The Sliding Rupee: Causes, Concerns and Consequences

26 May The Sliding Rupee: Causes, Concerns and Consequences

Posted at 26 May 2026 in Current Affairs by Ayush Ranjan 0 Comments

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This article covers “Daily Current Affairs”

SYLLABUS MAPPING : GS Paper 3 : Economy

FOR PRELIMS : NEER vs REER, RBI tools, CAD, FPI, FDI, J-Curve Effect, Managed Float, IMF SDR

FOR MAINS : The Reserve Bank of India operates a ‘managed float’ exchange rate regime rather than a fixed or freely floating system. Explain the distinction between these three systems and analyse the trade-offs RBI faces between preventing rupee depreciation, containing inflation, and supporting economic growth in the current macroeconomic environment.

Why in the News

The Indian rupee has depreciated sharply in 2026 — from around ₹85.5/$ in January 2026 to ₹96.8/$ by mid-May 2026, approaching the psychologically significant ₹100/$ mark. The depreciation is driven by a confluence of: a widening trade deficit (India’s merchandise trade deficit reaching $-29.4 billion as per the news image data), FPI (Foreign Portfolio Investment) outflows due to global risk-off sentiment and higher US interest rates, crude oil price spike driven by West Asia conflict, and capital account pressures from ECB loan outflows. RBI has been intervening by selling US dollars from reserves to arrest excessive volatility. India’s forex reserves stood around USD 690 billion (end-December 2025) — enough to cover ~10.5 months of imports. RBI Governor Sanjay Malhotra stated the rupee is not overvalued and the RBI does not target a specific exchange rate level — only intervenes to curb “abnormal volatility or undue speculation”. BusinessToday reports that the INR depreciation pace may strengthen the case for an RBI rate hike at the June 3–5 MPC meeting.

₹96.8/$

Rupee rate, May 2026 (vs ₹85.5 in Jan 2026)

$-29.4B

India’s merchandise trade deficit (latest quarter)

$690B

Forex reserves (Dec 2025) — ~10.5 months of imports

9.9%

Fall in REER — erosion of real purchasing power

$65B

RBI’s short forward book (USD positions)

₹17→₹97

Long-term rupee journey since 1991 liberalisation

Static Concept: Exchange Rate — Types & Systems

Type	Definition	India’s Relevance
Nominal Exchange Rate (NER)	The face-value price of one currency in terms of another (e.g., ₹96 = $1). Does not account for inflation differentials between countries.	The headline rate reported in markets; what importers and exporters transact at daily
NEER (Nominal Effective Exchange Rate)	A weighted average of the rupee against a basket of currencies of India’s major trading partners. Reflects overall external value without inflation adjustment.	Published by RBI; used to assess India’s trade competitiveness in nominal terms
REER (Real Effective Exchange Rate)	NEER adjusted for inflation differentials between India and trading partners. A REER > 100 means the rupee is overvalued in real terms; <100 means undervalued.	India’s REER fell by ~9.9% in 2025–26 — indicating the rupee’s real purchasing power is eroding, not merely nominal depreciation
Fixed Exchange Rate	Currency value pegged to another currency or gold. Requires constant central bank intervention to maintain the peg. E.g., Saudi Riyal pegged to USD.	India operated a fixed rate pre-1991 (₹17/$). Abandoned at liberalisation for market-determined rates
Floating Exchange Rate	Currency value determined purely by market forces of demand and supply. No central bank intervention. E.g., USA, EU (broadly).	India does NOT follow a pure float — excessive volatility is managed by RBI
Managed Float (India’s System)	Market determines the exchange rate, but the central bank intervenes to prevent excessive/disruptive volatility — not to maintain a specific rate. Also called “Dirty Float”.	India’s current system since 1993. RBI sells/buys dollars to smoothen volatility without defending a specific INR level

Static Concept: Balance of Payments (BoP) — Full Framework

India’s Balance of Payments (BoP) Structure

A. Current Account

A1. Merchandise Trade — exports minus imports of goods. India’s chronic deficit: goods imports far exceed exports (oil, gold, electronics)
A2. Services Trade — India’s strength: IT/BPO services, software exports create a large surplus (~$150B/year) that partially offsets goods deficit
A3. Primary Income — employee compensation, investment income (dividends/interest paid abroad); typically a small deficit for India
A4. Secondary Income — Remittances (India world’s top recipient — $125B in FY25) and grants. Major positive item for India’s current account
Net result = Current Account Deficit (CAD) for India typically — total goods+services+income flows

