The Reserve Bank of India’s Monetary Policy Committee began its three-day meeting on Wednesday. And while the committee is widely expected to retain the policy repo rate at 5.25%, a small but vocal segment is predicting an interest rate hike on Friday due to the tremendous pressure the rupee has been under and to ‘pre-emptively’ stamp out upside risks to inflation.After a prolonged period of stability, the exchange rate has over the last one year become the primary topic of discussion, with the RBI employing various instruments to stem its fall: foreign currency sales in spot and forward markets, swap windows and auctions, tightening norms to stop speculative bets, and reportedly even selling gold to save on foreign exchange reserves (something the central bank has denied). What about a rate hike?AdvertisementBack in 2013, the RBI had raised interest rates to defend the rupee. But that did not work. What did work was quickly raising Foreign Currency Non-Resident (Bank) Deposits. Of course, such a scheme, wherein banks get a subsidy of sorts from the RBI on the interest they pay on these deposits, would be far more expensive now as global interest rates are much higher than they were in 2013. Moreover, as Nomura economists point out, “if large rate hikes are used to defend FX, then weaker growth prospects will trigger more capital outflows.”Another option is a subsidised window to encourage public sector enterprises to borrow more from abroad. Whatever route the authorities choose, the amount that needs to be raised is substantially more than the $26 billion mobilised in 2013 through the FCNR(B) scheme.“It has to be $50-60 billion at least,” said an economist, requesting anonymity. “Considering the size of the Indian economy has increased in the last decade, the money that is raised should be sufficient to change the thinking of investors. The narrative around the rupee needs to be changed very quickly, and a big sum of foreign capital can do that.”The rupee narrativeAdvertisementHaving fallen by more than 10% against the US dollar over the last year, the RBI thinks the rupee is now undervalued, with Governor Sanjay Malhotra saying as much in an interview last week, pointing at the currency’s Real Effective Exchange Rate, which fell to 90.96 in April – the lowest since September 2013.Also Read | Why Indians are moving money from savings accounts to FDs, according to RBI reportThe REER measures the rupee’s value against a basket of 40 currencies, affording weights to each depending on India’s non-service trade in that currency. Depending on whether it’s below or above 100, the REER shows if a currency is under or overvalued. This means a REER of 90.96 indicates the rupee is roughly 9% undervalued against these 40 currencies.But is the rupee undervalued in the first place?Benefit of low interest ratesAs has been pointed out by economists repeatedly, the current currency weakness episode is rooted in the subdued capital inflows – since April 2024, net inflow from Foreign Direct Investment and Foreign Portfolio Investors is (-)$18.4 billion. But FDI inflows have been slowing down for years now. As Chief Economic Advisor V Anantha Nageswaran himself wrote in this paper last month, the 10 years prior to 2022 saw extraordinarily low interest rates and “produced an artificial compression of risk premia globally, flooding emerging markets with capital that was, in effect, seeking any yield whatsoever”.India was one of the beneficiaries of this low-interest rate era, as the above graphic shows: when US interest rates were near zero, net FDI into India rose. But what’s more important is what happened in the years not seen in the graphic: according to Sajjid Chinoy, Head of Asia Economic Research at JPMorgan, it is only between 2005 and 2010 that net FDI into India has meaningfully diverged from US bond yields.NewsletterFollow our daily newsletter so you never miss anything important. On Wednesday, we answer readers' questions.Subscribe“This should not be a surprise because these were the years when India saw a large private capex cycle which was pulling in strong FDI flows. What all this points to is that FDI is, unsurprisingly, governed both by ‘pull’ and ‘push’ factors,” Chinoy said.What this means is that after 2010, foreign investors haven’t had an India-specific reason to invest here; they only did so because they could borrow money on the cheap in their home country.If the value of the rupee, and the REER, in the decade prior to 2022 was due to the near-zero interest rates abroad, should it really be deemed undervalued when monetary policies have normalised?“If this is a case of a structural fall in the BoP, then a weaker currency is the correct outcome. But if the currency weakness has been substantial and pointing towards undervaluation, authorities may want to push the value higher, towards equilibrium. The truth is that it is hard to tell for sure in the immediate how much of the fall is due to a change in the equilibrium level, and how much is due to overshooting,” HSBC economists led by Pranjul Bhandari said in a report on Wednesday.Indian authorities have been at pains to point out that India is not the same economy it was in 2013. As such, it has used its $700 billion-plus of forex reserves (before the West Asia war) to ease the fall. But as an adviser to the government points out, “forex reserves should be used to lean against the wind and not change the direction of the wind”.