The Reserve Bank of India (RBI) is grappling with a delicate balance between managing inflation and addressing the pressures caused by a weakening rupee as it prepares for its upcoming monetary policy review in February. With the rupee having falling to record lows and nearing the 87 level, analysts are closely watching the RBI’s next move.
Under the new RBI governor Malhotra, it expects increased flexibility in exchange rate management, leading to higher volatility and a stronger correlation between the rupee and the US dollar.
Amid easing retail inflation, which fell to a four-month low of 5.22% in December, and slowing economic growth, analysts expect that the RBI may cut the repo rate by 25 basis points in February. A rate cut could be a strategy to support economic growth while managing inflation. However, the persistent weakness of the rupee complicates the situation. The depreciation has further stressed the RBI’s policy trade-offs, as the central bank has previously maintained a tight control over the currency, prioritizing stability and defending the rupee.
As part of these measures, overseas branches of Authorised Dealer banks are now permitted to open INR accounts for non-residents to settle permissible current and capital account transactions with Indian residents.
The RBI faces a delicate balancing act. With interbank liquidity expected to worsen to a Rs 4 trillion deficit by March 2025 without intervention, Nomura anticipates durable liquidity injections through longer-tenor VRRs, open market operations, buy/sell swaps of USD 15 billion, and a 50-basis-point cut to the cash reserve ratio.Despite the rupee’s decline, Nomura expects the RBI to cut policy rates by 25 basis points in February 2025, with further reductions totaling 100 basis points over the year. However, a stronger dollar or sustained portfolio outflows could slow the pace of rate cuts, adding pressure to India’s economic framework.
“We acknowledge that it is a close call between a dovish hold and a policy rate cut in the February 7 policy meeting. We retain our base case of a 25bp cut, alongside likely liquidity infusion measures such as OMO purchases and a further CRR cut. The experience from the 2013 Taper Tantrum episode showed that an interest rate defence of the rupee can actually be counterproductive; hence, we would advocate against a similar move even now,” Barclays said in a note.
The central bank is under significant pressure as India’s economy faces rising oil prices and a challenging external environment.
The evolving situation has prompted speculation that the RBI may shift towards a more flexible currency management approach, allowing the rupee to move more freely in response to global market conditions. This policy shift could provide the RBI with more leeway to focus on its primary mandate of controlling inflation while also accommodating growth.
The implications
The RBI’s decision on whether to cut rates will have significant implications for both the domestic economy and financial markets.
The potential for further depreciation of the rupee, combined with high crude prices, could exacerbate inflationary pressures. These factors may limit the RBI’s ability to ease policy rates significantly in the short term.
The depreciation of the rupee is expected to make imports, including crucial items such as crude oil, pulses, and edible oils, more expensive. While the rupee’s decline has benefited exports, the rise in import costs could add to inflationary pressures. Core inflation may also see upward pressure due to the depreciation, along with rising global crude oil prices.
