FCNR(B) – What does this domino effect mean for banks

(Continuing from yesterday…see here)

The implications of a successful FCNR(B) campaign for the banking sector are far-reaching.

First, and most directly, FCNR(B) deposits will not attract CRR or SLR requirements on the incremental amounts. This is not a new concession — the same dispensation applied in 2013 — but it means that every dollar raised through this route translates almost entirely into deployable liquidity. A $40 billion inflow, at a spot rate of approximately Rs 93-95 per dollar, would inject Rs 3.7-3.8 lakh crore into the system. This is a very large number. For context, the entire banking system’s liquidity deficit through most of early 2025 was in the range of Rs 1.5-2 lakh crore.

Second, the scheme addresses the CD ratio problem in a way that domestic deposit mobilization efforts cannot quickly replicate. NRI deposits are not cannibalizing domestic savings — they represent an external infusion. Banks that succeed in raising substantial FCNR(B) deposits could see their CD ratios ease meaningfully, reducing the pressure to offer higher domestic deposit rates and thereby protecting net interest margins.

Third, as one analyst report aptly noted, successful mobilization “should have a sobering effect on loan pricing and other market-based yields across commercial papers, certificates of deposit, and government securities, helping in true transmission.” Put simply, additional liquidity should reduce the cost of credit across the economy — something that rate cuts alone have struggled to deliver in a tight liquidity environment.

Fourth, the scheme provides a measure of protection against wholesale deposit instability. When a bank can replace jumpy institutional deposits with longer-tenor (three to five year) NRI money, the structural fragility of its liability side reduces meaningfully.

The BoP dimension: Managing the external account

The FCNR(B) scheme is as much an external account management tool as it is a banking sector liquidity measure. India’s balance of payments position is at risk of marked deterioration. The current account deficit could widen on account of sustained elevated crude oil prices and widening trade deficit with major partners. Simultaneously, Foreign Portfolio Investment (FPI) flows into Indian equities turned volatile and net negative through significant portions of FY26, as global investors rotated away to developed markets and other emerging markets.

The rupee, consequently, bore the brunt. Having crossed 90 against the dollar in early 2026 and continuing to slide toward 94-95 in subsequent months, the currency’s weakness threatened to become self-reinforcing through imported inflation, higher oil import bills, and corporate balance sheet pressures for those with unhedged foreign currency liabilities.

The RBI has been intervening, but at a cost. Since February 2026 alone, over $38 billion of foreign exchange reserves were deployed to cushion rupee depreciation — drawing down reserves from their peak of $728.49 billion. At $681-682 billion, reserves remain substantial (covering approximately 11 months of merchandise imports, per the RBI Governor), but the rate of attrition is a concern.

The FCNR(B) inflows would replenish that buffer without requiring the RBI to buy USD in the open market. In effect, the scheme converts long-term NRI savings into a direct reserve-building exercise — a far more durable source of forex inflows than short-term portfolio capital. In 2013, the $34 billion raised through FCNR(B) was widely credited with stabilizing the rupee and turning the BoP position around. The hope is for a similar impact, though the quantum and speed of inflows will determine the ultimate efficacy.

The 2013 Comparison: What is different this time

The 2013 FCNR(B) episode under Raghuram Rajan is rightly remembered as a masterclass in crisis management. Within weeks of the announcement, market sentiment turned, the rupee stabilized, and $34 billion flowed in — far exceeding initial expectations. But 2026 is not 2013, and a few important differences merit attention.

In 2013, the episode was triggered by a single, identifiable shock — the Fed’s taper tantrum. Once the global environment stabilized and the RBI acted decisively, confidence returned quickly. The current challenge is more diffuse: a mix of geopolitical risks (the West Asia war and its oil price consequences), US tariff uncertainty, structural domestic demand softness, and a banking system that is adjusting from a period of unusually high credit growth. There is no single event to “catch.”

Additionally, while NRI depositors have always been rate-sensitive, the global interest rate environment today offers them competitive alternatives that did not exist in 2013 in the same way. US Treasury yields, for instance, remain elevated. The deposit and lending rates in countries like the US, the UAE, and Singapore are also much higher as compared to 2013. The spread offered by FCNR(B) deposits may not be compelling enough to overcome home country inertia and alternative opportunity costs.

Finally, the RBI’s hedging cost today — borne at approximately 2.9% per annum — represents a meaningful cost to the central bank’s balance sheet and, by extension, to its future surplus transfers to the government. If $40-50 billion is raised, the annual hedging cost borne by the RBI could be in the range of $1.2-1.4bn. That is not a prohibitive number given the BoP stability it purchases, but it is not insignificant either, if we consider that the annual budget of ISRO is US$1.4bn.

Another point to be noted is that in 2013 most of the incremental FCNR deposits were used to augment the reserves. Besides, other measures, e.g., reduced LSR remittance limits, were also used to limit the outflows. This time, much of the incremental deposits could just end up replenishing the FII and Net FDI outflows.

Investment Implications: What Should the Analyst Track?

For investors in Indian banking stocks, the emerging picture suggests a period of transition rather than resolution. Several themes are worth tracking.

On the positive side, if FCNR(B) inflows are substantial — say in excess of $30bn — the banking sector will be a meaningful beneficiary. System liquidity improvement will reduce reliance on expensive wholesale deposits, compress deposit costs, and allow for better NIM protection. Banks with stronger NRI relationships and international banking capabilities — notably the larger private sector banks and SBI, which has an extensive overseas network — may be better positioned to capture these flows.

