It’s not often that events in Mumbai reverberate through global markets. But the Reserve Bank of India’s first interest rate hike in almost four years speaks volumes about the chaotic state of play.
The inflation slamming Asia’s third-biggest economy and the rupee’s drop to record lows left RBI Governor Sanjay Malhotra with no choice but to raise borrowing costs. It’s a dilemma that Federal Reserve Chairman Kevin Warsh, European Central Bank President Christine Lagarde and Kazuo Ueda understand all too well.
But India’s dilemma is more challenging. On Wednesday, the RBI raised its benchmark repo rate for the first time since February 2023 — a 25 basis-point move to 5.50%. The Monetary Policy Committee (MPC) also pivoted from a “neutral” stance to “calibrated tightening,” meaning markets can forget any possibility of rate cuts.
“The duration and extent of the rate hike cycle would be contingent on the actual growth-inflation developments and outlook, especially that of underlying inflation, the extent of broadening of price pressures and second-round effects of the supply shock, as well as the impact of demand impulses,” the MPC says.
For Malhotra, Wednesday’s tightening was a big change in tack. Since taking office in December 2024, he’s overseen a series of cuts. The quarter-point hike demonstrates how much has changed since the RBI’s last policy meeting in August. Inflation has accelerated further, oil prices have surged back above $100 a barrel, and the dollar’s strength put strong downward pressure on the rupee.
Also, foreign exchange reserves just posted a record weekly decline as Team Malhotra intervened to prop up the currency with greater urgency. The rupee was Asia’s worst-performing currency in 2025. And it has a decent chance of repeating that dubious honor in 2026, too.
With inflation near 5% and perhaps en route to 6%, a falling exchange rate simply isn’t an option. The only good news here is that the Indian economy remains reasonably resilient. That gives the RBI ample justification to hike borrowing costs without being blamed for any economic distress to come.
As such, IDFC First Bank economist Gaura Sen Gupta sees an argument for another 50 basis points of rate hikes by February. Those increases would be “aimed primarily at preventing the real policy rate from turning negative as inflation rises.”
Sen Gupta adds that a “shift in stance could indicate a deeper tightening cycle, which appears unwarranted given that inflation remains primarily supply-side driven and growth faces two-sided risks.”
This view is far from universal. Alexandra Hermann Prasad, economist at Oxford Economics, argues core inflation — which removes food and fuel — isn’t as problematic as many investors think. In fact, she notes that the RBI could even have scope to cut rates.
The counterpoint is that the RBI is also struggling with a sizable pool of excess liquidity. It’s keeping Indonesia’s overnight lending rates below the official RBI rate, leaving financial conditions more stimulative than Malhotra’s board might prefer.
Before Wednesday’s meeting, the RBI had been working frantically to stabilize the rupee. The currency, along with the Indonesian rupiah, is a top victim of the Iran war.
In the weeks before the Iran war began in February, officials in New Delhi were in celebration mode. Economists were declaring that India’s gross domestic product had surpassed Japan’s. Or at the very least, is on the verge of upending Tokyo’s year.
Becoming the globe’s fourth-biggest economy after Germany would be just the milestone Prime Minister Narendra Modi’s government needed in 2026. It’s still debatable, of course. The International Monetary Fund, for example, hasn’t yet made the change in the economic guard official.
Still, the bragging rights that come with your GDP topping three of the Group of Seven nations have tangible benefits, too. One is buttressing the argument that India is a viable alternative to China as a manufacturing center and investment destination. It also adds heft to the argument that India is enjoying a “Goldilocks” moment.
India ended 2025 growing 7.8%, comfortably above China’s 5% rate. The World Bank projects India to grow 7.1% in 2027. Modi’s economy is expected to continue growing somewhere in the neighborhood of 7% going forward.
Yet the Iran war and $100 oil are upending the global economy and India’s prospects, too. For now, the World Bank says, “India’s exports have performed better than expected and are likely to provide the main upside to the FY27 growth outlook relative to the April forecasts.”
India’s manufacturing activity, slowed to its lowest level in nearly four-and-a-half years. Factories have reduced output amid Iran-related gas shortages. So big risks remain.
The only good news here is that India’s manufacturing purchasing managers’ activity remains above 50 — it was 55.1 in September.
“Companies bought more materials and built up stocks to prepare for anticipated sales,” says Pranjul Bhandari, chief India economist at HSBC. “Finished-goods inventories recorded their second-largest increase in nearly 12 years, signaling a clear shift from leaner stock levels.”
For now, at least. The biggest problem, though, is India’s preexisting conditions. Namely, India’s failure to turn rapid growth into broader prosperity and economic stability.
Modi has led India since 2014. In that time, his Bharatiya Janata Party has talked early and often about reforms to raise India’s economic game. Implementation, though, remains glacial. Case in point: Modi’s “Make in India” program, launched a year before Xi Jinping’s “Made in China 2025” strategy.
Twelve years ago, the plan was to increase manufacturing’s share of GDP to 25% to reduce high youth unemployment. A dozen years on, the sector only drives about 17% of the economy. Now, as oil and fertilizer prices surge, changing engines will be even more difficult. With the global economy in turmoil, New Delhi is firmly in damage-control mode.
The idea of India topping Japan in GDP terms will be as big a deal in Tokyo as in New Delhi. The psychological blow of China zooming past Japan roughly 15 years ago still lingers. It marked the definitive end of Japan’s post-World War II economic miracle. It also compounded the perception that the costs of Japan’s “lost decades” of deflation and stagnation still reigned.
Being relegated to No. 4 or 5 by another developing economy will usher in a fresh era of unease. Japan, after all, is the biggest donor of overseas development assistance to Modi’s 1.4 billion people.
The counterpoint, of course, is that GDP size matters far less than per capita income. And it’s a solid one. China’s $20.6 trillion economy dwarfs Japan’s $4.2 trillion of output. Yet China’s GDP per capita is well below 50% of Japan’s. Japan’s GDP per capita is about 12 times India’s.
The state of play, it’s worth noting, has been muddied a bit by this year’s revision process in New Delhi. The Ministry of Statistics and Program Implementation tweaked its GDP measurement metrics.
It may have effectively reduced India’s GDP for this year from a forecasted $4.2 trillion to roughly $3.9 trillion. Yet India’s trajectory is clear, and Japan is watching its back. Germany, too, could find itself trailing India by 2030.
Still, it’s high time Modi’s government accelerated efforts to ensure India grows better, not just faster. Modi, remember, was elected to apply his “Gujarat model” across India.
Modi rose to national prominence on the strength of his 14 years running the western state of Gujarat. During that time, he developed a reputation for GDP rates that exceeded the national average with better governance and infrastructure and less corruption.
Too often, though, Modi has stepped into the overconfidence trap that has ensnared past Indian leaders. All too many governments abandon bold structural improvements and avoid disruption once headline growth tops 7%. Now, though, fallout from Iran means “Modinomics” faces greater challenges than ever.
So does every economy, particularly those in the developing-nation zone. Yet India’s past failures are haunting its future. Despite India’s recent momentum—and the triumphalism radiating from New Delhi—turmoil in the Middle East is an unwelcome reminder that Modi must refocus on preparing the economy for global prime time.
Follow William Pesek on X at @WilliamPesek
