By Ira Dugal and Dharamraj Dhutia
MUMBAI, Oct 16 (Reuters) - India's central bank will further tighten monetary conditions to counter capital outflows and raise the cost of betting against the rupee, but will stop short of the aggressive measures used in a previous currency crisis, two sources and analysts said.
The Reserve Bank of India raised policy rates this month for the first time in four years, while draining liquidity through bond sales and tighter reserve requirements for banks and large forex
hedging transactions.
The move came as inflation exceeded the bank's target and the rupee, one of Asia's worst performers this year with a loss of about 6%, threatened to breach a previous low of 96.96 against the dollar, though it has strengthened since to 94.71.
"The central bank is in calibrated tightening mode and that means tightening across the board," said one of the sources, who is familiar with the bank's thinking, adding it would continue to assess the need to tighten conditions, including liquidity.
At the bank's next policy review in December, it could also put up for discussion a hike of 50 basis points, should inflation conditions warrant front loading hikes, the sources said.
A decision on rates is taken by a six-member rate panel, which includes three external appointees.
Both sources declined to be identified as they are not permitted to speak to the media.
An email sent to the RBI went unanswered.
RBI Governor Sanjay Malhora said in an interview that monetary policy could not entirely be separated from financial stability, reversing the bank's earlier position that rates would not be used to defend the currency and prompting traders to ramp up rate hike bets.
The rupee swaps market is now reflecting the chances of an outsized rate hike at the next meeting and analysts have begun building in an increase of 50 basis points.
HSBC expects a 50-bp hike in December, it said in a report on Wednesday, joining State Bank of India's call.
FX TOOLKIT RUNS THIN
Among several steps since March to defend the rupee, the RBI has mobilised about $150 billion through inflow measures, including a subsidised dollar-deposit scheme for the Indian diaspora.
It has also cut foreign exchange position limits for banks, set reserve requirements for large hedge transactions and offered dollars to government oil firms directly from its reserves.
Continuing dollar sales in the spot market have drained reserves, pushing up the cost of betting against the rupee to a five-year high, and the currency has rebounded 2% from its lows.
The central bank has now started to nudge up domestic bond yields, which have risen 45 bps to 60 bps since the start of September.
"It feels like a re-run of 2013 measures, but in reverse order; markets are asking whether a series of rate hikes is next," Pranjul Bhandari, chief India economist at HSBC said in a an October 14 note.
During the last such episode of severe rupee pressure in 2013, the RBI first raised a short-term borrowing rate, the marginal standing facility (MSF), by 200 bps, followed by measures to mop up dollars and curb speculation.
It is unlikely to follow a similar rates playbook this time around, however, the first source said, adding that banks do not turn to the MSF window in times of surplus liquidity, so that measure had also proved unsuccessful in 2013.
FINANCIAL STABILITY VS GROWTH
Higher yields in India will support demand for local debt, investors said, potentially drawing debt flows to counter foreign selling in equity markets.
"Rate hike supports policy credibility, preserves some interest-rate carry, and reduces the incentive to position for further rupee weakness," said Norbert Ling, Invesco's head of fixed income portfolio management for the Asia-Pacific region.
Overseas investors net sold nearly $33 billion of Indian equities over 2026 and have turned net sellers of debt since August, snapping a four-month buying streak.
But very quick rate tightening could also risk hobbling the domestic economy with slower growth. Although the Indian economy grew 7.8% in the quarter from April to June, it is seen slowing in the second half of the fiscal year.
The second source said nearly 60% of loans are linked to external benchmarks such as the policy rate, allowing borrowing costs to pass through quickly and potentially hurt small borrowers.
"Using rates to target the currency would tighten conditions for an economy already absorbing an energy shock," said Alessia Berardi, head of global macroeconomics and emerging markets strategy at Amundi Investment Institute.
"Policy should stay anchored to the inflation target and inflation is expected to re-enter the tolerance band early in 2027."
(Reporting by Ira Dugal and Dharamraj Dhutia; Additional reporting by Jaspreet Kalra and Nimesh Vora; Editing by Clarence Fernandez)
