Business Standard: The impossible trinity, revisited

(The enclosed article appeared in Business Standard on 18th August 2026, link below: https://www.business-standard.com/opinion/columns/the-impossible-trinity-revisited-126081701502_1.html )

Large interventions across markets call for greater coherence in the RBI’s policy framework

The Reserve Bank of India says it does not target any level for the dollar/rupee (USD/INR) exchange rate and intervenes in currency markets only to curb volatility. However, its foreign exchange (FX) intervention is often on such a scale and so sustained that it influences not just volatility, but also the path of the exchange rate. What, then, guides the RBI’s intervention?

Separately, outside the Monetary Policy Committee (MPC), the RBI at times intervenes heavily in bond markets and manages banking liquidity to facilitate monetary-policy transmission. The external-sector consequences of such intervention get little explicit attention.

One way to bring greater transparency and objectivity to interventions across markets would be to incorporate the trilemma into policy deliberations, recognising the interactions and trade-offs between interest rates, capital flows, and exchange rates.

The scale of FX intervention

Over the last 10 years, across spot and forward markets, the RBI's net annual currency intervention has averaged about $60 billion, or 2 per cent of gross domestic product (GDP).

During FY21 and FY22, when India's balance of payments generated surpluses, the RBI net purchased $157 billion. That effectively put a floor on the exchange rate.

In contrast, the RBI sold a significant $118 billion in FY25, helping restrict the rise in USD/INR from 83.50 to 85.50. Between April 2025 and February 2026, the RBI sold another $37 billion, even as USD/INR moved up to 91. Following the outbreak of the Iran war, the RBI sold a further $37 billion in March 2026 alone, with USD/INR eventually ending the month around 93.50. The RBI’s continued interventions and policy actions eventually allayed concerns of a disorderly USD/INR move beyond 100.

Such interventions were not necessarily incorrect. But when sustained at this scale and over such timeframes, it inevitably influences currency levels, not just volatility. 

A formal inflation-targeting framework brought greater objectivity and transparency to monetary policy. Similarly, a better articulated framework around currency intervention could improve transparency and reduce any speculation around the political economy of any intervention.

The trilemma provides a ready basis for introducing such a framework.

The trilemma applies to the RBI 

India's interest-rate policy extends beyond the MPC setting the repo rate. The RBI also intervenes in bond markets and modulates banking liquidity to facilitate monetary-policy transmission.

During FY26, India's net government debt across central and state government bonds and Treasury bills grew by ₹17.8 trillion. About ₹10.6 trillion was net purchased by banks, insurers, and pension and provident funds, which have regulatory obligations to buy such bonds. The RBI’s own holdings net increased by the remaining ₹7.2 trillion, thus accounting for a substantial 40 per cent of the incremental government debt. There was negligible net demand from discretionary savers.

The RBI’s large bond purchases and liquidity operations helped keep rupee-denominated interest rates below levels that might otherwise have been required to attract discretionary savings. The benchmark 10-year India-United States government bond spread consequently averaged just 235 basis points during FY26, a multi-year low.

As argued previously in these columns, this had consequences beyond bond markets. Low headline fixed-income returns, exacerbated by taxation, pushed discretionary savings away from debt and into domestic equities, causing pockets of overvaluation there. Low interest-rate differentials also compressed USD/INR forward premia, making it cheaper to hedge and speculate against the rupee. All this likely deterred net foreign investments and incentivised outflows.

The outcomes illustrate this. During FY25 and FY26, the RBI net sold $192 billion. The cumulative current account deficit together with net foreign direct investment and foreign portfolio investment flows accounted for only $75 billion of this demand. The remainder likely reflected dollar demand from hedging and speculative positioning.

The RBI's significant intervention in interest rates may have contributed to external pressures, necessitating intervention there as well. Greater consideration of the trilemma might have suggested a more calibrated policy mix across policy rates, liquidity management and bond market intervention.

A framework, not exchange-rate target

Several inflation-targeting central banks, including the European Central Bank, the Reserve Bank of Australia, the Bank of England, and the Bank of Japan consider global monetary and financial conditions, interest-rate differentials and exchange rates while assessing monetary-policy choices. This neither dilutes the primacy of domestic monetary objectives nor implies targeting exchange rates. It simply recognises important constraints and transmission channels.

The distinction is particularly relevant for RBI actions outside the MPC. Under its current statutory mandate, the MPC must set the policy rate to achieve the inflation target. Large RBI interventions outside the MPC, across liquidity, government bonds and FX, should however explicitly consider their impact on interest-rate differentials, capital flows and exchange rates.

An FX framework cannot involve mechanical rules. The RBI must retain discretion to address disorderly markets that threaten financial stability. But discretion need not mean opacity. Broad principles could outline when large-scale intervention may be warranted, and how its interaction with monetary conditions and capital flows is assessed.

Allowing the trilemma to operate

For now, the RBI has eased the trilemma by attracting three-to-five-year foreign funds through its heavily subsidised FX-swap window. Low post-tax returns for domestic fixed-income savers partly contributed to external pressures. The fallout is being addressed by providing subsidies to non-resident Indian depositors, overseas lenders, and domestic banks and select borrowers.

Even this does not eliminate the underlying trilemma. Funds raised through the swap window will keep domestic interest rates below levels otherwise needed to attract discretionary savings. The more durable solution is to address the need for such intervention.

As argued earlier in these columns, lower taxation of fixed-income returns and capital gains could attract more discretionary savings into deposits and debt markets without requiring higher pre-tax rates. This would allow interest rates to be sustained by willing savers and ensure, in turn, that domestic equity valuations are sustained by risk-based asset allocation. This would help better attract net foreign investment across asset classes.

None of this requires the RBI to target USD/INR or dilute domestic monetary objectives. It only requires recognising that interest rates, capital flows and exchange rates are interconnected.

The impossible trinity cannot be wished away. Recognising the trilemma, particularly when undertaking large interventions, should foster greater coherence, transparency and discipline.