RBI’s Currency Curbs Risk a Deeper Trust Deficit

The Reserve Bank of India’s recent curbs on currency trades by banks rank among the most forceful interventions in the foreign exchange market in at least two decades. While the central bank has, in the past, imposed limits on net open positions to curb speculation, the latest measures go much further in both scale and scope.

What distinguishes this episode is not merely the intent to stabilise the rupee, but the manner in which it has been pursued. By targeting onshore trades linked to offshore markets, the RBI has effectively forced an unwinding of an estimated $30 billion–$40 billion in arbitrage positions. These trades, built over time between onshore and offshore markets, far exceed the exposures targeted in earlier episodes such as 2011 or 2013.

The immediate consequences have been disruptive.

Banks, in a bid to avoid crystallising large losses, initially sought to pass these positions on to clients. The central bank’s subsequent decision to close this route has left them with little choice but to square off positions at significant cost, with losses estimated at ₹30 billion–₹40 billion.

From the RBI’s perspective, such costs may appear justified. The rupee is under pressure from a confluence of external shocks, including a rising import bill, declining foreign exchange reserves, and persistent capital outflows. In such an environment, safeguarding financial stability becomes paramount. Like many central banks, the RBI has exercised its prerogative to ring-fence the currency, even as India has deepened its integration with global financial markets in recent years.

Yet, the issue is not whether the RBI should have acted, but how it chose to do so. The costs of the current approach extend beyond the immediate losses borne by banks. They risk altering behaviour across markets in ways that could prove counterproductive.

At a time when sentiment is already fragile due to geopolitical uncertainty, large and sudden losses are likely to dampen risk appetite within the banking system. This has implications that go well beyond the currency market. A retrenchment in risk-taking could reduce banks’ willingness to absorb government bond supply, potentially pushing up borrowing costs at a time when the economy is already grappling with growth risks linked to energy prices.

There are also external spillovers.

The unwinding of arbitrage positions has increased the offshore cost of hedging against rupee depreciation, making Indian assets less attractive for foreign investors. Evidence of this is already visible in the acceleration of outflows from the debt market. For an economy that continues to rely on stable capital inflows, this is an unintended outcome.

Trust Deficit

The more enduring concern, however, lies in the signal these measures send to market participants. India has, over the years, built a reputation as a relatively predictable and framework-driven emerging market. That reputation has not been derived solely from growth performance, but from a policy approach that emphasises gradualism, signalling, and consultation.

Against that backdrop, the abrupt imposition of restrictions that effectively delink segments of the onshore market from offshore dynamics raises questions. Market participants are left uncertain not only about the rules of the game, but also about how and when those rules might change.

This uncertainty is compounded by a lack of clarity on the underlying objective. If the concern was speculative pressure on the rupee, much of that activity originates offshore. Onshore arbitrage, by contrast, largely functions as a transmission channel, aligning prices across markets rather than creating directional pressure. In that sense, the measures appear to have targeted the mechanism rather than the source of the problem.

It is also important to recognise that not all offshore demand for dollars is speculative. A significant portion reflects hedging needs of investors with exposure to Indian assets. As global conditions evolve, a shift from unhedged to hedged positions is both rational and, arguably, desirable from a risk management perspective. Allowing such demand to be reflected in exchange rate dynamics need not be destabilising in itself.

The reputational loss will ultimately show up as an increase in India’s capital costs as investors will charge a steep regulatory risk premium for investing in the country. This doesn’t bode well for India that is a net consumer of capital, because of its current account deficit.

The episode also raises questions about policy sequencing.

In previous instances, strong measures have typically been preceded by a series of softer signals, including verbal guidance and incremental adjustments. Such an approach allows markets to recalibrate gradually, reducing the need for disruptive interventions. The absence of such signalling in the current case has amplified both the immediate impact and the sense of unpredictability.

A more calibrated strategy may have achieved similar objectives at lower cost. Addressing the underlying drivers of pressure on the rupee, including elevated oil prices, could have been one avenue. For instance, targeted mechanisms such as dedicated dollar windows for large importers might have helped contain volatility without distorting broader market functioning.

More fundamentally, the current episode points to a tension between control and credibility. While aggressive intervention can deliver short-term stability, it risks undermining the very confidence that supports longer-term capital flows and market development. For a country that has steadily moved towards greater integration with global markets, this trade-off cannot be ignored.

The decision to erect barriers between onshore and offshore markets, even if temporary, has implications for the broader trajectory of financial sector development. India’s engagement with global capital has been built on the premise of increasing openness, supported by a predictable regulatory framework. Departures from that approach, particularly when they are abrupt, risk setting back that progress.

In times of stress, central banks are often required to act decisively. Markets do not expect inaction. What they do expect, however, is clarity of intent and consistency of framework. Stability achieved at the cost of credibility can prove fragile.

The RBI’s recent measures may succeed in steadying the rupee in the near term. The more important question is whether they leave behind a residue of uncertainty that makes the task of managing future shocks more difficult.