The rupee stabilization effect, if it materializes, will reduce the import cost burden for the economy broadly and ease inflationary pressures, which would in turn support the RBI’s ability to maintain accommodative monetary conditions.

On the risk side, investors should remain cognizant that the FCNR(B) scheme creates a large matured liability for banks for three to five years hence. When these deposits mature — between 2029 and 2031 — the banks must return the foreign currency. If India’s external account is under stress at that point, the rollover risk could be significant. This is precisely what happened when the 2013 FCNR(B) deposits matured in 2016: the RBI had to manage a significant outflow, though it did so without incident. The lesson is that today’s relief is tomorrow’s contingent liability.

The fiscal trajectory remains a key watch item. A government that continues to miss its tax revenue targets while facing disinvestment underperformance will compete with the private sector for available savings — keeping yields higher than they otherwise would be and limiting the NIM upside from liquidity improvement. Resolution of the fiscal challenge is a necessary condition for a durable easing of banking sector stress, not a sufficient one in isolation.

FCNR(B) inflows – the likely scenario

Most large banks have announced rates for 3-year FCNR(B) deposits in excess of US$1mn in the range of 6-6.15%. Some smaller banks have even offered 7%.

The actual inflows would largely depend on the domestic credit franchise (how much of the mobilized USD it can lend/sell under LRS to the domestic borrowers) of the mobilizing banks.

The actual deal is the NRI depositor borrows from the overseas banks and deposits as FCNR(B) with an Indian branch.

The rate of lending to the depositors would depend on one-month SOFR and 3-year interest rate swap, expected credit cost provision and profit margin for the bank. Considering a 19x leverage (5% margin), the net return to the depositor could be in the range of 13-15% p.a. on the principal amount invested.

Conclusion

RBI, facing a multi-dimensional challenge — banking liquidity, currency weakness, BoP stress — has done well to use a time-tested measure. The FCNR(B) scheme could addresses all three simultaneously, while supplementing it with USD/INR swaps that ease domestic liquidity without burning down reserves. This is not panicked firefighting; it is deliberate central banking.

The banking sector will benefit, but investors should resist the temptation to extrapolate from 2013. The structural challenges that created the problem — a financializing household saving base that increasingly prefers non-bank instruments, a fiscal deficit that crowds and constrains, a growth model that generates more credit demand than the deposit base can organically support — will not dissolve with a single scheme, however well-designed.

The CD ratio will ease. The wholesale deposit overhang will moderate. Liquidity conditions will improve. But the medium-term question — how India’s banking system funds a $5 trillion economy when households are increasingly choosing the mutual fund and corporate debt over the fixed deposit — remains open. That is the question the banking sector and its regulators will have to answer over the coming decade, one policy measure at a time.

Also Read

How the Indian financial sector is navigating a perfect storm

 

Hope Fading, Prices Rising

The Reserve Bank of India (RBI) recently released the results of its latest forward-looking surveys (May 2026 Round). Based on the feedback received from respondents, the survey results provide important insights with respect to consumer confidence — both urban and rural — inflationary expectations and economic growth expectations from professional forecasters.

Urban Consumer Confidence – A third successive decline

Consumer confidence for the current period declined for the third successive round, with the Current Situation Index (CSI) falling sharply to 90.7 from 95.7 in the previous round. A value below 100 indicates a state of pessimism, and on this measure, urban households are now firmly in negative territory on their assessment of present conditions.

The deterioration is broad-based. Perceptions on the general economic situation worsened considerably — the net response on economic conditions fell by 7.9 points to -16.5, as nearly 48% of respondents felt conditions had worsened compared to a year ago. Sentiment on employment also deteriorated sharply, with the net response on employment falling to -14.4 from -9.1 in the March 2026 round. Income perceptions barely stayed positive, with a net response of just 0.9.

The forward-looking Future Expectations Index (FEI) also weakened, dropping 1.5 points to 118.7 — the lowest reading since September 2023. While the index remains in optimistic territory (above 100), the trajectory is concerning. Households have revised down their expectations on economic situation, employment, income and spending across both time horizons. The waning of confidence is primarily driven by ebbed sentiment on discretionary expenditure, with non-essential spending expectations falling sharply: the net response on future non-essential spending collapsed to 15.9 from 21.1 in the previous round.

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Rural Consumer Confidence – Similarly Strained

Rural confidence tells a similar story. The Current Situation Index (CSI) for rural households fell further to 95.2, declining for the second successive round from a recent peak of 100.9 in September 2025 — a fall of nearly 6 points over three survey rounds. Current perceptions on the economic situation moved into negative territory (net response of -2.5), and employment sentiment also turned negative (-1.2). Income perceptions remain weak at -5.8.

The Future Expectations Index (FEI) for rural households fell sharply to 119.3 from 125.1 in March 2026, with worsening conditions across all parameters except prices. Forward expectations on income fell to a net response of 38.9, down from 45.7. Spending expectations also softened notably, with non-essential spending expectations falling to a net response of just 42.6, from 59.5 in the previous round — a significant pullback suggesting rural households are tightening their belt.​

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Household Inflation Expectations – Rising Sharply

Urban households’ current median inflation perception jumped by 60 basis points (bps) to 7.8% compared to the previous round. Inflation expectations for the next three months and one year both edged up by 80 bps and 50 bps respectively, reaching 9.3% for both horizons. The proportion of respondents anticipating higher prices inched up across all product categories, with food products, non-food products and housing all seeing increased price pressure expectations.

