RBI Holds Rates Amid Middle East Crisis

The Reserve Bank of India (RBI) maintained its key policy rate at 5.25% on Wednesday, citing concerns over lower growth and higher inflation due to the ongoing Middle East crisis. The central bank warned that disruptions in oil supplies could impact economic momentum, reversing a previously stable 'Goldilocks' phase for the South Asian economy.

According to Reuters, RBI Governor Sanjay Malhotra stated that it is prudent to wait and watch the evolving growth-inflation outlook. The decision was unanimous, with all six members of the monetary policy committee voting to hold rates. The RBI also decided to continue its 'neutral' stance. The Indian rupee fell to a record low as foreign investors pulled nearly $19 billion between March and April.

The Middle East crisis has pushed oil prices sharply higher and disrupted gas supplies worldwide. India, which imports 90% of its oil, is particularly vulnerable. Reflecting this nervousness, the Indian rupee fell to a record low as foreign investors pulled nearly $19 billion between March and April.

The RBI's economic forecasts for the current financial year predict GDP growth will fall to 6.9% in 2026-27 from an expected 7.6% in the year ended March 31, 2026. Average inflation is seen at 4.6%, within the central bank's target band of 2-6%. The RBI also offered a forecast for core inflation, which it sees at 4.4% this financial year.

According to Reuters, economists and analysts expect the RBI to keep rates unchanged while emphasizing readiness to support the weakening rupee and inject liquidity to keep bond yields contained. The selloff in Indian government bonds accelerated, with the 10-year benchmark yield rising over just two trading sessions by as much as it had in the entire previous week.

The RBI's measures come amid worries over a deepening conflict in the Middle East keeping oil prices elevated and prompting foreign investors to yank money from Indian assets at a record pace. The central bank has taken steps to curb arbitrage and speculative trades that bet against the rupee, which rallied nearly 2% week-on-week to 93.10, its best weekly performance since November 2022.

Despite foreign funds exiting at a record pace, retail investors in India have increased their investments. In March, equity-oriented mutual funds recorded net inflows of 404.5 billion Indian rupees, up from 259.78 billion rupees in February. Inflows through monthly contribution plans like Systematic Investment Plans (SIPs) rose over 7% to a record 321 billion rupees.

According to Reuters, the Nifty 50 typically trades at a 50% price-to-earnings premium to the MSCI Emerging Markets index, but that gap has now halved, pointing to a favorable medium-term outlook for Indian equities. The RBI is also looking into the unwinding of rupee arbitrage trades by banks and plans to ask lenders to report all offshore trades involving the Indian rupee.

India plans to move ahead with a proposal mandating that banks report offshore rupee derivative trades despite objections from lenders. The RBI wants lenders to start sharing data on at least 70% of such derivative transactions starting February 2027. Domestic banks are already required to report all derivative transactions, including those by their overseas offices.

India's foreign exchange restrictions have made it costlier and more complex for overseas investors to hedge against rupee swings, denting the appeal of Indian bonds. The RBI's measures aimed at limiting arbitrage trades have eased pressure on the currency but increased hedging expenses for foreign bond investors in both onshore over-the-counter and offshore non-deliverable forward (NDF) markets.

One-year hedging costs in the onshore market have risen by about 30 basis points since the measures were introduced. Offshore, NDF hedging costs climbed nearly 70 basis points. In the immediate aftermath of the RBI's move, NDF hedging costs hit their highest level in more than 12 years.

Liquidity in the NDF market has thinned, making hedging both more expensive and harder to execute. Matthew Kok, a portfolio manager at Eastspring Investments, noted that such high hedging costs wipe out almost all the carry and roll-down from Indian government bonds. Eastspring is currently neutral on Indian bonds.

The RBI's measures have further darkened sentiment toward India at a time when surging oil prices following the outbreak of the Iran war were already weighing on the economic outlook. Foreign investors have sold about 211 billion rupees ($2.26 billion) of Indian government debt since the war began on February 28, with sales accelerating after the FX curbs were announced.

Higher oil prices are amplifying concerns among equity investors, who have sold about $38 billion of Indian shares since the start of 2025. Foreign outflows from equities totaled a record $12.7 billion in March alone. Brokerages have begun cutting earnings forecasts, with expectations that downgrades will broaden over coming quarters.

Goldman Sachs has lowered its earnings growth forecast for India by a cumulative 9 percentage points over the next two years. Nomura has warned of a 10–15% downside risk to consensus earnings estimates for the current financial year if oil prices remain at current levels, and has cut its December 2026 target for the Nifty 50 index by 15% to 24,600. The index has fallen more than 7% so far this year.