In 279 BCE, Greek king Pyrrhus of Epirus fought the Roman empire in the Battle of Asculum. Against steep odds, Pyrrhus won but lost most of his best generals and much of his army. Since then, a ‘pyrrhic victory’ is deemed to be one that comes at such a heavy cost that it feels like a defeat.
The Reserve Bank of India’s (RBI) foreign exchange swap window, having attracted a humungous $136 billion, risks becoming a Pyrrhic victory unless RBI (and the government) stay ahead of the curve to manage an unprecedented market impulse.
The victory in itself is clear. Despite RBI shutting the window for foreign currency non-resident (bank) or FCNR-B deposits more than a month before its original schedule, its scheme attracted huge flows, mostly through FCNR-B deposits that accounted for $127 billion of the $136 billion.
RBI’s swap boosted India’s forex reserves from $681 billion in May to $785.7 billion today. It also stemmed the somewhat worryingly rapid fall of the rupee, with the currency recovering from an all-time low of 96.50 against the US dollar to 94.50 on 7 September.
The explicit cost of these flows isn’t high, contrary to some claims made. While RBI has provided a 3-5 year swap subsidy, estimated to be worth 2-3% per annum, it will also earn 4-4.5% on the dollar assets accruing to its reserves that are not sold in rupee support.
Net of liquidity management costs (like interest paid on market stabilization scheme or MSS bonds), the cost should not be more than 2-2.5% per annum. That is around ₹25,000 crore, a small fraction of the annual dividend RBI pays the government.
The real cost, though, lies elsewhere: in the emerging ‘monetary quadrilemma’ for RBI and India. Now, the well-known trilemma is simple. Free capital flows, a fixed exchange rate and monetary-policy independence cannot all co-exist, so if capital moves in and out of an economy freely, a central bank can’t control the exchange rate and also conduct an independent monetary policy. But there is also a fourth variable: asset inflation and its impact on capital flows.
How India manages this quadrilemma will determine if its dollar-attracting exercise was a success or a pyrrhic win.
Some risks are obvious. The most immediate one is of a massive creation of incremental liquidity. With RBI swapping $136 billion into rupees, banks have close to ₹12 trillion of the currency’s balances (‘core liquidity surplus’ in banking jargon). That’s around 10 times recent levels. This reserve money, via a multiplier, can induce significant medium-term inflation. These risks are higher in a world of high and sticky commodity prices, and higher food prices due to monsoon-deficits and potential fertilizer shortages.
There exist tools to sterilize excess systemic liquidity—MSS bond issuance, a hike in the cash reserve ratio, aggressive open market operations (OMOs)—but the scale puts us in somewhat uncharted territory (covid times were similar, but global coordination helped manage an orderly unwinding).
The liquidity injection also reduces short-term market interest rates. Already, these have dropped below the policy repo rate. But in a world where Japanese yields have crossed 3% after decades and US rate hikes are now a question of ‘how many’ rather than ‘if,’ ultra-low market yields exacerbate the external imbalances that RBI’s forex swap window was expected to solve.
This brings us to the nub of the fourth leg of the quadrilemma—asset price inflation. For two years now, Indian rate spreads over US rates have been on a decline.
A mix of a less-hawkish monetary policy stance (RBI’s unwinding of covid-era loosening was less acute than what the US Federal Reserve did) and OMOs (RBI bond buying accounted for 35-40% of total government borrowings last year) has meant India’s 10-year government security today trades a tad more than 200 basis points over the US 10-year Treasury bond. This gap is at a multi-decade low.
Such low relative rates of interest have had their first-order impact. Valuations of Indian assets, both debt and equity, have been elevated compared to most major global markets. Low rate spreads also result in low dollar-rupee forward premia, enabling greater speculation against the rupee.
Also, there has been no let up in capex on AI in the US, driving spectacular US earnings (the S&P 500 is on track for a 30-40% earnings-per-share growth in 2026) and bond yields. Together, they have triggered a level of capital outflows from India not seen in post-1991 history. Unless excess liquidity is sucked out smoothly, the medicine may turn out to be worse than the ailment.
FCNR-B inflows buy India some time, but structurally restoring long-term capital flows is key. India’s current account deficit, the cause of our balance-of-payment discomfort, was seen as ‘ideal’ at around 1-2% of GDP, but today seems less manageable. A rupee slide aiding exports is a possibility, but on current evidence, its more of a hope than a plausible outcome.
Capital inflows need to be incentivized. To some extent, via public asset monetization; there is evidence of huge appetite for Indian infrastructure assets, for instance. But to a greater extent, by dampening asset inflation. Indian debt and equity valuations need to drop.
In the short run, that can be done by raising interest rates. In the long run, Indian industry must latch on to the global AI bandwagon and lift its growth profile.
Today’s macro situation needs India to be ahead of the curve, recognize the quadrilemma and respond to it coherently.
These are the author’s personal views.
The author is chief investment officer, ASK Private Wealth.