The rural picture is consistent. Median inflation perception among rural households rose by 30 bps to 5.9%, and one-year-ahead inflation expectations climbed 40 bps to 7.2%. Across age and occupation groups, the upward drift in inflation expectations is widespread — particularly notable among retired persons, who now expect inflation of 8.6% over the next year.

Professional Forecasters – GDP revised down, inflation revised up

GDP: Real GDP is now expected to grow at 6.5% in FY27, revised down by 40 bps from the previous round. For FY28, the forecast stands at 6.9%, modestly lower by 10 bps. Forecasters have assigned the highest probability to GDP growth in the 6.5-6.9% range for FY27, while for FY28, the modal outcome is also the same band. Annual growth in real PFCE and GFCF for FY27 are expected at 6.8% and 6.5% respectively, with GFCF revised down by 60 bps — a signal of tempered capital formation expectations.

Real GVA growth for FY27 is pegged at 6.6%, with services (7.7%) and industry (6.8%) doing the heavy lifting, while agriculture is expected to contribute a modest 2.4%.

Inflation: This is where the story turns uncomfortable. Annual headline CPI inflation is expected at 4.9% for FY27 and 4.5% for FY28. The quarterly path, however, reveals a more concerning picture: CPI is forecast at 4.0% in Q1 FY27, rising to 4.9% in Q2, accelerating to 5.5% in Q3, and easing only marginally to 5.2% in Q4. Core CPI (excluding food and fuel) is expected to rise from 3.9% in Q1 to between 4.4-4.7% through the rest of the year.

WPI inflation forecasts have been revised up sharply. WPI All Commodities is projected at 8.9% in Q1 FY27, 9.0% in Q2, before moderating to 7.9% in Q3 and 6.5% in Q4.

External Sector: Merchandise exports are expected to grow 5.0% in FY27 and 4.7% in FY28 in US dollar terms. Imports, however, are forecast to grow much faster at 10.5% in FY27, before normalizing to 4.6% in FY28. This asymmetry pushes the current account deficit (CAD) to 2.1% of GDP in FY27 — a significant deterioration of 60 bps from the previous round’s estimate — narrowing to 1.2% in FY28. The median USD/INR rate is pegged at around 95.4-96.6 across the quarters of FY27, with crude oil (Indian basket) expected in the $85-105/barrel range across quarters.

The takeaway

Taken together, the May 2026 round of RBI’s surveys paints a picture of an economy that is growing at a reasonable but moderating pace, against a backdrop of rising inflation pressures and rapidly eroding consumer confidence — across both urban and rural India.

The triple squeeze is hard to miss: households feel worse off today than a year ago, they expect prices to be significantly higher a year from now, and they are pulling back on discretionary spending. Professional forecasters have simultaneously marked down growth and marked up inflation. The widening CAD and sharp upward revision in WPI forecasts add to the headwinds.

Hope was the dominant sentiment in previous survey rounds. In this one, it is fading. The optimism that characterized forward expectations — buoyant FEI readings, resilient income outlook, strong discretionary spending intentions — is giving way to something more sober. If the quarterly CPI trajectory plays out as forecast, with inflation touching 5.5% in Q3 FY27, the RBI will face an uncomfortable policy tradeoff, even as growth edges lower.

For investors, the signposts are clear enough: demand recovery may disappoint consensus, margin pressures from higher input costs are likely to persist, and the consumer staples vs discretionary divide may widen further. The surveys may not move markets directly, but they sharpen the lens through which to read the earnings season ahead.

 

Markets in a state of disbelief

“Markets stop panicking when the authorities begin to panic.”

The logic behind this old adage is intuitive: in a sudden crisis, financial markets typically price in the worst-case scenario well before governments, central banks, and regulators even acknowledge the problem. Once the authorities do act — through stimulus, rate cuts, liquidity injections, or other interventions — the corrective measures tend to limit the actual damage, providing an immediate floor and often a sharp rebound to stock prices that had already discounted catastrophe.

Empirical evidence

1990 — Balance of Payments Crisis: Fuelled by fiscal deficits, dwindling foreign reserves, and the Gulf War oil shock, India was pushed to the brink of sovereign default. The government’s eventual response — including pledging gold reserves and accepting an IMF bailout — marked the beginning of India’s landmark economic liberalisation. Markets recovered.

1998 — Asian Financial Crisis Contagion: Contagion from the 1997 Asian Financial Crisis rattled the rupee and slowed growth. Tight monetary policy and fiscal prudence steadied the ship.

2008 — Global Financial Crisis: The collapse of Lehman Brothers triggered a sharp stock market crash and industrial slowdown. A coordinated response of fiscal stimulus, rate cuts, and liquidity injection arrested the fall.

2013 — Rupee and Current Account Crisis: A widening current account deficit combined with US Federal Reserve tapering signals drove the rupee to ₹68/USD with inflation surging. The RBI’s decisive rate hikes and forex market interventions restored confidence.

