The Reserve Bank of India’s Monetary Policy Committee (MPC) raised the repo rates aggressively by 50 basis points (bps) taking it to 5.9 per cent. This has surprised economists and commentators who were anticipating a smaller hike of 25-35 bps.

With this hike the repo rate has been hiked 190 bps since May 2022.

Though the inflationary expectations going ahead were cited as the reasons by RBI Governor Shaktikanta Das, the rupee’s fall in recent days must have been a bigger factor for the hike. This was the hint one could sense from the Governor’s brief speech this morning while announcing the MPC’s decisions.

The RBI retained the inflation projection at 6.7 per cent for FY23 which is still 0.7 percentage points higher than the upper band of RBI’s comfort zone of 2-6 per cent.

The rupee plunged to a new low on Tuesday when it breached the ‘psychological’ mark ₹81 to the dollar. One could also detect a faint annoyance in the Governor’s tone over the Fed’s aggressive rate hikes. The rupee’s fall is a direct impact of the US Fed’s aggressive 75 bps rate hike in its FOMC meeting last week.

This has led to the funds outflow from emerging economies, a continuing trend over the last few months, as a strengthening dollar has attracted investors to the US market. This is causing massive disruption to financial markets in the emerging economies and leading to economic pain.

The ECB too on cue raised policy rates after the US Fed’s move. The US Fed’s move has caused serious heartburn across the world, especially in Asia, but the Fed doesn’t seem to care, focused as it is to bring down inflation in the US down to 2 per cent.

Inflation worries

Though the RBI has retained its inflation projections but inflationary expectations seemed to be a bigger worry which it is also trying to temper.

The Governor spoke about the robust spike in domestic demand, both rural and urban, which from the growth point of view is positive but could fuel inflation at least in the short term. It seems for the RBI now inflation is no longer a supply-side issue and the current rate hike could be seen as measure to compress demand.

Growth projections

The RBI seems more sanguine about the growth path and predicts a 7 per cent GDP growth for FY23. For Q1 of FY24, it has projected 7.2 per cent GDP growth.

This is in sync with projections made by S&P Global and OECD, which have forecast 7.3 per cent GDP growth for FY23. S&P Global’s reasoning is that India’s more domestic-oriented economy is likely to weather the current storm better than more export-reliant economies such as South Korea and Taiwan.

The Governor also made an important point on the rising capacity utilization in the corporate sector.

External conditions

The RBI is also clearly worried about the growing current account deficit, which has shot up to 2.8 per cent of GDP from Q1 FY23 from 1.5 per cent of GDP in Q4 of FY22.

Though the Governor struck a positive note on the 35 per cent jump in services exports in April-July, the uncertain external scenario is worrying the RBI. With falling exports and rising imports going ahead the trade deficit is likely to worsen and here the rupee’s slide could make things worse.

India’s rupee woes

How does a falling rupee impact the Indian economy? Firstly, imports become more expensive. Also in the current scenario, the rupee’s fall has nullified the positive impact of the falling global crude oil prices. Though a weak rupee helps exporters as it makes Indian exports cheaper in the global markets, this too could be illusory as India’s major exports have a high import component.

The other crucial impact will be that borrowings, both for individuals, corporates and the government, will become more expensive.

Forex reserves

Though the RBI has been dipping into the forex reserves recently to shore up the rupee, the Governor allayed worries expressed over the depleting reserves. He made an interesting point about the changing valuation of forex reserves and how the dollar gaining strength is a bigger factor than the RBI’s drawing down of reserves.

Apart from this, RBI has to take some countercyclical measures to shore up the rupee. It has to go out of its way to attract foreign funds and here tapping the sizeable Indian diaspora, as it did successfully in 2013, may be worth the while. The RBI had in July eased the external commercial borrowing rules for corporates to borrow in dollars abroad.

What is becoming apparent is that the US Fed’s actions are creating severe imbalances to the finances of nations across the world especially in the emerging economies.

Even within the US the Fed’s aggressive stance has attracted criticism as there real fears of the US economy heading to a recession. Columbia University Professor and Nobel Laureate Joe Stiglitz in a recent column, along with Dean Baker, (written before this round of rate hike) had advised the Fed to pause on rates, arguing that prices are already slowing in the US. They argued that now inflation in the US is more a supply-side issue and more rate hikes would lead to unemployment and recession.

It is not easy being a central banker in the best of times. In a world fraught with uncertainty, the RBI’s tightrope walk has become harder.