Investment Advisory
Investment Advisory
The RBI’s 25 bps hike to 5.50% and its move from “neutral” to “calibrated tightening” came as a supply shock from West Asia pushed major central banks in the same direction. Within about a week in September, the ECB, the Fed and the Bank of Japan all raised rates while the Bank of England held steady. The BoE looks next in line if there is no Middle East ceasefire. Seen against this backdrop, the RBI is following a global move, not leading one. This action seems to be in line with the August 2013 “global financial cycle” argument associated with Hélène Rey, and the Mundell-Fleming’s policy trilemma which states that an open economy can only choose two out of three: Managing currency, Free capital flows and Independent Interest rate policy.
The real rate after this repo rate hike is still thin by historical standards. With the RBI projecting about 5.8% CPI over the next three quarters and 5.6% in Q1 FY28, the forward real rate is roughly zero to slightly negative. On trailing August CPI of 4.8% it is only about +0.7%. Historically India’s neutral real-rate scenarios were around 1–2%, so this policy is not yet restrictive.
Deeply negative real rates in 2010–13 coincided with entrenched inflation and the 2013 taper tantrum rupee crisis. India then had a current account deficit near 5% of GDP and reserves well under half of today’s US$734.6 billion. Today’s buffers are much stronger, with a CAD of 0.5% of GDP and large reserves, so a repeat is unlikely. Even so, the lesson is that real rates close to zero plus global tightening plus an oil shock is a combination that has hurt the rupee before. Real rates were also very high in 2025, when inflation collapsed while the repo stayed at 5.50%, so the policy rate is now catching up to inflation as much as leading it.
The yield differential and the carry cushion have shrunk. Carry-trade logic and uncovered interest parity say foreign investors hold rupee assets only if the yield premium compensates for expected depreciation. India’s benchmark 10-year yield settled at 7.24% after the policy, its highest since December 2023. With US 10-year at about 5.31%, that leaves a spread of roughly 190 bps. By comparison, the decade average spread was about 4.1 percentage points, with a peak near 5.9 points in 2016. At the short end, India’s 5.50% repo sits only about 160 bps above the Fed’s 3.75–4.00%, and that gap shrinks with every Fed hike. Foreign portfolio investors have already pulled out US$10.3 billion this fiscal year. With US yields at multi-year highs and fiscal-sustainability worries pushing global term premia up, India’s yields need to rise further, or the rupee needs to weaken further, to restore the cushion.
Currency market reaction on the policy day was telling. The rupee hit 96.845 per dollar, close to its record low of 96.96 from 20 May, before ending 0.4% lower at 96.775. Traders seem to be disappointed by the absence of more aggressive steps to tighten liquidity and support the currency. RBI intervention coincided with a US$51 billion fall in forex reserves over four weeks to 2 October. While the Governor argued that short-term market behaviour is “irrational” and that several estimates suggest the rupee is undervalued, according to Dornbusch’s overshooting model, a currency can overshoot its fundamental value after a shock, and a credible central bank should lean against it. The risk is that overshooting turns into self-fulfilling expectations if reserves keep draining. Currency depreciation also feeds inflation through imported oil and goods, so currency weakness strengthens the case for tightening, though pass-through is partial. Our read is that the RBI hiked 25 bps while keeping liquidity loose enough to avoid choking credit growth.
Will there be bigger hikes? Our base case is a 25-bps hike in December to 5.75%, which we feel the market has already built into expectations, and possibly one more in February, for a terminal rate of 5.75–6.00%. SBI Research had expected 50 bps of tightening in total through December. A 50-bps move is a tail risk, which we would put at roughly 15–20% for any single meeting, and it would likely need one of these triggers: the rupee breaking decisively through 97–98 with reserves still falling, core inflation moving above 5%, the Indian crude basket staying above US$115 a barrel, or a further Fed hike. The arithmetic shows how far policy would have to go to be restrictive. Lifting the forward real rate to +1% against inflation near 5.6–5.8% needs a repo rate of around 6.5%, or about 100 bps more. That is an upper bound, not a forecast.
Several things argue against an aggressive path: growth is projected at 7.1%, the shock is mainly supply-driven, two MPC members preferred a neutral stance, and the RBI’s own guidance says, “a hike or a pause.” We expect the RBI to use liquidity tools, such as VRRRs, OMO sales and possibly a CRR change, to deliver extra tightening before it resorts to a bigger repo move.
Implications and our view. The hike is directionally right but arguably could be too gentle, and the rupee and bond markets are saying so. On the fixed income side, one should find comfort in short-to-medium duration until the Fed path and the US-India spread stabilise, and we would treat 7.25% on the 10-year as a level to watch rather than a ceiling. For currency-sensitive positions, exporters gain from a weaker rupee, while importers and companies with unhedged foreign borrowing carry the risk. For banks, the tightening helps margins, but the credit-deposit gap needs to be watched, and funding discipline matters more than loan growth. Rate-sensitive consumer sectors face a demand drag, and equity inflows are likely to stay hostage to US yields. The key factors and numbers to watch are September CPI, the MPC minutes on 21 October, the US FOMC meeting on October 28, the ECB policy on 29 October, the BoE on 5 November, and the next MPC meeting on 2–4 December. A rupee stabilising above 97 without fresh reserve losses would suggest the RBI’s mix is working, and a break well past 97 would raise the odds of a 50-bps move. This is our view and not an investment advice.
The RBI’s 25 bps hike to 5.50% and its move from “neutral” to “calibrated tightening” came as a supply shock from West Asia pushed major central banks in the same direction. Within about a week in September, the ECB, the Fed and the Bank of Japan all raised rates while the Bank of England held […]
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