As the rupee weakens, the RBI may struggle to contain higher prices

Kolkata | MUMBAI: The policy trade-off between inflation and currency management may be difficult for new Reserve Bank of India (RBI) governor Sanjay Malhotra as the rupee hits 86 to the dollar, with the central government looking to keep the local unit stable amid growing concerns over imported inflation. Therefore, the intervention of the bank removes the liquidity of the rupee from the banking system.

ET spoke to 10 people who track the foreign exchange market and all participants expect the rupee to touch the 86-level soon. Three of them expect the rupee to move towards 86.5 by the end of March due to sustained dollar strength and a possible new US tariff policy. The US President-elect Donald Trump’s swearing-in ceremony on January 20 is strengthening the dollar. The dollar index rose to 109.54 last week.

“A weakening currency complicates trade-offs for inflation-fighting central banks. Encouragingly, global crude prices are at benign levels, which has a spillover on prices at that time. Pass-through in other import costs still poses a risk,” DBS Senior Economist Radhika Rao said.

In the annual outlook note, DBS highlighted the risk of the rupee touching the 86 level against the US greenback due to dollar strength as well as pressure on capital and investment flows. IDFC First Bank had projected the rupee to reach 86 to 86.50 by March 2025.

Bank of Baroda Chief Economist Madan Sabnavis said, “Rupee depreciation will increase imported inflation and hence RBI will weigh currency management with reserves.”

The rupee hit a closing low of 85.82 against the dollar on Monday, down 1.3% in a month. Prior to this recent adjustment, the local currency was among the most resilient among its volatile Asian peers.

To be sure, as Sabnavis said, a lot will depend on the RBI’s perception of how the rupee fares against other currencies. “As the dollar strengthens and the Fed slows down on rate cuts, foreign portfolio investors are also affected. We will have a better outlook once Donald Trump takes office and announces policies,” he added.

Gaura Sengupta, chief economist at IDFC First Bank, said the sustained pace of rupee depreciation would not add much to inflationary pressures.

“As per RBI, a 5% rupee depreciation from the baseline assumption would add 35 basis points to headline inflation. A 5% depreciation from the RBI’s baseline assumption would imply a level of 87.68, we remain significantly below this level,” she said.

India’s retail inflation as measured by the Consumer Price Index (CPI) was 5.48% in November, up from 6.21% in October. However, the central bank’s target of bringing inflation down to 4% on a sustainable basis is still far off.

IDFC First Bank expects the rupee to touch 86.5 per dollar by March as it has not adjusted against the dollar against other currencies. This has resulted in an overvaluation of the rupee at REER (real effective exchange rate) to 8.1%.

Anshul Chandak, Treasury Head, RBL Bank, and Anindya Banerjee, Head, Research, Currency and Commodities, Kotak Securities, also did not rule out the possibility of the rupee touching 86.5 per dollar.

The RBI’s forex market intervention has focused on easing the pace of rupee depreciation which requires significant dollar sales. This has resulted in a decline of over $60 billion in forex reserves in the last three months from the all-time high of $704.885 billion seen on September 27, 2024.

Between October and December last year, net dollar selling by central banks through operations in the onshore/offshore OTC segment was $48 billion, resulting in a significant reduction in liquidity in the banking system. “While the RBI may intervene to iron out larger swings, it is likely to allow the rupee to align with its peers and limit the impact of forex intervention on domestic liquidity,” said Sakshi Gupta, chief economist at HDFC Bank.

The banking system saw a liquidity deficit of ₹ 68,469 crore in December for the first time since June 2024, even as both phases of Cash Reserve Ratio (CRR) easing came into effect on December 14 and 28, respectively, which saw inflows of ₹ 1.16 lakh crore. Quarterly advance tax outflows in mid-December also pushed liquidity into deficit but that was a factor-based event, economists said.