B. Capital & Financial Account

B1. Foreign Direct Investment (FDI) — long-term, stable inflows into equity/greenfield projects. India target: $100B annually
B2. Foreign Portfolio Investment (FPI) — stocks and bonds investment by foreign institutions. Volatile — flows out quickly during global risk-off or when US rates rise
B3. External Commercial Borrowings (ECB) — loans raised by Indian companies abroad. Repayments create dollar demand, pressuring rupee
B4. NRI Deposits — FCNR(B), NRE, NRO accounts. Relatively stable; RBI periodically uses FCNR(B) schemes to attract dollar inflows
Errors & Omissions — statistical residual accounting for unrecorded flows

Current Causes of Rupee Depreciation (2025–26)

📦 Trade Deficit

India’s merchandise trade deficit widened to $-29.4 billion — more dollars leaving India to pay for imports (crude, gold, electronics) than entering through exports. More dollar demand = rupee weakens.

📉 FPI Outflows

Foreign Portfolio Investors — holding Indian stocks and bonds — sell Indian assets and repatriate dollars when US interest rates are high (higher returns in safer US assets) or global risk aversion rises. Each FPI outflow = dollar demand surge.

🛢 Crude Oil Shock

India imports ~85% of its crude oil needs. West Asia conflict in 2026 pushed oil above $82.5/barrel. Every $10 rise in crude prices widens India’s import bill by ~$15–18 billion annually — amplifying the trade deficit and rupee pressure.

💵 Strong US Dollar

When the US Federal Reserve keeps rates high, global capital flows toward the dollar (higher yield, safer currency). Dollar Index (DXY) strengthening means most emerging market currencies — including INR — depreciate simultaneously.

🏦 ECB Repayments

Indian companies that borrowed dollars abroad must repay principal and interest — creating periodic surges in dollar demand. These External Commercial Borrowing (ECB) outflows are captured in the capital account and put downward pressure on the rupee.

📊 Speculative Pressure

Currency speculators (short sellers of INR) amplify genuine depreciation — betting the rupee will fall further. RBI’s concern about “undue speculation” is a specific reason it intervenes — to prevent self-fulfilling currency crises driven by market sentiment rather than fundamentals.

Impact of Rupee Depreciation

Trade

Imports costlier— crude oil, fertilisers, capital goods, and electronics become more expensive in rupee terms, raising production costs across industries
Exports cheaper— Indian goods become price-competitive globally; IT services, textiles, pharma, and engineering exports benefit
J-Curve Effect— in the short run, the trade deficit mayworsenbefore improving, because import contracts are pre-committed and exports take time to adjust; the trade balance improves only after a lag
Remittances becomemore valuable in rupee terms— NRIs sending $1,000 get more rupees, incentivising higher remittance flows

Inflation

Imported inflation— costlier crude raises petrol/diesel/LPG prices, which cascade into transport and food prices across the economy
Fertiliser prices rise— India imports significant share of potash and phosphatic fertilisers; rupee depreciation increases subsidy burden on the government
Rising inflation may forceRBI to hike repo rate— higher borrowing costs slow investment and consumption, creating a growth-inflation trade-off
Core inflation (non-food, non-fuel) can rise if firms pass on higher input costs — impactingCPI and WPI simultaneously

Sectoral

IT/BPO sector benefits— revenues earned in dollars translate to more rupees; Infosys, TCS and Wipro see margin expansion
Pharma exporters gain— dollar revenues boosted; India’s generic drug competitiveness rises in global markets
Airlines hurt— aviation fuel (ATF) priced in dollars; aircraft lease payments in dollars; rupee fall squeezes margins severely
Oil marketing companies (OMCs)under pressure — IOC, BPCL, HPCL face higher crude costs; government may delay petrol/diesel price hikes for political reasons, leading to OMC losses
Gold becomes expensive— India imports ~700–800 tonnes of gold annually; higher gold prices in rupee terms may dampen demand but also reduce current account outflow

Financial

FPI further outflows — falling rupee reduces dollar-denominated returns on Indian assets, triggering more FPI selling → a self-reinforcing depreciation spiral
India’s external debt servicing burden rises — companies with dollar-denominated ECBs must pay more rupees to service the same dollar debt
Forex reserves depleted — RBI’s dollar-selling interventions reduce reserve buffer; if reserves fall below 6 months of imports, investor confidence weakens
Higher risk premium demanded by foreign investors leads to higher sovereign bond yields, raising government borrowing cost