2020 — COVID-19 Pandemic Shock: Nationwide lockdowns contracted GDP by an estimated 7.3%. But aggressive fiscal support (PMGKY), RBI liquidity measures, and deep repo rate cuts helped markets stage one of their sharpest recoveries on record.

In each case, the pattern held: authorities panicked (or at least acted decisively), and markets calmed.

The latest episode

The Indian economy is navigating a confluence of serious headwinds. The India-Pakistan military stand-off in May 2025 rattled investor sentiment. Sweeping changes to US tariff and immigration policy, which began taking effect through 2025, disrupted trade flows and created uncertainty for Indian exporters and the IT-services sector. An escalating conflict in West Asia — with implications for oil prices, remittances, and regional stability — has added another layer of risk as of early 2026.

Financial markets have responded accordingly, and painfully. Bond yields have risen sharply. The rupee has weakened significantly, ranking among the worst-performing major currencies over the past year. Equity markets have corrected meaningfully — the Nifty 50, which stood near 23,465 in mid-2024, has gone essentially nowhere in two years, even as several peer markets have advanced. Indian equities have strikingly underperformed comparable emerging markets.

So far, this fits the familiar script. Market pricing in the worst.

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The adage is being tested

The Prime Minister has, in recent public statements, signaled growing concern about the economic situation — a rare and telling departure from the usual official optimism. The RBI Governor has similarly struck a more cautious tone. In other words, the authorities appear to be beginning to panic.

By the logic of the old saying, this should be the inflection point. Markets should be bottoming out. Relief should be setting in.

And yet — the panic in markets is not subsiding.

Why are markets in a state of disbelief?

Is it that investors doubt the adequacy of the policy response? Is the nature of this crisis — multi-front, geopolitical, and partly beyond India’s control — fundamentally different from past ones? Or is something else at work?

…more on this next week

 

RBI status quo - A Prudent Pause or a Risky Delay?

The Reserve Bank of India's Monetary Policy Committee wrapped up its 60th meeting on Wednesday with a unanimous vote to hold the policy repo rate steady at 5.25%. The SDF rate stays at 5.00%, the MSF and Bank Rate at 5.50%. MPC maintained a neutral stance, while keeping a flexibility to act if need arose.

Governor Sanjay Malhotra termed the MPC decision as one of prudent watchfulness, emphasizing that the Indian economy confronts a genuine supply shock from the West Asia conflict, and with core inflation still muted and fundamentals sound, the MPC chose to observe rather than act.” On the surface, this reads as responsible central banking. Below the surface, several questions deserve sharper scrutiny. In particular, the following points need to be kept in mind by investors.

Is this a prolonged pause?

The language in the MPC’s statement is telling. The MPC “decided to continue with the neutral stance, retaining the flexibility to respond judiciously to incoming information.” To me it translates to – “no rate cut is on the table for now, and the Committee is giving itself maximum optionality.”

The RBI is effectively signaling that the next move — whether a cut or a hike — depends entirely on how the West Asia conflict evolves. It explicitly lists supply chains, energy infrastructure damage, shipping routes through the Strait of Hormuz, and potential El Niño conditions as risk factors. Until these clarify, it is reasonable to expect RBI to stay on pause.

In my view, a prolonged pause — potentially through H1 FY27 — is the base case. If El Niño materializes and energy prices stay elevated, the next move could even be a hike, though that remains a tail risk. Rate cut expectations should be firmly pushed to H2 FY27 at the earliest.

Is the Inflation Forecast Adequate?

The RBI has projected CPI inflation for FY27 at 4.6%, with a Q3 spike to 5.2%. Core inflation is seen at 4.4%. At first glance, this appears to meaningfully revise up from the recent sub-4% prints. But look harder and the forecast raises uncomfortable questions.

The statement acknowledges that crude oil price volatility is a major upside risk — but the baseline assumption appears to embed a relatively contained near-term impact. Retail petrol and diesel prices have not been revised as of the statement, even as LPG, commercial fuels and premium petrol variants have already seen increases. If the government is forced to pass through higher crude costs to retail consumers — a political decision, not an economic one — inflation could easily breach the Q3 estimate of 5.2%.

The Governor also acknowledged that the Indian rupee depreciated more in 2025-26 than in prior years, even with relatively stronger fundamentals. A materially weaker USD/INR naturally amplifies imported inflation — particularly for crude, edible oils, and fertilizers. The statement reiterates that RBI policy is to smooth volatility, not target levels. But if the rupee faces sustained depreciation pressure from FPI outflows (US$5.4 billion already in April 1–6 alone), the inflation math becomes harder. The forecast does not appear to explicitly model a significantly weaker rupee scenario.

The 4.6% average forecast looks understated if oil stays elevated and USDINR weakens further. A realistic upside scenario puts FY27 average CPI at 4.9–5.2%. The Q3 estimate of 5.2% may prove to be a floor, not a peak. Investors may not assume monetary easing on the basis of this forecast alone.

Is the Growth Forecast Realistic?

The RBI projects real GDP growth of 6.9% for FY27, stepping down from the estimated 7.6% in FY26. Quarter-by-quarter, growth is expected to trough at 6.7% in Q2 before recovering to 7.2% by Q4.

