India: Will the easing cycle be constrained by a weak rupee?

This month, the Reserve Bank of India's monetary policy committee unanimously decided to lower interest rates. This was in contrast to the rate review in December, which voted 4-2 to maintain rates on hold. The hitherto held hawkish tilt softened as a result of the MPC's composition shift, which included the appointment of new external members in October 2024, a new governor in December 2024, and a new deputy governor to be selected shortly (represented by Deputy Governor Rajeshwar Rao until then). Given that high-frequency growth indicators show poor momentum and inflation has been on a downward trajectory toward the 4 percent objective, this was probably motivated by worries about falling behind. Policymakers are hampered by the currency's recent downward pressure. In the fourth quarter of 2024, the rupee lost 2.1 percent against the US dollar, after being almost unchanged in the first three quarters. A further 2 percent decline this quarter-to-date among the worst-performing companies in the Asia-10 space showed that the waning bias persisted into the New Year. The currency rate has also been impacted by overvaluation of the broad real effective exchange rate (REER), which was off high in December but is still substantially above 100 and one standard deviation above the moving 10-year average. Over the last eight years, Indian authorities have implemented an asynchronous currency management technique that is split into two stages. In the first, aggressive intervention absorbed dollar inflows during periods of wider dollar weakness, restraining the rupee's rise. However, a robust USD-led increase in the USD/INR was mostly accepted, causing the rupee to gradually decline while intervention reduced volatility. In order to reduce volatility, intervention has been focused on both sides of trade since 2023. Since late 2024, the dynamics seem to have changed as the rupee declined in line with a higher US dollar, increasing forward premiums and implied volatility. Although there is a noticeable change in the RBI's tolerance, the rate of rupee loss cannot be entirely ascribed to the central bank's change in leadership. Strong-handed intervention was no longer viable because the dollar's sharp increase exacerbated the liquidity imbalance and made it more necessary to loosen control over the rupee. FPI withdrawals and a precipitous decline in net FDI contributed to the liquidity constraint, which caused the balance of payments to also turn negative from 4Q24. As an example, consider the significant depreciation of the rupee during the second week of February, which prompted the central bank to take significant action (market estimates of up to $10 billion in two days). In order to neutralize the intervention efforts and avoid any influence on liquidity conditions, bond purchases of Rs 400 billion were announced concurrently. This follows closely behind a number of other actions, such as dollar swaps, VRR auctions, OMOs, etc.