RBI’s Tools to Manage the Rupee

Tool	Mechanism & How It Helps
Forex Market Intervention (Direct)	RBI sells US dollars from its reserves in the spot market to increase dollar supply — reducing dollar’s price relative to rupee. Conversely, buys dollars when rupee appreciates too much. India’s $690 billion reserves give RBI significant intervention capacity. RBI does NOT target a specific level — only smooths “excessive and disruptive volatility”.
Repo Rate Adjustment (Indirect)	Raising the repo rate makes Indian assets more attractive to foreign investors (higher yield), attracting capital inflows and supporting the rupee. The June 2026 MPC meeting may consider a hike given rupee at ₹96.8/$ — though raising rates also slows domestic growth.
Forward Market Operations	RBI operates in the forward/futures forex market — buying/selling dollar forwards to signal intent and manage expectations. India’s $65 billion short forward book (commitments to sell dollars in future) acts as a currency shield and calms speculative attacks.
NRI Deposit Schemes	In crisis periods, RBI has launched special FCNR(B) deposit schemes offering higher interest rates to NRIs — attracting large dollar inflows. Used in 2013 (Raghuram Rajan) to attract $34 billion and stabilise the rupee during the “taper tantrum”.
Capital Controls (Selective)	RBI may tighten norms on ECB outflows, FPI position limits, or restrict speculative forward positions in extreme cases. India does NOT impose full capital controls — it maintains a partially convertible capital account (current account is fully convertible since 1994).
Import Restrictions (Policy)	Government may impose higher import duties on gold (2013, 2023 precedents) or restrict non-essential imports to reduce dollar demand. The gold import duty hike to 15% in 2013 helped narrow the CAD from 4.8% to 1.7% of GDP within two years.
Liberalise FDI/FPI Inflows	Government may relax FDI norms in strategic sectors (defence, insurance, retail) to attract stable long-term dollar inflows. Increasing FPI limits in government securities also broadens dollar supply by inviting more foreign bond investors.

Static: J-Curve Effect & Marshall-Lerner Condition

J-Curve Effect

When a currency depreciates, the trade balance worsens initially before improving — the trajectory looks like the letter “J”
Short run: Import contracts are pre-fixed in dollars — India still pays same dollar amount, but now costs more in rupees. Export volumes have not yet adjusted to the new competitive prices
Long run: Exporters gain market share due to price competitiveness; importers shift to cheaper domestic substitutes — trade balance improves
Lag is typically 6–18 months for India — meaning RBI must sustain intervention during the J-curve adjustment phase

Marshall-Lerner Condition

States that currency depreciation will improve the trade balance only if the sum of price elasticities of demand for exports and imports exceeds 1 (|PEDx| + |PEDm| > 1)
If exports and imports are price inelastic (e.g., essential crude oil imports which India cannot easily replace), depreciation widens the deficit
India’s crude oil imports are highly inelastic — making rupee depreciation less effective at reducing the trade deficit compared to countries with diversified import baskets
India’s IT service exports are highly elastic — a weaker rupee significantly boosts their dollar-revenue conversion

Critical Perspectives on Rupee Management

Case for Allowing Gradual Depreciation

A weaker rupee boosts export competitiveness — India’s IT, pharma, and textiles sectors gain global market share as Indian costs become cheaper in dollar terms
Defending a specific exchange rate depletes reserves unnecessarily — the $690B war chest is better preserved for genuine crises rather than routine currency management
Natural adjustment mechanism — a depreciating currency reduces imports (by making them costlier) and boosts exports, eventually restoring BoP equilibrium without central bank intervention
Over-intervention creates moral hazard — importers delay hedging if they expect RBI to always support the rupee

Case for RBI Intervention to Curb Depreciation

Imported inflation — uncontrolled depreciation raises oil/fertiliser/capital goods prices, eroding real wages of the poor and triggering a cost-push inflation spiral
Debt servicing burden — Indian companies with $250+ billion in dollar-denominated ECBs face rising rupee costs for repayments, risking corporate distress
Investor confidence — a freely falling rupee signals macroeconomic instability, deterring FDI inflows India desperately needs for its manufacturing push
Speculative self-fulfilling depreciation is dangerous — panic-driven capital flight can crash a currency far below its fundamental value, as seen in Asia’s 1997 currency crisis

India’s Structural Vulnerabilities in External Sector

Chronic Weaknesses

Oil import dependence — India imports ~85% of crude needs (~$150–180 billion/year); every crude price spike directly pressures the rupee and CAD
Gold imports — India imports 700–800 tonnes annually (~$40–50 billion/year); cultural demand is price-inelastic, making this a persistent CAD driver
Electronics imports — India remains a net importer of semiconductors, telecom equipment, and consumer electronics despite PLI push — a structural deficit driver
Volatile FPI capital — unlike FDI, FPI can exit within seconds; India’s reliance on FPI to fund CAD makes it structurally vulnerable to global risk-off episodes