The statement points to robust rabi crop prospects and healthy reservoir levels (47% of capacity vs. 40% a year ago) as support factors. But ground reports of untimely rains and hailstorm damage to standing rabi crops across several key producing states — Madhya Pradesh, Maharashtra, Uttar Pradesh, Punjab, Haryana, Rajasthan — suggest the actual rabi outturn may disappoint against the Second Advance Estimate. The RBI's own footnote flags that rabi foodgrain production growth of 3.0% could be an overestimate. Separately, the El Niño risk to Kharif 2027 is flagged as a concern but remains outside the baseline assumption. If both rabi disappoints and Kharif is weak, rural income stress will weigh on private consumption and demand — which the RBI is banking on as a growth driver.

Merchandise exports contracted 0.2% during January-February 2026, with the US (India's largest market) registering a 17.5% contraction. Trade deficit widened sharply to US$61.8 billion in Jan-Feb vs. US$37.1 billion a year ago. The RBI's own data shows FPI outflows of US$16.5 billion in FY26 and a further US$5.4 billion in just the first week of FY27. The 6.9% growth projection implicitly assumes these headwinds are manageable — but if global demand weakens further and the conflict prolongs, the export channel offers little buffer.

The government has budgeted central capex to rise 11.5% in FY27, with effective capital expenditure (including state transfers) growing 22.1%. This provides a genuine growth floor that partly justifies the RBI's relatively sanguine baseline. But public capex cannot offset simultaneously weaker exports, a stressed rural economy, and a cautious private sector.

In my view, 6.9% growth for FY27 is achievable only under benign assumptions — conflict contained, El Niño averted, rupee stabilized, rabi harvests close to estimates. Strip out even two of these assumptions and growth is more likely in the 6.0–6.3% range. The RBI appears to have incorporated a partial haircut from 7.6% but may not have gone far enougWhat Else Did the RBI Announce?

What else RBI announced

Beyond rates, the RBI announced several regulatory and market development measures. On capital adequacy, it proposed removing the NPA provisioning condition for inclusion of quarterly profits in CRAR — a modest relief for bank capital reporting. The Investment Fluctuation Reserve (IFR) requirement is also being dispensed with for commercial banks, given that they already maintain market risk capital charges.

On market development, the term money market is being opened up to non-bank entities (AIFIs, NBFCs, housing finance companies), which should deepen market participation and improve monetary transmission from overnight to longer-term rates. MSME onboarding on TReDS platforms is being simplified by removing the due diligence requirement — a small but meaningful ease-of-business move for smaller firms.

Conclusion

The RBI maintained the status quo on the expected lines. But “wait and watch” has its own risks in a fast-moving geopolitical environment. Three gaps stand out in today's statement:

·         The pause is likely longer than markets expect.

·         Inflation risks are real and may be underweighted. The rupee, oil, and El Niño form a perfect storm.

·         Growth of 6.9% relies on a lot going right. Agriculture, exports, and financial markets are all flashing amber.

Investors may do better adequately discounting RBI forecasts and position accordingly.

 

New watchlist

The RBI in its latest Financial Stability Report, has cautioned about the emerging risks in the markets. In particular, the RBI highlights three risks to be watched carefully by the investors – (i) financial sector asset quality, especially for the private banks and small banks; (ii) valuation risk in the equities; and (iii) financial risks emanating from stablecoins and private credit.

Credit Quality is good, but needs to be watched

One of the clearest messages from the RBI’s latest Financial Stability Report is this: India’s banking system is in good shape, but some areas of concerns have emerged.

Banks today are better capitalized, more profitable and far cleaner than they were a decade ago. Capital adequacy ratios are well above regulatory requirements; liquidity buffers are comfortable and gross NPAs continue to trend down. Even under RBI’s worst-case stress scenarios, banks remain resilient.

For investors, this is a big positive. Strong banks mean smoother credit flow, better transmission of monetary policy and lower risk of sudden financial shocks.

But this is not a “no-risk” story.

The RBI flags specific pockets of concern—especially unsecured retail lending and microfinance. Some private banks have seen higher slippages and write-offs in unsecured personal loans. While this is not system-threatening yet, it is an area to monitor closely if economic conditions tighten.

On the NBFC side, balance sheets look stable and asset quality is improving. However, NBFC-MFIs face rising credit costs, and fintech-led unsecured lending is growing rapidly. Regulation and underwriting discipline will matter a lot going forward.​

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Banks and large NBFCs remain long-term structural winners. However, investors should prefer institutions with strong deposit franchises, conservative underwriting and diversified loan books. Avoid chasing growth at the cost of asset quality.

Lower volatility may be deceptive

If you only look at market volatility, everything seems fine. But the RBI tells a different story beneath the surface.

Equity valuations—globally and in India—are at the higher end of historical ranges. A small set of AI-linked stocks has driven a disproportionate share of global returns. This concentration makes markets vulnerable to sharp corrections if expectations change.

India has handled global shocks well so far, thanks to strong domestic investor flows and resilient earnings. SIP inflows into mutual funds continue to act as a stabiliser. But earnings forecasts have softened, and equity risk premiums are rising.

Bond markets are also adjusting. Government borrowing remains high, yield curves have steepened, and long-term bond demand from banks and insurers has moderated.

This is not a time for blind risk-taking. Quality matters more than momentum. Valuation discipline, earnings visibility and balance-sheet strength should drive investment decisions. Expect higher volatility, even if it hasn’t shown up yet.

Stablecoins, private credit & interconnected risks

One of the most important—and less discussed—parts of the FSR is its focus on new-age financial risks.

