rather than chronic drains on the balance of payments.

A second advantage of allowing the rupee to depreciate is that it would enhance the competitiveness of Indian exports. This would be a powerful way – more powerful than targeted subsidy programs -- of ensuring that India would be able to gain some of the global market share that China has been giving up. And in doing so, it would ensure that exports, the key motor of India’s post-pandemic growth, does not seize up at such an early stage of the recovery.

Of course, a currency depreciation could add to the inflation problem, by increasing the rupee price of imported goods. But the effects would likely be minor, as long as monetary policy remains tight.

In other words, the benefits of this strategy are likely to far exceed the costs. The good news is that the RBI already seems to be on this path. After a period of trying to stabilise the currency, the RBI has recently allowed the rupee to depreciate. Rupee has reached an all-time low of nearly 83 against the dollar.

For the first time in several decades US inflation exceeds Indian inflation. Looking forward, as long as the Fed persists with rate hikes, there will be pressure on the rupee to depreciate. In response, the RBI should continue to let the rupee respond to market forces. This policy should be accompanied by appropriate government support, such as moving away from protectionist policies, and taking steps to create a more export-oriented environment so that firms can reap full advantage of a weaker rupee. These policy actions may in turn help turn the growth cycle around for India, and help cement its position as a fast-growing economy.