RBI’s Real Test Lies Beyond Rates in a War-Driven World

September 16, 1992, is Black Wednesday in British history. That day, the British Pound tumbled 5%, in what would be the beginning of a prolonged slide attributable to its peg to the Deutsche Mark; the fall was made worse due to the shorting of the Pound by billionaire investor George Soros. By the end of the year, the British Pound had lost 25%, even defying desperate rate hikes by the Bank of England. There are instances when speculators can hold even central banks to ransom. 

The incident would have rung a bell when the Indian rupee breached the psychological 95 to the greenback on March 30. The Reserve Bank of India couldn’t have waited any longer. It aggressively intervened, capping banks’ Net overnight open position limits to no more than $100 million, following it up with a clampdown on Non-Deliverable Forwards for residents and non-residents. Rupee did appreciate by 2% in a single day, though the fundamental factors driving it are extraneous over which there is little control.

Monetary authorities across the globe and emerging markets like India, in particular, have to wage wars on different fronts.

War Shock
First, central banks have to grapple with events shaped by the Iran-US-Israel war and President Trump’s inconsistency. The price of the Indian crude basket is upwards to $120 per barrel; Russian Urals, which used to come discounted, trades at $5-7 per barrel premium; The Strait of Hormuz, through which 20 million barrels of crude transited daily during pre-war days, has virtually come to a standstill with gas and fuel-loaded tankers stuck for 35 days. In the best-case scenario of the conflict ending the next day, it would take not less than 4 to 5 months to clear the backlogs of tankers, attributable to congestion, renegotiation of insurance contracts and repairs to critical infrastructure that might have been damaged during the war. Moreover, some shipping companies have contracts allowing crew to abstain from work, should they so desire. It is a no-brainer that the adjustments to the disruptions would be through the price mechanism. It looks implausible for Brent crude to tumble below $100 for another 3 to 4 months, though a brief but temporary spell of decline is likely when the war stops, only to bounce back again.

Secondly, central banks must battle risks to growth. The challenge to growth from a war of this scale is multi-dimensional, led largely by supply chain disruptions that hit net importers the hardest. For instance, adverse shocks due to gas price disruptions go beyond their immediate impact on inflation and high gas prices. A host of industries, for which gas is a vital input, face production delays-fertilisers, petrochemicals, cement, plastics, polyesters, granules, packaged consumer goods, to name a few. The agriculture sector faces risks to yields arising from rising fertiliser prices. Industry bears the brunt of supply chain disruptions and costlier cost of funds. The service sector suffers from dwindling tourism and travel , a dysfunctional hospitality industry and subdued exports due to muted global growth prospects, which could spill over to service exports.

India will retain its number-one status as the fastest-growing economy, though the growth print is likely to be 50-100 basis points below the original forecasts. RBI will face the test of balancing the growth-inflation trade-off, with its inflation targeting mandate and growth support role possibly pulling in opposite directions. Elevated crude and rupee weakness could potentially push up retail inflation by an additional 1%, depending on the duration of the conflict. It is pertinent to note, however, that major drivers of a growth slowdown are not attributable to domestic factors.

Currency markets bore the brunt heavily with the Indian rupee losing 11% in 2025-26 and 4% in March alone, yet again earning the worst performer tag among Asian currencies.

External Strain
Both net FDI and net FII flows turned negative, with $22 billion pulled out. Debt market inflows, historically exhibiting stability, witnessed outflows with the Fully Accessible Route category seeing a net outflow of $1.9 billion in March. Restrictions on overnight positions and NDF trades at best prevent a disorderly depreciation in the rupee and cannot overcome the fundamental factors at play.

India continues to show a deficit in the current account. Capital account flows, once adequate to finance this deficit, have turned negative in the last three quarters, exerting a heavy bias to further rupee weakness.

Why is the rupee the worst-performing Asian currency?

