The rupee confronts an external shock: for the optimal response, here’s what policymakers should do

We cannot ignore capital flows in a world dominated by these. What intrigues many people today is why the rupee is under pressure at a time when the Indian economy’s fundamentals are sound. In a world where purchasing-power-parity theory holds, exchange rates ought to reflect economic fundamentals. But that is not so when capital flows dominate.

To be sure, these flows do reflect the fundamentals in the medium- to long-term, but not necessarily in the short-term, especially when FPI flows are in play. In the current situation, a sense of trepidation appears to have driven capital outflows. China seems to have fared better despite its GDP growth slowing.

Its decline in exports to the US has been compensated by increased exports to the rest of the world. But in the case of India, such export diversification appears to be modest. While our trade surplus with the US narrowed by about $6.5 billion in 2025-26, it has not resulted in any significant reduction in deficits with West Asia and other markets.

What should be our response?

The first is purely diplomatic. The war should be brought to a close soon. In such an event, the value of the rupee could recover quickly. However, over the medium-term, we should build buffers so that we can handle such situations for extended periods. Buffer stocks for essential items such as food, fuel (including gas) and fertilizers should be the focus. The alternative energy mix that India has adopted recently is another step in the direction.

Second, we should work on altering the perceptions of foreign portfolio investors and draw their attention to domestic fundamentals. Recent reports by the International Monetary Fund and World Bank project India’s economic growth in 2026-27 at 6.5% and 6.6%, respectively. Since recent FPI outflows may not reflect structural weaknesses in India’s economy, they could be transitory. However, the risk that it has exposed India’s external account to is real; both the current account deficit and rupee are currently under strain.

As the current rupee shock is largely exogenous, it can change only if peace is restored. In 2025-26, the tariff impact was limited, as it covered only half the year. But if supply disruptions of the ongoing war continue, we must be prepared for a tougher situation.

Domestic prices of petroleum products, which are being raised gradually, must be adjusted to the fullest extent of the global crude-oil price increase. A reduction in the consumption of such products is necessary. By reducing excise duty, the government has absorbed the oil shock to a major extent. But it should pass on the full impact of the shock to fuel consumers. Shielding them will widen the fiscal deficit, worsening the effects of its monetization, and must therefore be avoided.

Another concern raised is that the rupee has suffered a sharper drop than other currencies (Japan’s yen weakened by 9.4% against the dollar, China’s yuan by 5.5%, Indonesia’s rupiah by 5% and South Korea’s won by 5.5%).

We have already identified capital outflows as a major reason as far as India is concerned. This may be true for other some countries too, though to a less extent. But the global perception may be that India is overly vulnerable to the oil shock, as 80% of our crude oil requirement is imported.

The Reserve Bank of India (RBI) appears to face a sort of ‘impossible trinity’ problem.

So far, RBI has let the rupee fall smoothly through intervention aimed at reducing volatility. Today’s economic situation has been aggravated by non-economic factors. So, as long as the Strait of Hormuz is blocked for geopolitical reasons, a crude oil and gas scarcity will probably keep their prices high.

India’s forex reserves are not useful if hydrocarbon supply is the constraint. We must continue the present policy and let the rupee find its market level. However, we do not think that India will gain much because of the rupee’s depreciation. True, exporters will gain in rupee terms in the short-term, but our export volumes are unlikely to expand. Exports with high import content, for example, will see costs rise, which will limit the price edge in export markets.

Meanwhile, if the war continues, India’s production system itself could be affected. We should explore the possibility of getting crude oil and gas from sources other than West Asia. While this war holds out many lessons on crafting a medium-term strategy, we need gas and crude oil at the earliest.

India’s options at the moment are very limited. A rise in inflation is inevitable. The current account deficit will also increase. We have solid forex reserves. But the fiscal situation needs to be kept under watch. The government must resist the temptation to absorb the oil shock, even though this may be difficult.

As for monetary policy, authorities will face more than inflation as challenge. As US bond yields rise, India’s FPI flows may get hit. If there is no relief from uncertainties and war disruptions, policymakers must be prepared to raise the policy rate of interest.

The authors are, respectively, former chairman, Economic Advisory Council to the Prime Minister, and former governor, RBI; and director, Madras School of Economics.