4 min readJul 28, 2026 04:28 PM IST
First published on: Jul 28, 2026 at 04:28 PM IST
The Reserve Bank of India finds itself caught between the challenges of managing inflationary pressures and the sharp depreciation of the rupee. With the bank formally committed to maintaining price stability, the options before it are regulatory tweaks to capital inflows.
The Indian rupee is not an outlier, as the dollar has broadly appreciated against a range of currencies. The Indonesian rupiah, Japanese yen and Korean won are among the currencies that have depreciated since the beginning of the war. The exchange rate matters primarily because 45.8 per cent of India’s GDP is attributable to trade in goods and services, which means the shocks from the external account percolate to domestic growth.
The movements in the exchange rate are driven by net capital flows, and more specifically portfolio flows. These flows are sensitive to relative rates of return in India and the US. The benchmark risk-free return of government yields in India exceeded those in the US for a long time and has converged swiftly since 2025. Even though India’s financial reputation improved after S&P upgraded its sovereign rating, global investors became more risk-averse and preferred to put their money in the United States, which they regarded as a safer destination. This compounded the shocks from trade frictions, making it difficult for the RBI to stand still as foreign exchange reserves depleted in May and June.
The RBI’s intervention in the rupee market has been strategic. It has refrained from committing to a price and has stepped in to manage the volatility in the exchange rate. Despite being more volatile than the yen, won and baht over the 2021-25 period, the rupee has remained relatively stable in 2026.
The closest comparable event is the taper tantrum in 2013 when the RBI adopted a more proactive stance, including liberalising the rules around foreign currency non-resident (FCNR) deposits. This time, the RBI has taken more steps to ensure inflows by bearing almost all costs of hedging for these deposits, as the interest and principal are payable in foreign currency. It is no surprise that foreign investors and banks have been keen to utilise the scheme. It has reportedly drawn inflows of $17.4 billion in early months as against $26 billion over the entire duration in 2013.
The question before the RBI is whether this is enough to set off the outflows by portfolio investment and the impact when these deposits mature over two or three years. In 2016, there was a sizable retreat of FCNR deposits, and it is possible that in three years the reversals can have an impact on the rupee.
The RBI has also opened up further foreign investments in government securities through the inclusion of more long-term debt under the more fully accessible route. Fiscal relief like the capital gains and withholding tax exemptions make these more attractive. FPIs purchased debt worth Rs 21,652 crore under FAR in June that dissipated in July. Yet again, the impact of moves over the long run cannot be gauged as there are a lot of moving parts globally.
The RBI’s interventions in the forex market have also been calibrated through forward contracts, and interestingly, it has turned a net seller of dollars since October 2023. With significant build-up of these contracts, markets have interpreted this as a weak outlook for the rupee. More so, the RBI’s response to address the impact of speculative forces in the non-deliverable forwards for the rupee by limiting domestic participation in these markets was perceived unfavourably.
A more fundamental question confronts the RBI: Should it pursue more permanent capital account openness akin to countries like Korea or guard the rupee through controls?
The writer is associate professor, NIPFP