Our Asian peers that matter run a surplus or a negligible deficit in their current accounts. India needs to significantly improve its share in global trade to halt the rupee slide. Exports need to be reinvigorated for the current account to post surpluses in a secular and sustained manner. Monetary policy has limited tools to achieve structural current account surpluses. RBI is not among the central banks that explicitly target the exchange rate as a policy variable. Fiscal policy has a much larger role. Monetary policy can complement fiscal initiatives.

Fuel prices and muted export growth may not be the sole culprits behind persistent current account deficits. If the war lingers on, remittances could disappoint on the downside, which usually stays between $140-150 billion. Since the war started, an estimated 0.37 million Indians returned from the Middle East, home to a sizeable Indian diaspora of 10 million.

To be sure, RBI’s short forward book has bulged to record highs, estimated to be $100 billion as a defence mechanism for exchange rate stability.

A good chunk of this should mature this fiscal draining rupee liquidity unless rolled over. These factors could limit the degrees of freedom available to central banks in managing interest rates. During the 14-month period between January 2025 and March 2026, system liquidity averaged ₹ 1.05 trillion, attributable to more than ₹ 10 trillion of OMOs and dollar rupee buy-sell swaps of an even higher magnitude. This is 0.5% of the banking system's net Demand and Time Liabilities. As rupee weakness is the likely norm going forward, monetary policy can ill afford to lose its guard over the adequacy of liquidity.

Policy Limits
Moreover, the war is likely to shrink fiscal space further as more subsidies and tax cuts can be expected. The recent cut in special additional excise duty will likely burn a ₹1.5 trillion hole in government coffers, which could be compensated for by cuts to spending to preserve the sanctity of fiscal targets. This can impede liquidity, with adverse consequences for short-term interest rates. Monetary policy faces challenging times under these circumstances. It must ensure that short-term rates are well anchored, while surging inflation could necessitate a hike in repo rates.  Monetary authorities need to keep a hawk’s eye on evolving liquidity dynamics and signal its unequivocal commitment to adequate liquidity in the banking system.

There could be a silver lining, though. Deposit growth, a laggard for quite some time now, might see some revival, thanks to massive erosion in stock market capitalisation. Past crisis behaviour bears testimony to this, though the extent of growth has varied. However, there is no liquidity crisis. Most banks are well above the regulatory liquidity coverage norms.

As these are unprecedented times, some unconventional measures could be in order. The central bank could examine the East Asian crisis period playbook when Resurgent India Bonds were floated.

Yet another measure could be a separate window for oil companies to buy dollars. The swap window of 2013 that attracted $35 billion is also fresh in memory. But there is a difference. India is now much stronger and resilient, though more financially liberalised. In 2013, the current account deficit was 4.8%. Now it is not even a third of that. We were then classified among the ‘Fragile Five’ economies. Now we are a far cry from that dubious distinction.

Since the war began, bond yields have surged across major economies. The 10-year Indian benchmark bond surged 38 basis points in March. This is very similar to yield spikes in Germany and the US though the surge has been much sharper for the United Kingdom.

Ever-increasing defence budgets could complicate fiscal and bond maths. America, with a debt-to-GDP ratio exceeding 125%, could see this worsening, hardening US bond yields. This does not augur well for emerging market (EM) bonds. A safe-haven bond yielding 4.5% to 5% would be preferred any day to an emerging market bond due to varied risk perceptions. It is observed that two major metrics with the most impact on Indian bonds are US Treasury yields and crude prices. US Treasuries hardening towards the 4.5% mark risks Indian gilts surging to 7.25%, with implications for the bottom lines of financial institutions.

These are undoubtedly one of those times when monetary policy faces the onerous job of managing three objectives: inflation control, financial stability and growth. The first bi-monthly review set to be announced on April 8 is expected to spell out the thinking of the RBI on the evolving domestic and global scenario. Of vital interest would be the policy stance, outlook on growth and inflation dynamics, liquidity assessment and views on risks to financial stability. Suffice it to say that monetary policy in isolation has no magic wand to ensure orderly conditions in the economy. Fiscal policy needs to be in lock-step with it.

*  Views expressed are personal.