As India’s shock resilience and outperformance, including lower sensitivity to higher oil prices, become clearer, forex outflows should reverse
There is an impressive consensus among economists and analysts for the Monetary Policy Committee (MPC) to give a pause in repo rates. Normally, in an emerging market (EM) under pressure from global volatility, with headline inflation crossing the inflation target, there should be calls to raise rates!Putting core forecasts in the public domain may have helped moderate analysts’ inflation expectations. June headline inflation came in at 4.4 per cent but core inflation was only 2.5 per cent, implying there is no sign of generalised excess demand. It is increasingly recognised that volatile components revert to a more stable trend. Firms’ pass-through of commodity price spikes has also fallen in the inflation targeting regime and can be expected to be muted to the extent consumer confidence and spending fall in difficult times.There is more of an understanding of inflation targeting and that temporary spikes can be looked through, with the tolerance band giving the space to accommodate such spikes.While the monsoon has picked up in the key planting month of July the Middle East tensions continue. But countries and the oil market are finding substitution possibilities as well as ways to keep oil flowing. Crude oil futures are in the early eighties while the MPC had taken the value of 95. There may even be room to reduce headline inflation forecasts. However, if inflation rises persistently, the MPC will act to ensure inflation expectations remain anchored. How much pass-through there is and how persistent the commodity shocks are, remains to be seen.Growth has held up well despite global shocks, but there is some softening and it is below potential. Moreover, aspirational youth are restless for progress. Signs of a broad-based revival in the private sector investment cycle also need support.Using policy to counter global shocks is essential for this. A data-based pause and continuation of the neutral stance is best, while waiting for current high levels of uncertainty to resolve.Financial conditionsThe measures in the last policy are enabling banks to raise interest rates for NRIs and help solve the mismatch in deposit and credit growth without a general rise in interest rates. The rupee has more support, which is the dominant factor to attract fixed income flows.As a result G-sec yields are also softening, which will help the interrupted transmission of lower repo rates. Interest differential with the US has come down from around 5 per cent in end-2023 to around 2 per cent but is adequate as risk and inflation have fallen in India, but risen in the US. Spreads still exceed the average EM spread of 2 per cent.Both the rupee and G-sec yields have suffered from adverse sentiments more than from real weakness — so demonstration of levers to attract multiple types of inflows is a confidence builder, even as the repo rate remains focused on the domestic cycle.Nervousness regarding RBI’s large forward book is unwarranted. Intervention using forwards, with a rising share of non-deliverable forwards (NDFs), has many rationales. First, since causality runs from the NDF market to domestic markets during global volatility, such intervention is more effective.Second, NDF intervention does not drain domestic liquidity unlike dollar sales in the spot market or settlement of domestic forwards. It helps insulate domestic liquidity from forex (FX) intervention. A domestic liquidity squeeze often accompanied past FX outflows, therefore markets fear it. But now, despite large outflows, durable liquidity remains in surplus.Third, buying dollars forward does not reduce reserves immediately and may not even in the future. The forward book can be rolled over if needed. In NDF contracts only the net loss has to be paid. The cost maybe higher if the rupee is depreciating at that time. But so far the RBI has made large profits on its FX interventions. Therefore, the claim that the forward book has to be deducted in order to see what reserves really are is not entirely true. Derivatives are a more modern and economical way of intervening to reduce unwarranted risk perceptions. Their share in intervention has risen since 2013.Fourth, the debate often worries about large new peaks in absolute numbers. A short forward book of above $100 billion! But, because the size of relevant markets is growing, ratios are not materially larger. Intervention as a ratio of FX turnover this year is less than it was in 2014 or 2021.Forward bookA similar build-up of the forward book occurred during earlier global shocks, but was unwound or rolled over without problem. Already inflows under the FCNR(B) scheme have been used partly to close short NDF contracts maturing over the next three months. Returning inflows will be more than enough to unwind the forward book, to build up reserves and for the rupee to appreciate — because more than surplus dollars, appreciation just needs sentiment to change.EMs tend to have self-fulfilling cycles of depreciation; advanced economy currency overshoots and then reverses.Since inflation and risk are lower today in India, we could see nominal appreciation once sentiment improves.Past global shocks were temporary and outflows always reversed. This period of volatility has, however, persisted since the end of 2024, longer than usual. The US tariffs were negative for India; FPI began chasing AI investments. War related oil shocks and other supply disruptions followed.Global current account imbalances have increased to Covid-19 levels. The US deficit exceeds the large combined China and Euro Zone surplus. China’s surplus has increased to $300 billion. Compared to many countries India’s deficit is tiny. Yet it has been punished inordinately by outflows. The lesson for the long term is to move to a surplus, with independence from any one kind of inflow for financing. There are many initiatives for this.As India’s shock resilience and outperformance, including lower sensitivity to higher oil prices, become clearer, outflows should reverse. Advantages of natural and policy supported diversity are text-book plays to counter shocks.Moreover, some of the shocks themselves are dissipating. The present 10 per cent US tariff on India is actually less than on its competitors and exports have anyway continued to do well. The AI play has begun to be questioned and Indian stock markets are set for a diversification payoff. The main benefit of AI is going to come from applications from which India is poised to benefit as it develops small language models using customisable open weight AI.The world is going through unprecedented crises. The Indian policy response has sustained growth; monetary policy also is demonstrating that a good pilot can reach harbour even in stormy seas. For this it has to keep a steady course and also communicate ability and intent to nervous markets. US bond market yields rose, although a hold was widely expected, because the Fed Chair did not communicate inflation fighting intent alongside. Twice, when the governor hinted the rupee was undervalued, it appreciated.The writer is President, TIES, and Professor Emeritus, IGIDRPublished on August 4, 2026