Stablecoins are growing fast and are now deeply linked to traditional financial markets, especially US Treasury markets. During stress events, stablecoin runs could amplify global liquidity shocks. While India’s direct exposure is limited, spillovers are real.

Private credit is another area of concern. Globally, opaque lending structures, leverage and interconnected financing raise the risk of hidden losses. Indian banks are increasing exposure to private credit vehicles, which needs careful monitoring.

Finally, financial interlinkages are growing. Banks, NBFCs, mutual funds and insurers are more connected than ever. This improves efficiency—but also means stress can spread faster.

Innovation is positive, but complexity increases risk. Investors should be cautious with businesses dependent on opaque funding, excessive leverage or regulatory arbitrage. Transparency and governance will be key differentiators.

Bottomline for investors

India’s financial system is strong, but this is a phase for selectivity, patience and risk awareness—not complacency.

 

RBI Financial Stability Report (FSR) – December 2025

The December 2025 Financial Stability Report (FSR) presents a cautiously optimistic assessment of India’s financial system amid a volatile and uncertain global environment. While global macro-financial risks remain elevated due to geopolitical tensions, trade fragmentation, stretched asset valuations and rising public debt, India stands out as a relative anchor of stability, supported by strong domestic demand, improving balance sheets and prudent regulation.  

High global growth masks vulnerabilities

Globally, growth has surprised on the upside in 2025, aided by front-loaded trade, fiscal support and unprecedented investment in artificial intelligence (AI). However, the RBI flags that this apparent resilience masks deeper vulnerabilities. Equity valuations, particularly in AI-linked stocks, are stretched, hedge fund leverage is rising, private credit markets are expanding rapidly with limited transparency, and stablecoins are becoming more systemically relevant. The disconnect between high uncertainty and low market volatility raises the risk of abrupt corrections. A disorderly adjustment in global risk assets, especially US equities, could have meaningful spillovers across emerging markets.

Indian economy remains resilient

Against this backdrop, India’s macroeconomic fundamentals remain robust. Real GDP growth exceeded expectations in the first half of FY26, driven by strong private consumption and sustained public capital expenditure. Inflation has moderated materially, fiscal consolidation is progressing, and India’s sovereign rating was upgraded by S&P in August 2025. The external sector remains resilient, with a manageable current account deficit, improving financial account balance, and foreign exchange reserves providing more than 11 months of import cover.

Domestic financial system remains robust

The domestic financial system continues to display strength across institutions and markets. Scheduled Commercial Banks (SCBs) report strong capital adequacy, ample liquidity buffers, improving asset quality and stable profitability. Stress tests indicate that even under severe macroeconomic shocks, banks would maintain capital well above regulatory thresholds. Credit growth has revived, with improving risk profiles in both corporate and household lending, though pockets of stress remain in unsecured retail loans and microfinance.

Non-Banking Financial Companies (NBFCs) also remain resilient. Capital positions are strong, asset quality is improving and profitability is stable. While NBFC-MFIs have seen some rise in credit costs, overall systemic risk remains contained. Importantly, stress tests suggest that aggregate NBFC capital would remain above regulatory requirements even under adverse scenarios.

Financial markets stable despite foreign outflows

Financial markets in India have been relatively stable despite global volatility. Equity markets have been supported by strong domestic institutional investor flows, resilient SIP inflows and improving corporate earnings. However, valuations remain at the higher end of historical ranges, and earnings expectations have softened. Bond markets are adjusting to higher sovereign issuance and a steepening yield curve, while demand for long-term government securities from traditional institutional investors has moderated.

A notable theme in the report is the growing interconnectedness between banks, NBFCs, mutual funds and other financial entities. While this enhances credit transmission and financial deepening, it also amplifies contagion risks during stress episodes. The RBI’s network and contagion analysis shows that while the system is resilient, shocks can propagate faster in an increasingly interconnected environment.

The report also places emphasis on emerging risks from stablecoins, private credit, climate finance and artificial intelligence. Stablecoins, in particular, are highlighted as a potential channel of cross-border spillovers due to their scale, reserve composition and links to traditional financial markets.

Regulatory framework continuously strengthening

On the regulatory front, Indian authorities continue to strengthen resilience through enhanced supervision, improved governance standards, simplified regulatory frameworks and stronger customer and investor protection. The approach remains balanced—supporting innovation and growth while safeguarding systemic stability.

In conclusion, the December 2025 FSR reinforces confidence in India’s financial system. Strong growth, sound institutions and sizable buffers provide resilience against global shocks. However, elevated asset valuations, global spillover risks and evolving non-bank and digital finance channels warrant continued vigilance. For investors, India remains a structurally strong but tactically selective opportunity.

…more on this tomorrow 

Why the market is not buying “Goldilocks”

In a rare instance of exuberance, the RBI governor termed the present moment as “rare Goldilocks period” of the Indian company, after cutting the policy rates by 25bps and quietly opening the liquidity taps. This should have enthused the financial markets but to the contrary, markets have turned even more cautious; especially, the foreign investors. This market behavior phenomenon might raise several questions in the minds of small investors. For example, -

·         Whether the rate cut decision is driven by conventional macroeconomic and monetary policy conditions, i.e., to support growth, considering that growth rate is already high and above the RBI estimates or the decision is driven by non-monetary policy considerations, e.g., driving bond yields down in anticipation of larger borrowing targets in FY27, or to drive INR further lower to help exporters manage tariff situation well, etc.?

