Here are four significant economic distortions that India must sort out to shield its economy

As pointed out in our 2025-26 Year End Macroeconomic Review (NIPFP Policy Brief 49, May 2026), this was mainly on account of RBI interventions. Till February 2026, RBI had net sold $43 billion in the spot market in 2025-26. It further net sold foreign exchange of $18 billion during March and April 2026.

But interventions in the spot and forward markets are not working. The rupee started depreciating after US President Donald Trump’s announcement of punitive tariffs on 2 April 2025 and this decline accelerated after the Iran war that broke out on 28 February.

Meanwhile, the outflow of foreign capital continues. Net foreign portfolio investment (FPI), especially equity investment, has been negative in most months since October 2024. Net foreign direct investment (FDI) has also been negative in most months since July 2024. The dollar premium in the forward market indicates that the market expects the rupee to depreciate further.

Most professionals agree that rupee depreciation is being driven mainly by capital outflows and not the trade deficit. They also agree that instead of RBI depleting limited forex reserves, the rupee should be allowed to drop to its market clearing level (for example, C. Rangarajan and N.R. Bhanumurthy, Mint, 25 May).

This would also help reduce the current account deficit by reducing imports and increasing exports. However, if perverse expectations prevail, the dollar premium may persist. Sajjid Chinoy has suggested that RBI should buy dollars, even at a premium, to augment forex reserves (Indian Express, 25 May). This could, hopefully, kill perverse expectations and arrest rupee depreciation.

Such dollar purchases would add to existing surplus liquidity, so RBI would need to sterilize excess liquidity through open market operations. This would further raise bond yields, which have been rising due to the excess supply of government debt.

An increase in the repo rate, held constant for a long time, would add a tailwind to this process. This would help contain if not reverse the outflow of foreign capital. Such tightening of monetary policy would also contain the second-round effect of cost-push inflation driven by supply-side disruptions.

The third area requiring urgent policy reversal is the blocked pass-through of global fuel and fertilizer price increases. By April 2026, the price of Brent crude had spiked by nearly 78% year-on-year.

Prices of LPG and LNG had also risen sharply. But the ‘oil and gas’ basket in the consumer price index increased by only 0.11% (NIPFP Policy Brief 49). These prices are administered and the government blocked the pass through to retail prices until recently, with the delay possibly on account of elections in several states.

This has entailed huge losses for oil marketing companies, which will be passed on to the government in some form sooner or later. The same applies to fertilizers.

By way of illustration, India has been buying urea at $935 per tonne but selling it to farmers at only $70 per tonne, a mind-boggling subsidy of $865 per tonne (A. Gulati and R. Juneja, Indian Express 25 May).

The government is already off its fiscal consolidation path (NIPFP Policy Brief 49). The huge increase in the fuel and fertilizer subsidy burden will knock the government further off this path.

Besides, such massive subsidies encourage diversion of supplies to the black market.

The government has started passing on fuel import price increases gradually, but not yet for fertilizers. A full pass- through of the increase in import prices of both to consumers is urgent not only to contain demand, but also contain the damage to government finances. Vulnerable consumer groups can be protected through direct transfers.

The final area requiring immediate policy action is trade diversification. The high share of fuel and fertilizer imports from the Gulf region makes India particularly vulnerable to the Hormuz blockade. Efforts to diversify imports to alternative Gulf routes and non-Gulf sources like Russia, Africa and South and North America need to be scaled up on an urgent basis.

On the export side, India is overly exposed to the US not just for goods exports, but more importantly the export of services, especially IT-enabled services. To reduce that exposure, legal impediments to exports to the EU, UK and other trade-agreement partners need to be urgently addressed.

Quick reversals of the policy distortions highlighted above should enable India to weather the storm and position itself for more longer-term structural reforms and an eventual return to a high-growth path.

These are the author’s personal views.

The author is chairman, Centre for Development Studies.