In recent months, the Indian rupee has depreciated noticeably, and its slide has been more pronounced than that of many other Asian currencies. This downward trend has surprised many observers, particularly because there has been no major negative news about India that might have typically rattled financial markets. For instance, the brief Indo-Pak conflict, which could have potentially destabilised the region, concluded swiftly and had little impact on financial markets. This raises an important question: why has the rupee weakened so substantially, and what does the future hold for its trajectory?
The answer lies in two principal factors—one that is tactical and short-term in nature, and another that is more fundamental and structural.
RBI’s Critical Role
In the short term, the Reserve Bank of India (RBI) has played a critical role in managing the rupee’s movements through its intervention in the foreign exchange market. The RBI has been actively selling US dollars through derivative instruments to manage excessive volatility in the exchange rate. Central banks worldwide often resort to such measures to moderate currency fluctuations while avoiding any visible depletion of their foreign exchange reserves or the tightening of domestic liquidity conditions. At present, the RBI’s outstanding forward contracts in USD/INR stand at approximately $70 billion, which includes contracts extending up to three years. To put this into perspective, this amount represents more than 10 per cent of the RBI’s total foreign exchange reserves, highlighting the scale of the central bank’s currency intervention efforts.
By selling dollars forward, the RBI effectively commits itself to providing dollars in the future. This helps keep the rupee from appreciating too quickly, a dynamic that supports India’s export competitiveness by making its goods and services more attractively priced on global markets. However, this strategy also creates a significant short position for the RBI in the dollar, which the central bank will eventually have to unwind. In order to do so, it must buy dollars in the spot market, which increases demand for dollars and puts downward pressure on the rupee. This unwinding process has already begun and is expected to continue over the coming months, suggesting that the rupee will remain under depreciation pressure in the near term.
A Deep-Rooted Structural Challenge
Beyond these short-term tactical considerations, there is a more deep-rooted structural challenge that is weighing on the rupee’s prospects: a steady decline in India’s net Foreign Direct Investment (FDI) inflows over recent years. Historically, FDI has been a reliable and relatively stable source of foreign capital for India, serving as a cushion during periods of market volatility or external shocks. Unlike portfolio flows, which can be fickle and quick to reverse, FDI tends to be committed for the long term, providing a consistent inflow of foreign exchange and reinforcing confidence in the currency. Unfortunately, this stabilising force has weakened.
Several reasons explain the decline in FDI inflows. One is that valuations of Indian assets have become quite high, making investment opportunities less attractive to foreign investors. Geopolitical tensions, as well as shifts in global supply chains, have also disrupted the pattern of capital flows from key partners such as China and the United States. Although India continues to hold long-term appeal as an investment destination, the elevated costs of acquiring assets, combined with the challenges of doing business, have collectively dampened foreign investors’ enthusiasm.
Reduction in FDI Inflows
This reduction in FDI inflows has eroded the diversity and resilience of India’s external financing options. In simpler terms, the rupee is now more vulnerable to bouts of depreciation, especially during global financial or geopolitical uncertainty. The traditionally stabilising role of FDI inflows in supporting the current account and currency value is no longer as robust as it used to be. Nonetheless, there are important buffers that continue to support India’s external position and prevent a disorderly collapse of the rupee. Despite the country’s persistent trade deficit—which typically exerts downward pressure on the rupee—substantial inward remittances from the Indian diaspora, along with healthy software export earnings, continue to provide a crucial stabilising force. These flows help offset the deficit on the trade account and act as a counterbalance to any outflows of capital. As a result, the rupee’s depreciation is likely to be gradual and relatively controlled, rather than abrupt or chaotic.
However, the decline in FDI inflows does mean that India’s external sector is less resilient than before. For example, should there be a sharp spike in geopolitical tensions—say, an escalation of conflict in the Middle East that drives up crude oil prices—or a slowdown in the growth of developed economies, which would reduce demand for Indian software exports, the rupee could come under sharper pressure.
Another complicating factor is the RBI’s large outstanding forward short position in US dollars. This position restricts the RBI’s flexibility to intervene aggressively in the foreign exchange markets if there is a sudden shock. Since the central bank will eventually need to cover these forward positions by buying dollars, its ability to mount strong interventions during a crisis is limited. This constraint creates an added layer of vulnerability for the rupee in the event of sudden external volatility.
What Lies Ahead for Rupee?
The most plausible scenario is that the rupee will continue to depreciate gradually over the next few months. This trend is expected to persist unless there is a significant change in global economic or geopolitical circumstances that could accelerate the decline. Several factors could, however, modify this outlook. For instance, Indian equity and debt markets are currently relatively expensive compared to global peers. This high valuation has acted as a deterrent for fresh capital inflows. If there is a correction in domestic asset prices, or if the market enters a phase of more moderate price growth, the relative attractiveness of Indian assets could improve, encouraging more investment from abroad.
In addition, a sustained improvement in India’s economic fundamentals could bolster investor confidence and provide a tailwind for the rupee. This improvement could be driven by a variety of reforms, infrastructure investments, and productivity gains across sectors. The government’s efforts to simplify regulations, promote ease of doing business, and invest in critical infrastructure could eventually increase the confidence of foreign investors and support stronger inflows.
One of the more challenging but crucial long-term priorities for India is to increase the share of its manufacturing exports. Currently, India’s trade deficit is heavily skewed by large imports of crude oil and capital goods, while manufacturing exports remain relatively modest. By improving its competitiveness in manufacturing, integrating more closely with global supply chains, and expanding export opportunities, India could narrow its trade deficit and reduce its dependence on volatile capital flows. Such structural adjustments would provide a more durable basis for the rupee’s stability.
In the absence of these deeper reforms, however, the rupee will likely remain on a path of gradual depreciation. With fewer stabilising buffers from FDI and a constrained intervention capacity for the RBI because of its forward positions, the Indian currency will continue to be vulnerable to any future external shocks. As such, both policymakers and investors would be wise to stay alert, keeping a close eye on global economic developments and domestic indicators that could change the outlook.
The rupee’s current weakness is a product of both tactical central bank interventions and structural shifts in the pattern of foreign capital inflows. While the RBI’s forward dollar sales have helped moderate volatility and supported exports in the short term, they have also created a future burden that will weigh on the rupee as these positions are unwound. Simultaneously, the erosion of steady FDI inflows has removed a crucial source of support for the currency, making it more sensitive to sudden shocks.
Challenges But Not Dire Situation
Despite these challenges, India is not in a dire situation. The strong flow of remittances and the robust performance of software exports continue to offer resilience. As a result, any depreciation of the rupee is expected to be gradual and orderly rather than panicked or chaotic. Yet, the vulnerability created by reduced FDI and the RBI’s constrained ability to intervene means that the currency will remain exposed to the risk of sharper declines if there is an external crisis.
Therefore, the most realistic outlook is one of a steady, mild depreciation in the coming months. For a more stable and robust rupee over the longer term, India will need to pursue reforms that boost its manufacturing sector, improve infrastructure, enhance productivity, and reduce the costs of doing business to attract more sustainable capital flows. Only by addressing these structural challenges can India build a stronger foundation for the rupee’s resilience in a world that remains volatile and uncertain.