·         Is the RBI more concerned about global situation worsening impacting India’s external balance and a redux of 2013 like BoP crisis?

·         Is the RBI really confident about measures taken to stem FII/FDI outflows or it is accepting outflows as a fait accompli?

·         Is Inflation sustainably pivoted below RBI tolerance band or it's just seasonally down and may rise again in 2026?

·         Whether the RBI also does not rely on quality of GDP growth data and believes actual growth to be slower and hence feels the need for rate cut to provide support?

In my view, these doubts may be unfounded.

Summary of RBI policy statement

Policy rates and stance

Repo rate: cut by 25 bps to 5.25% (unanimous).

SDF: cut by 25bps to 5.00%

MSF / Bank Rate: cut by 25bps to 5.50%

Policy Stance: maintained “neutral” (one member wanted it to be accommodative) .

Growth outlook (RBI’s own numbers):

Q2 FY26 real GDP growth: 8.2%, six-quarter high.

H1 FY26: 8.0% growth, 2.2% inflation – RBI calls this a “rare Goldilocks period”.

FY26 GDP forecast raised to 7.3% (from 6.8%): Q3-7.0%; Q4-6.5%; Q1FY27-6.7%; Q2FY27-6.8%

Inflation outlook (this is the big story):

Q2 FY26 avg CPI: 1.7%, below the 2% lower band for the first time under FIT.

October 2025 CPI: 0.3% y/y – lowest in the current CPI series.

Food prices in Oct: –3.7% y/y; vegetables –27.6%, cereals –16.2%.

FY26 CPI forecast cut to just 2.0%: Q3-0.6%; Q4: 2.9%; Q1FY27-3.9%; Q2FY27-4.0%

Core ex-gold inflation in Oct: 2.6%; RBI says nearly 80% of CPI basket is now below 4% inflation, a broad-based disinflation.

External sector

CAD: 1.3% of GDP in Q2 FY26 (down from 2.2% a year ago).

Trade: Oct trade deficit $41.7 bn (all-time high).

Services exports & remittances are strong; RBI expects “modest” CAD for FY26.

FX reserves: $686.2 bn, >11 months import cover.

External debt/GDP down to 18.9%; net IIP improved.

FDI: gross +19.4% y/y in H1; net FDI +127.6%.

FPI: small net outflow of $0.7 bn so far in FY26, driven by equities.

Liquidity & operations

System liquidity: average ₹1.5 lakh crore surplus since the Oct meeting.

RBI announces two big additional moves: OMO purchases of G-secs worth ₹1,00,000 crore in Dec. 3-year USD/INR buy–sell swap of $5 bn this month.

Governor stresses

OMOs are for “durable liquidity”, not directly targeting G-sec yields.

LAF operations (repo/VRRR) handle short-term liquidity; both can run simultaneously.

Repo rate remains the primary monetary policy instrument.

Goldilocks

Growth: 8%+ in H1, with tax cuts, GST rationalisation, and capex doing the heavy lifting.

Inflation: crashed to levels that make inflation-targeting central bankers in advanced economies slightly jealous (and maybe a bit suspicious).

Credit conditions: Banks & NBFCs well-capitalised, low NPAs, credit growth ~11–13% and rising.

Policy support: The RBI has done four cuts this year, total 125 bps, latest repo at 5.25% with a neutral stance.

Primary reading

In my view, prima facie, disinflation has given RBI room; it’s using it to ease conditions without declaring a full-blown easing cycle. Durable liquidity addition may flatten the yield curve slightly; therefore, investors need to watch for an appropriate time to increase duration. To answer the doubts, my view is as follows:

Conventional macro driver: yes – inflation far below target plus expectation of only mild growth softening.

Non-monetary flavor: also yes – the OMO + FX swap combination clearly supports bond yields and provides FX/liquidity comfort.

External worries: acknowledged but framed as manageable; policy is not being tightened for external reasons.

Inflation: seen as temporarily too low but structurally under control; forecast path rises towards 4%, not above it.

Growth data: RBI leans into the official strength and even upgrades forecasts; no sign they’re cutting because they think “true” growth is collapsing.

I would therefore explain the rate cut by:

The cut is better explained by:

·         A genuine disinflation surprise,

·         A desire to re-align real rates downwards while growth is still strong,

·         And some prudence ahead of expected softening in growth, not a collapse.

Insofar as the near term market reaction is concerned, it may be driven by several matters that are technical in nature and unrelated to the policy measures. 

Refinement of the monetary policy framework in India

 The Reserve Bank of India adopted its current monetary policy framework in August 2016, under the governorship of Dr. Raghuram Rajan. This marked a major shift in the monetary policy formulation process in India.

In the pre-independence era, the function of monetary policy was mainly to maintain the sterling parity, with the exchange rate being the nominal anchor of monetary policy. Liquidity was regulated through open market operations (OMOs), bank rate and cash reserve ratio (CRR). After independence, India adopted the planning model of development, loosely based on the USSR model. The role of RBI monetary policy in this model was mostly to regulate credit availability, employing OMOs, set bank rate and reserve requirement in congruence with the planning objectives and development needs of the country.

