Bank of America (BofA) analysts have observed a noticeable shift in the behavior and volatility of the Indian Rupee (INR), pointing to changes in how the Reserve Bank of India (RBI) manages the currency.
According to the report, the RBI has transitioned from relying heavily on foreign exchange reserves to stabilize domestic monetary conditions. Instead, it’s now focusing on using interest rates to defend the INR, conserving its reserves in the process. This shift comes in the wake of the INR facing significant pressure during the fourth quarter, largely due to corrections from previous overvaluation compared to its global peers. A change in RBI leadership has further accelerated this new approach.
BofA’s analysts caution that defending a currency using interest rates tends to be less effective in the short run, potentially leading to higher INR volatility. Markets have also adjusted their expectations, moving away from predicting a rate cut at the RBI’s February policy meeting. The knock-on effects of this FX volatility have impacted domestic rates, suggesting that the RBI may maintain tighter financial conditions than what domestic factors alone might justify.
The report highlights ongoing challenges with liquidity. The RBI’s efforts, such as FX swaps or repo operations, haven’t fully eased the tight liquidity situation in the call money market. This suggests the central bank is more focused on discouraging INR short positions and clearing its forward book.
Looking ahead, BofA notes that while these policy changes may cause short-term disruptions, including elevated front-end swaps, they could bring long-term benefits. Greater flexibility in managing the currency could eventually allow the RBI to adopt looser monetary conditions once its non-deliverable forward (NDF) book is cleared.
