Is the worst over for the Indian economy?

Why in the News

The Reserve Bank of India (RBI) has been fighting three battles at once: curbing inflation, arresting the rupee’s decline and preventing a steep rise in government bond yields. A recent easing of external pressures has given it room to act. Its moves so far show no coherent strategy.

What is the RBI’s dilemma?

1. Three goals, one main tool: Higher interest rates curb inflation and support the rupee but raise government borrowing costs. It is like a driver told to speed up and brake at once.
2. Inflation above target: October inflation has likely crossed the upper limit of the RBI’s inflation targeting framework, the band within which the RBI must keep inflation.
3. Late, small rate rise: Rate changes act on prices with a long delay, so rates should have risen earlier and by more. The RBI waited till October and raised them by only 25 basis points (0.25 percentage point).
4. The takeaway: Without a clear priority, the RBI’s moves on rates, the rupee and bonds pull against each other.

Why did the RBI wait so long to raise rates?

1. Missed build-up: The RBI failed to anticipate rising prices. Its August policy statement and the minutes of that meeting point in different directions, a gap left unexplained.
2. Growth fears: The RBI feared growth would collapse, since underlying momentum is weak. That fear explains why real interest rates (policy rate minus inflation) stayed negative.
3. Government borrowing costs: Higher rates raise government borrowing costs. On October 21, the RBI rejected all bids at a Rs 23,000 crore auction of treasury bills (short-term government debt) as investors sought higher yields.

Why can’t reserves alone defend the rupee?

1. Forex intervention: The RBI drew down its foreign exchange reserves to sell dollars in the currency market, but this did not stop the rupee’s fall.
2. Size of the market: Daily onshore and offshore rupee turnover was $185 billion in 2025, per the Bank for International Settlements (BIS), more than the RBI can match indefinitely.
3. China’s 2015 lesson: By some estimates, China lost hundreds of billions of dollars defending its dollar peg, a fixed exchange rate against the dollar.
4. Side effects: The RBI also used financial engineering and other counterproductive measures. These squeezed liquidity (cash available to banks) and raised hedging costs, the price of protection against currency swings.

What has turned around, and why is the relief fragile?

1. AI boom cooling: Stocks in the artificial intelligence (AI) ecosystem such as NVIDIA, TSMC and SK Hynix are correcting, so the boom pulls less capital from India.
2. Cheaper oil: Brent crude fell below $98 a barrel after the US mid-term elections, easing price pressures and the demand for dollars.
3. Foreign capital returning: Lower US bond yields and cheaper Indian assets made foreign portfolio investors net buyers of $4.1 billion of equity in the first week of November.
4. Reversible gains: Hostilities in West Asia could resume, oil could jump and capital could flee to safety.

Should the RBI target inflation or the exchange rate?

1. Currency as shock absorber: A rupee allowed to move absorbs external shocks. A more uncertain world needs more shock absorbers, not fewer.
2. Inflation targeting first: Shifting from inflation targeting to exchange rate targeting (defending a rupee level) was a mistake. The RBI cannot keep real rates negative, defend the rupee, drain liquidity and cap yields forever.
3. Electoral cycle: Worries about elections should not guide policy on the rupee or petrol prices, so that political problems do not become economic ones.

Challenges

1. Imported inflation: A weaker rupee raises the cost of oil and other imports, feeding the inflation the RBI must curb.
2. Thin reserve buffer: Dollars spent defending the rupee leave less cover for a future shock.
3. Weak growth momentum: Rate rises could slow an economy whose underlying growth is already soft.

Way Forward

1. Clear priority: The RBI should state that inflation within its target band comes first and adjust rates in time.
2. Two-way rupee movement: Limit intervention to smoothing sharp swings and let the rupee find its level.
3. Rebuild reserves: Add to reserves during periods of foreign inflows such as the current one.

Conclusion

The RBI’s room to pursue inflation, the rupee and bond yields together has come from outside India, not from its own policy. Whether it commits to its inflation mandate before oil or capital flows turn again is the test to watch.

Matching Previous Year Question

“[2017] Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? 1. It decides the RBI’s benchmark interest rates. 2. It is a 12-member body including the Governor of RBI and is reconstituted every year. 3. It functions under the chairmanship of the Union Finance Minister. Select the correct answer using the code given below: (a) 1 only (b) 1 and 2 only (c) 3 only (d) 2 and 3 only ANSWER: (a)”