The monetary policy framework witnessed a major shift between from mid 1980s to late 1990s. In 1985, on the recommendation of the (Dr. Sukhamoy) Chakravarty Committee, a new monetary policy framework was implemented. This framework was primarily based on targeting with feedback models. This framework was termed “Monetary Targeting with Feedback” as it was flexible enough to accommodate changes in output growth. The RBI was mandated to control inflation within acceptable levels with desired output growth. Further, instead of following a fixed target for money supply growth, a range was followed which was subject to mid-year adjustments.

Developments like deregulation of interest rates, integration of the Indian economy with the global economy, liberalization of the exchange rate system, etc. in the mid 1990s, warranted a change in the monetary policy approach. The RBI began to deemphasize the role of monetary aggregates and implemented a multiple indicator approach (MIA) to monetary policy in 1998 encompassing all economic and financial variables that influence the major objectives outlined in the Preamble of the RBI Act. This was done in two phases—initially MIA and later augmented MIA (AMIA) which included forward looking variables and time series models.

The current monetary policy framework of the RBI was adopted in 2016. This framework was based on the recommendations of the (Dr. Urjit) Patel Committee report. The Committee recommended a monetary policy framework that was largely based on the US FOMC model – flexible inflation targeting by RBI and a six-member statutory Monetary Policy Committee (MPC) for setting the policy repo rate. The key tools of monetary policy implementation under this framework have been the repo rate as the primary policy rate, supported by liquidity management tools like open market operations, standing deposit facility, and marginal standing facility.

The Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the RBI in February 2015 to formally adopt the flexible inflation targeting (FIT) framework. This was followed up with the amendment to the RBI Act, 1934 in May 2016 to provide a statutory basis for the implementation of the FIT framework. The Central Government notified in the Official Gazette dated August 5, 2016, that the Consumer Price Index (CPI) inflation target would be 4% with ± 2% tolerance band for the period from August 5, 2016 to March 31, 2021. The same tolerance band has however continued even after the March 2021 deadline.

The framework has, so far, helped anchor inflation expectations, reduce inflation volatility (from 7.5% pre-2016 to ~5% post-2016), and support growth, though challenges remain due to supply-side shocks (e.g., food and fuel prices) and external spillovers.

The RBI has now released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. The goal is to maintain price stability while supporting economic growth and financial stability in a dynamic global and domestic environment.

Proposed refinements

Inflation target and tolerance band: Retain the 4% CPI inflation target but review the ±2% tolerance band. RBI proposes (i) narrow the band (e.g., ±1.5%) for stricter inflation control; or (ii) maintain the current band but clarify its use to avoid misinterpretation as a range for persistent deviation; or (iii) Introduce asymmetric bands (e.g., tighter upper bound to prioritize high inflation control). RBI also suggests considering core inflation (excluding volatile food and fuel prices) as a secondary guide to better reflect demand-driven pressures. Public comments are invited by September 30, 2025, on key questions: Should the 4% target or ±2% band be revised?

Scope of inflation targeting: Continue using headline CPI as the primary metric due to its broad coverage and public relevance. Explore supplementary indicators (e.g., core inflation, inflation expectations, or sectoral indices) to address supply shocks like food price spikes, which are less responsive to monetary policy.

Monetary policy committee (MPC) processes: Enhance transparency through more detailed MPC minutes and forward guidance on policy intentions. Propose increasing the frequency of MPC meetings (e.g., monthly instead of bimonthly) to respond more swiftly to economic developments. Consider expanding external member expertise to include climate economics and global trade specialists.

Incorporating new challenges: RBI proposes to incorporate certain contemporary challenges in the process of setting monetary policy. These new challenges include - (i) Climate Risks: Integrate climate-related risks (e.g., weather-induced food price shocks) into the framework, potentially through adjusted forecasting models or stress-testing scenarios. (ii) Digitalization and Fintech: Account for the impact of digital currencies and fintech on money supply and monetary transmission. (iii) Global Spillovers: Strengthen coordination with global central banks to mitigate the impact of external shocks (e.g., U.S. Federal Reserve rate hikes, commodity price volatility).

Monetary policy transmission: Address lags and inefficiencies in policy transmission (e.g., slow pass-through of rate changes to lending rates) by improving banking sector competition and liquidity management. The RBI proposed exploring alternative tools, such as forward guidance or yield curve control, to enhance transmission in volatile markets.

Growth and financial stability: Balance inflation control with growth objectives, especially in the context of India’s post-pandemic recovery and structural reforms. Strengthen coordination between monetary and fiscal policies to avoid conflicting signals (e.g., high fiscal deficits undermining inflation control).

Rationale for Review

Changing economic landscape: Rising supply-side shocks (e.g., food and energy prices, climate disruptions) and global uncertainties (e.g., geopolitical tensions, monetary tightening in advanced economies) require a more adaptive framework.

Inflation dynamics: Persistent food inflation and volatile global commodity prices challenge the FIT framework’s effectiveness.

Stakeholder feedback: Public and expert consultations highlight the need for greater clarity on the tolerance band and flexibility in addressing non-monetary inflation drivers.

 

Expected Impact

Price Stability: A refined framework could better anchor inflation expectations, reducing volatility.

Economic Growth: Enhanced flexibility may support growth without compromising inflation control.

Resilience: Addressing climate and global risks could make the framework more robust to shocks.

Challenges: Narrowing the tolerance band or increasing meeting frequency may strain RBI resources and require careful calibration to avoid over-tightening.