The rupee at record low will end India’s cheap-money era

India’s challenge is similar to Japan’s, where the yen slid past the 160 mark against the dollar to its weakest level since 2024. Just as the Bank of Japan under Governor Kazuo Ueda is reluctant to commit to a rate increase, his RBI counterpart Sanjay Malhotra, too, has signaled a preference to stay on pause. The central bank would step in, he said in an April 18 speech at Princeton University, “through its influence on inflation expectations rather than through blunt demand compression,” a euphemism for monetary tightening.

Still, Malhotra’s cheap-money era is likely drawing to a close — thanks to the pressure from the foreign-exchange market. The war in Iran started two months ago, and it has hammered the Thai baht, the Philippine peso, and the Indonesian rupiah, too. Their central banks are also hesitant to raise their benchmark rates, with the notable exception of the Philippines. But the Indian currency has been Asia’s worst performing over the past two years, and staying pat for too long may backfire.

A weaker rupee in 2025 may have been a deliberate strategy to insulate exporters from punitive US tariffs. The RBI slashed its key borrowing cost by 125 basis points after Malhotra took on the governor’s job in December 2024. It also pumped nearly 20 trillion rupees ($210 billion) into banks, nearly double the amount of liquidity support during the pandemic.

Yet the funds simply leaked out of the country’s banking system as global money managers dumped local assets and took dollars home. As a result, funding for banks remains tight. And now that the choked arteries of Middle Eastern oil and gas flows threaten to drag the rupee toward the psychological barrier of 100 to the dollar (it closed at 94.92 Thursday, after breaching 95 in intraday trading), there’s a risk that the capital exodus will accelerate. Of the $26 billion pulled out of the equity market by overseas investors over the past year, $20 billion of outflows have taken place since January.

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Interest-rate derivative markets are betting — excessively, according to some fund managers — that the RBI would be forced to roll back its pro-growth, easy-money strategy to defend the exchange rate from extending a 12% decline over the past two years. That creates a headache for bankers: How will they find takers for pricier loans in the middle of an unprecedented energy crisis?

Before the closure of the Strait of Hormuz, credit to consumers and businesses was growing at a healthy 14.5%, and the RBI was looking to give lending a further boost by allowing banks more freedom to deploy their capital, bringing local practices in line with international norms.Those gains will have to wait for the fog of war to lift. The Finance Ministry’s monthly economic review warned this week that while a supply shock is already apparent in the economy, “an accompanying demand compression is a serious concern.” If those apprehensions materialize, then the outlook for loans is dim.

Indian banks’ reported asset quality is the healthiest it has been over the past decade, though from next year the RBI wants them to make provisions against the expected risk of loan losses. It won’t be a problem for private-sector banks, but their state-run rivals with large exposure to small enterprises may have quite a bit of cleaning up to do.

More than 25% of the nonperforming loans at state-run lenders last year were from micro, small and midsized firms, which means banks will likely be cautious about deploying capital to these segments. Their goal may be “to protect asset quality under stress as opposed to increasing lending,” according to a recent report by BMI, a Fitch Group company.

So far, the government has forced refiners to not pass on the burden of more expensive crude oil to consumers already battling a crunch of liquefied petroleum gas, the main kitchen fuel. New Delhi doesn’t have the fiscal capacity to shield consumers indefinitely. The overall price gauge rose 3.4% from a year earlier in March, well within the central bank’s target. But with north India currently gripped by extreme heat waves — and a prediction of below-normal monsoon rainfall that may affect harvests — higher inflation may be around the corner even without energy shortages.

The time to avoid a blunt tool like interest-rate hikes may have passed. Although lenders will want to hold on to loan growth, some amount of demand destruction is inevitable. Delay it too long, and the healthy-looking bank balance sheets will be revealed for what they are: the echoes of a peace-time economy that no longer exists.

Once consumers and producers confront high inflation, their expectations of the future may worsen dramatically. The price of putting the genie back in the bottle will then be higher-for-longer rates, a painful reversal of the credit cycle Malhotra has spent nearly 16 months trying to spark.