India’s External Sector Strengths

Services surplus — India’s IT/BPO services export (~$280B in FY25) provide a large, stable dollar inflow that partially offsets merchandise deficit
Remittances — World’s largest recipient at ~$125B in FY25; NRI remittances are highly stable even during crises — unlike FPI flows
$690B forex reserves — among the world’s largest; provides ~10.5 months of import cover; acts as a shock absorber for currency volatility
RBI’s forward book ($65B) — additional future dollar supply committed in forwards, effectively extending India’s currency defence capacity beyond spot reserves

Way Forward

Reduce oil import dependence: Accelerating domestic renewable energy transition — solar, wind, green hydrogen — directly reduces India’s crude import bill, the single biggest structural driver of rupee weakness. Every 1% reduction in oil import saves ~$1.5–2 billion in dollar outflows annually.
Deepen export diversification: Rupee stability requires a broader export base beyond IT services. PLI schemes for electronics, semiconductors, and specialty chemicals must be urgently scaled — shifting India from a net electronics importer to exporter reduces CAD structurally.
Rupee internationalisation: Promoting trade invoicing in INR — already begun with 22 countries including Russia and UAE — reduces India’s dollar dependency for trade payments. Expanding INR-settled trade reduces the demand-supply pressure on dollar-rupee pair.
Attract stable long-term capital: FPI flows are the most volatile component of India’s capital account. Policy must favour FDI over FPI — simplifying FDI approvals, reducing repatriation restrictions, and deepening India’s manufacturing ecosystem to attract anchor investors who don’t flee at the first global shock.
Corporate hedging mandate: RBI should mandate minimum hedging ratios for large ECB borrowers — reducing the systemic risk from unhedged foreign currency exposure that amplifies rupee pressure during depreciation episodes.
Fiscal consolidation: A lower fiscal deficit reduces government borrowing, curbs inflationary pressure, and signals macroeconomic discipline to foreign investors — reducing the risk premium demanded on Indian assets and attracting more stable capital inflows that underpin a stronger rupee.

Prelims Practice Question

Consider the following statements regarding India’s exchange rate management and Balance of Payments:

1. India follows a fixed exchange rate system where the RBI pegs the rupee to the US dollar at a predetermined level.
2. The Real Effective Exchange Rate (REER) adjusts the Nominal Effective Exchange Rate (NEER) for inflation differentials between India and its trading partners.
3. Under the Marshall-Lerner condition, currency depreciation improves the trade balance only if the combined price elasticity of demand for exports and imports exceeds unity (1).
4. India’s current account has been fully convertible since 1994, while the capital account remains only partially convertible.

Which of the statements given above are correct?

(A) 1, 2 and 3 only
(B) 2 and 3 only
(C) 2, 3 and 4 only
(D) 1, 3 and 4 only

✅ Correct Answer: (C) — 2, 3 and 4 only

Statement 1 — INCORRECT: India does NOT follow a fixed exchange rate. Since the 1991 liberalisation and the 1993 shift to market-determined rates, India has followed a managed float (dirty float) system — market forces determine the exchange rate, but RBI intervenes to prevent excessive/disruptive volatility. India does not target or peg to any specific exchange rate level — as confirmed repeatedly by RBI governors including Sanjay Malhotra in May 2026.

Statement 2 — CORRECT: REER = NEER adjusted for inflation differentials. If India’s inflation is higher than its trading partners, the REER rises (rupee becomes less competitive) even if the nominal rate stays stable. India’s REER fell ~9.9% in 2025–26 — showing the rupee’s real purchasing power erosion beyond just nominal depreciation.

Statement 3 — CORRECT: The Marshall-Lerner Condition states that depreciation improves the trade balance only when |PEDexports| + |PEDimports| > 1. India’s case is complicated because crude oil imports are highly price-inelastic — meaning rupee depreciation may not reduce import volumes enough to improve the trade balance in the short run.

Statement 4 — CORRECT: India moved to full current account convertibility in 1994 — allowing free conversion of rupees for trade in goods and services, remittances, and income. However, the capital account (FDI, FPI, ECBs) remains partially convertible — RBI retains the power to impose limits and controls to prevent destabilising capital flows. Full capital account convertibility (recommended by the Tarapore Committee I & II) has not been implemented.

Mains Practice Questions

“India’s persistent Current Account Deficit and reliance on volatile portfolio capital make the rupee structurally vulnerable to global shocks.” Critically examine the causes of the recent rupee depreciation, RBI’s tools and the limits of monetary intervention, and suggest structural reforms needed to ensure long-term exchange rate stability. (15 M)