India's Central Bank Puzzles Markets with Dollar-Backed Monetary Policy

RBI Keeps Repo Rate Unchanged, Unveils Measures to Attract Dollars

The Reserve Bank of India (RBI) surprised markets by keeping the repo rate unchanged at 5.25 percent in its June policy decision, a move that was expected given the increasingly dovish stance. However, the central bank's decision to retain its neutral stance belies a more significant shift in its response function. While the repo rate remained untouched, the RBI unveiled a coordinated set of measures aimed at strengthening India's external financing conditions.

The backdrop for the policy decision is challenging, with the prolonged West Asia conflict pushing up global energy prices, disrupting supply chains, and increasing volatility across financial markets. For India, this is translating into a weaker currency, higher imported inflation risks, and rising concerns over the balance of payments. The RBI reflected these pressures in its revised macro projections, raising CPI inflation for FY27 to 5.1 percent from 4.6 percent earlier, while core inflation is now projected at 4.7 percent versus 4.4 percent previously.

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The central bank also flagged the risk of second-round effects from higher fuel and commodity prices, even as it maintained that underlying demand-side inflation remains contained for now. Growth projections were lowered to 6.6 percent from 6.9 percent, with energy costs, supply disruptions, and a likely weak monsoon expected to weigh on activity in coming quarters.

The Monetary Policy Committee (MPC) faced a difficult trade-off in its decision-making process. A rate hike could have reinforced inflation credibility and potentially supported the rupee at the margin. However, with inflation still broadly within tolerance and growth risks rising, the MPC chose to wait for greater clarity on the persistence of global shocks and the transmission of cost pressures into domestic inflation.

The more important story, however, lies outside the repo rate decision. The RBI announced a series of capital flow and external sector measures, including a concessional swap facility for PSU external borrowing, full hedging cost support for FCNR(B) deposits, extension of export realisation timelines, and further liberalisation of foreign investment limits in government securities. These measures were complemented by the government's move to remove capital gains tax and interest withholding tax on foreign portfolio investment in specified government bonds.

Taken together, the policy direction is unambiguous: to attract dollars rather than tighten liquidity conditions through rates. The logic is rooted in India's external balance dynamics, with higher crude prices widening concerns over the current account deficit and foreign portfolio flows remaining weak, particularly in equities.

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Initial market reaction suggests investors viewed the package positively. Government bond yields declined across the curve, with sharper moves at the front end. OIS rates softened as rate hike expectations were pared back, while the rupee strengthened in early trading. The response indicates that markets see capital flow measures as a more credible stabilisation tool than a marginal rate adjustment in the current environment.

For now, the RBI has chosen patience over pre-emptive tightening. However, the policy is not without caution. With inflation expected to drift toward the upper end of the tolerance band later this year and core inflation trending higher, the central bank has retained full optionality should second-round pressures become more entrenched.

The June policy, therefore, was not a simple "no change" decision. It marked a subtle but important shift, from relying primarily on interest rates to actively deploying the capital account as the first line of defence. In short, the RBI chose dollars over rate hikes.