Weighted moves: RBI's shock therapy restores stability to the forex market

After falling sharply against the US dollar in December and January, the rupee has remained stable since the Reserve Bank of India’s (RBI’s) policy repo rate cut on February 7.

 

The Indian currency’s rapid fall from 85 to 86 in just 16 days, and from 86 to 87 in another 15 days, highlights the volatility in the foreign-exchange market during those months. In contrast, it had taken 478 days for the rupee to weaken from 84 to 85 per dollar.

 

Between late 2022 and September 2024, the rupee remained largely stable. This led to debates about whether such stability was counterpro­ductive for a country aiming to become a manufacturing hub under the ‘Make in India’ initiative.

 

The currency came under further pressure after Donald Trump was elected US President in November 2024. Trump’s protectionist policies, including higher tariffs, prompted foreign investors to withdraw from emerging markets, including India. Since October, foreign portfolio investors (FPIs) have sold approximately ₹2 trillion worth of Indian equities, dragging stock markets down from their highs. In the first six weeks of 2025 alone, FPIs offloaded over $10 billion (₹97,000 crore) worth of Indian stocks. India Inc’s weak earnings further weighed on equity markets.

 

Then came the policy repo rate cut expectation from the RBI amid slowing economic growth. Gross domestic product (GDP) growth in the second quarter this financial year plunged to a seven-quarter low of 5.4 per cent mainly due to weak consumption.

 

The anticipation of a rate cut — the first in five years — intensified pressure on the rupee. After depreciating by 1.31 per cent in December 2024, the rupee fell by another 1.16 per cent in January 2025.

 

It was widely expected that the RBI would cut rates by 25 basis points (bps) in its February review, the first under Governor Sanjay Malhotra. Many currency traders anticipated that the rupee would breach 88  by March, but the timeline accelerated, with that level appearing likely in early February itself.

 

While the RBI delivered the expected rate cut, the anticipated further depreciation of the rupee did not materialise. 

 

Beyond factors like Trump’s presidency, weak corporate earnings, and slowing GDP growth, another key reason for the rupee’s sharp depreciation was the massive short positions built on the assumption that the central bank would allow the currency to weaken further. 

 

On February 10 and 11, state-run banks reportedly sold around $12 billion in the foreign exchange market on behalf of the central bank, various estimates suggest. This intervention not only prevented the rupee from breaching 88 but also brought it back below 87. According to treasury officials, the large-scale dollar sales triggered stop-losses for many speculators betting against the rupee.

 

“As the rupee hit a record low of 87.95 against the dollar, the RBI intervened aggressively, selling an estimated $10–$11 billion in the forex market during the week ending February 14, 2025,” said Abhishek Goenka, founder and chief executive officer of IFA Global. “The move aimed to curb speculative long positions in the dollar-rupee pair and stabilise volatility. As a result, the rupee appreciated to 86.50, marking its sharpest weekly gain in over 19 months.”

 

“Volatility was excessive. Many traders had short positions, but after the intervention, they have become cautious about taking big positions against the rupee,” said the head of treasury of a private sector bank.

 

Following two consecutive weeks of depreciation, the rupee appreciated by 0.69 per cent last week (February 10-14).

 

“There is uncertainty with regard to what people expected the RBI to do before this intervention and what’s happening now,” said another treasury head at a private bank. “No one can take a weaker rupee for granted anymore, as the RBI remains an active player in the market.”

 

In February so far, the rupee fell 0.39 per cent against the dollar.

 

The central bank’s dollar sales have consequences. Injecting dollar liquidity while withdrawing rupee liquidity tightens money market conditions. Liquidity was already constrained due to limited government spending and strong loan demand in the fourth quarter, which is traditionally a ‘busy season’ for banks. Liquidity shortages exceeded ₹3 trillion on several occasions in January.

 

Recognising these challenges, on January 27, the RBI announced open market operations (OMO) to inject ₹60,000 crore in liquidity through government bond purchases in three tranches. Additionally, the RBI held a 56-day variable rate repo (VRR) auction for ₹50,000 crore on February 7 to ensure liquidity coverage until the financial year’s end. A $5 billion dollar-rupee buy-sell swap auction with a six-month tenor was also introduced. Later in February, the size of the final two OMO tranches was doubled.

 

“Currently, the banking system faces a liquidity deficit of nearly ₹ 2 trillion, with a durable surplus also in deficit by about ₹400 billion,” said Vikas Jain, head of India FICC Trading at Bank of America. “For overnight rates to stay close to the repo rate, a durable liquidity surplus of ₹1-1.5 trillion is ideal.”

 

He noted that with persistent foreign-exchange outflows over the past four or five months, the RBI has limited options for injecting liquidity.

 

“The RBI can use OMOs, cash reserve ratio adjustments, or foreign exchange swaps. We expect them to continue using OMOs as the preferred tool,” Jain added.

 

While stability has returned to forex markets, the question remains about how long the RBI can defend the rupee since outflows are showing no signs of abating.

 

“The intensification of equity outflows from Q4 2024 is a key concern,” said Mitul Kotecha, head of FX & EM Macro Strategy Asia at Barclays. “If equity inflows don’t rebound quickly, concerns over financing India's current account deficit could resurface, adding pressure on the rupee, though we are not there yet. However, we still see positive prospects for bond inflows due to passive buying from index inclusion.”

 

Barclays forecasts the rupee at 87.5  by the end of March.

 

“While the rupee has rallied recently, risks remain on the downside should the Chinese yuan depreciate more than expected,” Kotecha said. “Rupee overvaluation, a growing RBI forward book, and the resumption of broad dollar strength are factors that could weaken the rupee in the months ahead.”

 

Goenka, meanwhile, said: “The RBI’s ability to defend the rupee without significantly depleting reserves is a key concern. The new governor’s more flexible approach might help keep the rupee within a broader range. We expect the dollar-rupee pair to trade between 86.00 and 87.50 over the next couple of months.” 

 

The real effective exchange rate (REER) of the rupee moderated to 107.20 in December after peaking at 108.14 in November. The REER, which measures a currency’s inflation-adjusted value against its trading partners, is often used as an indicator of external competitiveness.

 

Meanwhile, the RBI’s forward book deficit, which stood at $58.85 billion in November, is estimated to have expanded to $80-85 billion by the end of January. 

 

How the central bank manages this position will be crucial for maintaining forex-market stability.