Rupee Under Pressure, India's Central Bank Could Follow Indonesia's Lead

The logo of the Indian central bank, the Reserve Bank of India (RBI) is seen at its office gate in New Delhi, India. (Photo: Antara)

JAKARTA - The Indian central bank is starting to face a dilemma that Indonesia is also familiar with. Letting the currency weaken, or raising interest rates when the economy is still vulnerable to being burdened by expensive interest rates.

According to a CNBC report quoted Wednesday, June 3, the majority of economists expect the Reserve Bank of India or RBI to keep the benchmark interest rate, namely the basic interest rate that serves as a benchmark for loans, at 5.25% in the monetary policy meeting on Friday. However, the possibility of an interest rate hike is not closed. The reason is that the rupee is weakening, inflation is lurking.

CNBC surveyed nine economists ahead of the RBI's decision. Most see a new rate hike possibly coming later this year. But a minority expect the RBI could move faster to hold off a rupee that has fallen to an all-time low against the US dollar.

Venugopal Garre, Managing Director and Head of India Research at Bernstein, considers the interest rate hike to be more reasonable. In CNBC's Inside India program, he said the move could align India with the global interest rate direction and help contain capital outflows, namely investor funds leaving the Indian market.

The biggest pressure on policymakers today is currency depreciation. This means that the value of the currency weakens against other currencies, in this case the rupee against the US dollar.

India is not the only country to take a tough stance. Indonesia had earlier raised its interest rate by 50 basis points, or 0.5%, on May 20, larger than market expectations, to curb the weakening of the rupiah. Sri Lanka also raised its interest rate by 100 basis points, or 1%, on May 26, the largest increase in four years.

The rupee is under pressure from ballooning import bills and outflows of capital. The Indian government has even taken a number of emergency measures, including selling dollars through state-owned banks, according to Reuters quoted by CNBC. The government also raised gold import duties to curb demand and maintain foreign exchange reserves, i.e. the country's foreign currency stocks.

In the same report, CNBC said the rupee is still one of the most fragile currencies in Asia. Markets are also watching the important figure of 100 rupees per US dollar.

RBI Governor Sanjay Malhotra earlier said the central bank would do whatever it takes to ensure orderly formation of prices in the foreign exchange spot market. The statement to the Mint website on May 25 did not mention an immediate hike in interest rates, but signaled that all options were still open.

The problem is, the pressure does not only come from the exchange rate. Inflation is also starting to appear.

India's inflation is still below the RBI's target of 4%. However, economists see new risks from rising energy prices, a weak rupee, and disruptions in food production due to weather.

Sakshi Gupta, chief economist at HDFC Bank, said the risk of inflation could come from rising energy costs passed on to consumers and weather disruptions due to El Nino. El Nino is a warming of sea surface temperatures that can disrupt rainfall patterns.

In April, consumer inflation, or the increase in the price of goods felt by the public, rose for the sixth consecutive month to 3.48%, even though the government was still holding back fuel prices at gas stations. In the last two weeks, fuel prices have been raised several times. This can make inflation move faster.

The cumulative increase in fuel prices reached 7.5 rupees per liter, higher than Citi's initial estimate of 5 rupees. Therefore, Citi raised its forecast for India's average inflation for the fiscal year ending March 2027 to 4.9%, from the previous 4.6%.

Citi still expects the RBI's Monetary Policy Committee, the rate-setting body, to hold rates in June. But it expects two hikes, of 25 basis points each, in August and October.

Another threat comes from the weather. UN Secretary-General Antonio Guterres said El Nino has a 90% certainty of coming in the coming months. He called it an urgent climate warning.

For India, this is not a matter of ordinary weather. Nearly 60% of the country's agricultural sector depends on rainfall. The monsoon forecast was also lowered to 90% of the long-term average, weaker than the previous projection of 92%. If true, it could be the worst monsoon in 11 years.

Food inflation rose to 4.2% in April, from 3.87% in March. The pressure is getting heavier because India is also at risk of fertilizer shortages ahead of the Kharif planting season, India's main growing season during the rainy season.

FAO Chief Economist Maximo Torero warned that the Gulf conflict and below-normal monsoon rains could raise import costs, reduce domestic fertilizer supplies, and depress food prices, especially wheat, rice, and vegetables.

Here, the RBI's position is becoming difficult. Holding interest rates can help the economy move more freely, but the rupee can be further depressed. Raising interest rates can hold the exchange rate, but borrowing costs also rise.

India is now at a familiar crossroads for many developing countries. They must keep an eye on the currency, hold inflation, and ensure the economy continues to move.