RBI holds rates, unveils dollar-inflow measures to defend rupee as Iran war strains India's economy

The Reserve Bank of India held its policy rate on Friday but surprised markets with a package of measures designed to draw U.S. dollar inflows and arrest the rupee's slide, as the war in the Middle East drives up crude prices and fuels record equity outflows. The currency posted its biggest single-day gain in two months, while stocks gave up early gains to end slightly lower after the central bank raised its inflation forecast and cut its growth outlook.

The RBI's currency defence

The central bank rolled out several initiatives to bolster India's balance of payments. These include a discounted forex swap facility for public sector companies and banks raising external commercial borrowings, a similar facility covering the full hedging cost for banks raising multi-year deposits from non-resident Indians under the Foreign Currency Non-Resident (Bank) scheme, and a widening of foreign investor access to certain Indian government bonds.

A realistic base-case estimate would be around $25-30 billion, with upside potential if global bond investors increase allocations to India amid relatively attractive real yields.

Sodhani, head of treasury at Shinhan Bank, said the window for raising foreign currency deposits from non-resident Indians and the expansion of bonds under the Fully Accessible Route are the most likely to deliver the largest and fastest inflows. In a parallel move, New Delhi announced it will exempt foreign investors from capital gains tax on receipts from interest or sale of government bonds, further boosting market sentiment.

Inflation and growth outlook darken

The RBI raised its inflation projection for the ongoing financial year to 5.1% from 4.6% and trimmed its GDP growth forecast to 6.6% from 6.9%. The revisions reflect increasing pressures from the Iran war-linked energy crisis and the projection of a weak monsoon.

For investors, the message is simple: don't expect rate cuts to do the heavy lifting from here. Markets will now need earnings growth to justify valuations, not cheaper money.

Nahar, partner and fund manager at Qode Advisors, captured the cautious mood after the decision. The benchmark Nifty 50 fell 0.21% to 23,366.70, while the BSE Sensex shed 0.16% to 74,243.34. Both had risen about 0.3% immediately after the rate decision before surrendering those gains.

Foreign investors reposition in bonds

Ahead of the policy decision, overseas investors had already been pivoting toward short-term Indian government bonds, finding attractive entry points as the interest rate cycle shows signs of turning. Bonds with maturities of less than five years made up over two-thirds of the top 10 notes foreign investors bought during March to May, up from less than half in January and February.

The 10-year benchmark bond yield rose 34 basis points from March to May, while the five-year yield jumped 55 basis points, with the spread dropping to an eight-month low of 15 basis points.

In such an environment, the front end offers more attractive risk-adjusted carry with lower duration risk, while the long end remains vulnerable to further repricing if the tightening cycle materialises.

Bhimavarapu, APAC economist at State Street Investment Management, noted that while the RBI was widely expected to hold rates, the policy direction is clearly shifting. Standard Chartered Bank had called for a 25-basis-point hike ahead of the meeting.

Broader market and geopolitical context

The rupee gained 0.9% to end at 94.9450 per dollar, its biggest gain since April 2. Forward premiums plunged to 2.67 rupees, the lowest this financial year, down from 2.85 rupees. The Nifty and Sensex fell about 0.8% and 0.7% for the week, taking their year-to-date losses to 10.6% and 12.9% respectively.

Asian cues were largely negative amid caution over a flare-up in Middle East hostilities, with U.S.-Iran talks still in limbo. Separately on Friday, the U.S. Treasury Department imposed sanctions on a network of individuals, entities, and tankers smuggling Iranian-origin liquid petroleum gas disguised as Omani LPG to South and East Asia. The UK's FTSE 100 bucked the risk-off mood, rising 0.45% as data suggested inflationary pressures from the Middle East war may be less severe than feared.