How soon and to what extent will the Reserve Bank of India hike interest rates? After the rupee hit a record low on Thursday due to increased energy import costs, bankers in Mumbai now have pressing questions.
India's situation is comparable to Japan's, when the yen fell below 160 versus the US dollar to its lowest level since 2024. In the same way that Governor Kazuo Ueda of the Bank of Japan is hesitant to commit to raising interest rates, Sanjay Malhotra of the RBI has also indicated a desire to hold off. In a lecture at Princeton University on April 18, he stated that the central bank will intervene "through its influence on inflation expectations rather than through blunt demand compression," which is a euphemism for monetary tightening.

However, given the pressure from the foreign exchange market, Malhotra's period of cheap money is probably coming to an end. The Thai baht, the Philippine peso, and the Indonesian rupiah have all been severely impacted by the conflict in Iran, which began two months ago. With the notable exception of the Philippines, their central banks are also reluctant to increase their benchmark rates. However, during the previous two years, the Indian currency has performed the poorest in Asia, so holding off too long could backfire.
It's possible that a weaker rupee in 2025 was a calculated move to shield exporters from harsh US tariffs. Following Malhotra's appointment as governor in December 2024, the RBI reduced its key borrowing cost by 125 basis points.Additionally, it roughly doubled the amount of liquidity support provided during the pandemic by pumping nearly 20 trillion rupees ($210 billion) into banks.
However, as international money managers liquidated local assets and withdrew dollars home, the money just seeped out of the nation's financial system. As a result, banks continue to have limited funding. Additionally, there is a chance that the capital flight would quicken as the constricted channels of Middle Eastern oil and gas flows threaten to push the rupee toward the psychological barrier of 100 to the dollar (it finished at 94.92 on Thursday, after breaking 95 in intraday trading). Twenty billion of the $26 billion that foreign investors have removed from the equity market in the last year have done so since January.

Some fund managers claim that interest-rate derivative markets are placing excessive bets that the RBI would have to reverse its pro-growth, easy-money policy in order to prevent the exchange rate from continuing its 12% slide over the last two years. In the midst of an extraordinary energy crisis, this presents a challenge for bankers: how can they find takers for more expensive loans?
Prior to the Strait of Hormuz's closing, credit to households and companies was expanding at a robust 14.5%. The RBI sought to further stimulate lending by granting banks greater latitude in allocating their resources and aligning local practices with global standards.The fog of battle must clear before those benefits may be realised. Although a supply shock is already evident in the economy, "an accompanying demand compression is a serious concern," according to the Finance Ministry's monthly economic review this week. The future of loans is bleak if such concerns come to pass.
The reported asset quality of Indian banks is at its best point in the last ten years, but from next year, the RBI requires them to make provisions against the anticipated risk of loan losses. Private-sector banks won't have any issues, but their state-run competitors that have significant exposure to small businesses could need to do some cleaning.

Micro, small, and midsized businesses accounted for more than 25% of state-run lenders' nonperforming loans last year, so banks will probably be wary of allocating resources to these markets. According to a recent assessment by BMI, a Fitch Group company, its objective might be "to protect asset quality under stress as opposed to increasing lending."As of right now, the government has made refiners refrain from passing on the cost of more expensive crude oil to consumers who are already struggling with a shortage of LPG, the primary fuel used in kitchens. New Delhi lacks the financial resources to protect consumers indefinitely. In March, the overall price gauge increased by 3.4% over the previous year, which was well within the central bank's aim. Even in the absence of electricity shortages, increased inflation may be imminent due to the strong heat waves that are already plaguing north India and the forecast of below-normal monsoon rainfall that could impact harvests.

It might be too late to use a blunt instrument like interest rate increases. There will inevitably be some degree of demand destruction, even though lenders will wish to maintain loan growth. If you put it off too long, the seemingly sound bank balance sheets will be exposed as the remnants of a vanished peace-time economy.
Expectations for the future may drastically deteriorate once producers and consumers face excessive inflation. Higher-for-longer rates will be the cost of putting the genie back in the bottle, a painful reversal of the credit cycle that Malhotra has been attempting to ignite for almost 16 months.