The Reserve Bank of India’s struggle to steady the rupee is once again colliding with the need to keep money available to banks and borrowing costs manageable. A surge of foreign currency inflows had eased that tension. With the liquidity cushion now shrinking and bond yields rising, the relief is beginning to look less durable than its scale initially suggested.

The pressures are connected, as selling dollars to support the rupee withdraws rupees from the banking system unless the RBI offsets the drain. Injecting cash can ease funding conditions, but may complicate efforts to tighten monetary policy. Each intervention has consequences beyond the market it is intended to stabilise.

Ahead of the December 2025 policy review, the RBI had faced tight liquidity, rising bond yields and a weakening currency. Government bond purchases and dollar buy/sell swaps injected rupees into the system, easing funding conditions and supporting bond prices. These measures appeared to give liquidity and borrowing costs priority, while allowing the exchange rate greater room to adjust.

The West Asia conflict and continued selling by foreign portfolio investors made that balance harder to sustain. Dollar outflows added pressure that domestic liquidity operations could not resolve on their own. In June, the RBI responded with incentives to attract foreign currency, including concessional swaps for overseas borrowing by public sector companies. Cheaper overseas borrowing offered public sector companies an alternative to domestic funding, potentially easing pressure on borrowing costs.

It also bore the hedging cost on eligible fresh foreign currency non-resident bank deposits, or FCNR(B) deposits. Banks could exchange the dollars raised for rupees with the RBI, adding to foreign exchange reserves and domestic liquidity. Cheaper overseas borrowing offered public sector companies an alternative to domestic funding, potentially easing pressure on borrowing costs.

Temporary Relief
The initial response was substantial. Mobilisation under the special foreign currency facilities reached about $143 billion, helping lift reserves to around $785 billion. The rupee gained some ground, and average banking system liquidity was in surplus by nearly ₹8 trillion in September.

That abundance brought its own difficulties. Short-term rates fell sharply, and the RBI sold ₹1 trillion of government bonds to absorb cash. Surplus funds were also concentrated in a few banks, so the comfortable aggregate position concealed differences in access to money across the system.

Even then, the softening in bond yields was largely confined to securities maturing within three years. Longer maturities remained exposed to rising global yields and inflation concerns. The divergence showed the limits of relying on abundant bank liquidity to contain borrowing costs across the economy.

Renewed tensions in West Asia pushed oil prices higher, increasing India’s import bill and the risk of broader inflation. The Indian crude basket averaged $116.1 a barrel in September, up from $90.2 in August. The same shock was therefore straining the currency and the outlook for domestic interest rates.

Against this backdrop, the RBI raised the repo rate by 25 basis points to 5.50% on October 7, and changed its stance from neutral to calibrated tightening. Containing inflation risks now required firmer monetary conditions, making the earlier objective of easing funding pressures harder to pursue.

Returning Tensions
Post policy, the yields continued to move higher and the Rupee was a whisker away from the all time low while liquidity started to shrink as RBI tried to balance the conditions. The subsequent measures reflected that balancing act. Banks were required to maintain 99% of their prescribed cash reserves daily, up from 90%. This reduced their flexibility in managing daily balances, while leaving the cash reserve ratio itself unchanged.

The RBI also imposed a 20% reserve requirement on specified foreign exchange hedges and opened a special window to sell dollars to three public sector oil marketing companies through designated banks. These steps sought to ease pressure on the currency, but their effects extended into funding and hedging markets.

The spot rupee found some relief, while the premium for buying dollars a year ahead rose from ₹3.40 to ₹4.01 per dollar. Businesses seeking to secure dollars for future payments therefore faced a larger premium over the spot rate. The cost of hedging was becoming another consideration in assessing the effects of currency stabilisation measures.

Meanwhile, recent liquidity readings of around ₹2.42 trillion show how far the surplus has narrowed. Call money rates of 5.75% and secured overnight borrowing rates of 5.71% are near the upper end of the RBI’s policy corridor. Festive cash withdrawals could tighten conditions further, while the 10-year government bond yield has risen to around 7.38%.

Some tightening is consistent with the RBI’s new stance. The risk is that dollar sales, liquidity absorption and seasonal cash demand together could push funding conditions beyond the degree of restraint intended. The concentration of surplus cash in a few banks makes that risk harder to judge from the headline liquidity number alone.

The RBI therefore needs to assess its interventions across markets.

Currency support may need to be accompanied by liquidity provision if funding pressures become disruptive, while bond yields must retain room to reflect inflation risks. The next test is how well the central bank manages the domestic cost of defending the rupee as its liquidity cushion shrinks.

The forces of impossible trinity may again be challenging the Central Bank.