RBI governor caught on horns of trilemma as decision on rate cut looms

MUMBAI: The monetary policy announcement scheduled for Friday will be the most difficult decision for RBI governor Sanjay Malhotra in his first year in the corner room on the 18th floor of the Mint Road headquarters. The MPC led by him is caught in a trilemma of blowout growth, massive rupee depreciation which is the worst since 2022, and a benign inflation that’s at a multidecadal low, which in the normal course would have been a clear signal for more easing. The monetary authority is also caught in another tight spot as the difference between the overnight repo and the benchmark bond yields are a record high of 100-110 bps above the repo rate, which impacts liquidity. While most economists still believe there is room for a 25 bps easing in the repo rate that has already been slashed by 100 bps between February and June to 5.5%, fund managers, forex traders and currency experts warn against any such adventure as that will put more pressure on the rupee which has already been bleeding since the beginning of this fiscal, losing over 5.5% year to date. Meanwhile, the rupee plumbed more depths on Thursday, hitting 90.49, down from 90.15 Wednesday, and recovered to close at 89.92 to a dollar on the likely heavy intervention by Mint Road. This recovery came after six consecutive days of bleeding. This makes the rupee the worst among all Asian currencies. It's also the third biggest laggard among all emerging markets after the Argentinian peso and the Turkish lira, which have depreciated 29.18% and 16.69% respectively against 5.5% by the rupee. The plunge underscores a divergence in the domestic and external macroeconomic position of the nation. While GDP growth has been stronger-than-expected, punitive US tariffs and weak capital flows have piled pressure on the rupee. "Every day that we do not have a trade deal, the forex demand from the trade deficit and outflows keep pushing the dollar higher, while forex supply is relatively thin and inconsistent," HSBC said in a note, which also added that "foreign investors are also losing patience. We had one month of net inflows in October, but without any more trade deal headlines since then, net flows have become flat." "The longer it takes for a trade deal to come, the longer the pressure on the rupee is likely to persist," said Sakshi Gupta, principal economist at HDFC Bank, who pegged the immediate resistance level of the rupee at 92-93. "The rupee has been weakening as the government and the Reserve Bank want to help exporters," Anil Kumar Bhansali of Finrex Treasury Advisors has said, adding a repo rate cut now would invite further selling pressure on the rupee. Radhika Rao, senior economist at DBS Bank, said, “The authorities are likely to keep the rupee at competitive levels and in undervalued territory, as signaled by the correction in the real effective exchange rate to sub-100 levels." Anindya Banerjee, head of commodities and currency at Kotak Securities, said, “A wave of stop-losses is being triggered above the 90 level, especially from leveraged traders and option sellers who were defending that zone; and finally steady importer demand, particularly from sectors like oil, metals, and electronics, which continues to absorb available dollar liquidity.” In a note, Gaura Sen-Gupta, the chief economist at IDFC First Bank, said the choice facing the RBI is between preserving monetary policy independence and maintaining currency stability, with the central bank toeing a delicate balance between the two. “While its tolerance for a faster pace of rupee depreciation will help limit the drain on domestic liquidity, this shift in intervention pattern stems from the build-up of buy-sell swaps in the RBI’s forward book, which constrains its ability to sterilize spot dollar sales which is around $63 billion now," he said. Only a trade deal with the US can provide a temporary relief to the rupee but depreciation is expected to resume, albeit at a more moderate pace. Seasonal factors will also support the rupee in Q4, when the trade deficit narrows, and BoP tends to be in a surplus. The rupee is likely to reach 88.50 by March and 89.50-90 by next June, Sen Gupta said. A fund manager at Axis Mutual Fund said the RBI is expected to stay accommodative to avoid tighter financial conditions that could weigh on next year’s GDP and attributed the rupee fall to the rising trade deficit and the delay in a tariff deal with the US. On the likely outcome of the MPC meeting Friday, they see some scope for a rate cut, which would be limited as much of the transmission has already occurred and they also expect bond yields to stay in the 6.40–6.60% range with index inclusion potentially supporting a flatter curve. However, currency experts said any rate cut will only add more pain to the rupee. According to Abhishek Goenka of India Forex Asset Management, the RBI seems to be adopting a more soft touch approach to market intervention, given that it is already considerably short in forward contracts, including NDF (non-deliverable forward). It may therefore want to use its intervention power judiciously. Jateen Trivedi of LKP Securities says a muted RBI intervention has contributed to the swift depreciation of the rupee. With the RBI policy announcement due now, markets expect clarity on whether the central bank will step in to stabilise the currency or not, he added. Governor Malhotra, who has been vocal in saying the RBI has not set any particular level for the rupee but only seeks to contain volatility, recently said the rupee's ongoing weakness reflects natural market dynamics, and that an annual depreciation of around 3-3.5% aligns with long-term trends. This stance allows the MPC to retain room for a growth-supportive rate cut, without being tied to defending any particular level, and intervene in the markets to stabilise volatility.