The Solution To The Falling Rupee Lies in Diplomacy

The recent decline in the value of the rupee has unsettled markets and citizens because it has occurred despite strong economic indicators such as high growth, low inflation, and a modest current account deficit (CAD). This has raised concerns about the underlying causes of the currency’s weakness.

Strong Macroeconomic Fundamentals

• High Economic Growth: India’s GDP growth for the current year is estimated at 7.4%, indicating a resilient economy.
• Low Inflation Environment: CPI inflation declined to 1.33% by end-2025, remaining below the RBI’s lower tolerance band for the fourth consecutive month.
• Manageable External Balance: The current account deficit in the first half of 2025–26 stood at 0.76% of GDP, lower than 1.35% in the previous year.
• Unexpected Currency Movement: Despite these favourable macroeconomic fundamentals, the rupee depreciated by about 6% since April 2025.

Capital Outflows as the Main Cause

• Limited Role of Trade Deficit: The combined merchandise and services trade deficit rose to $96.58 billion during April–December 2025 from $88.43 billion a year earlier, which is not large enough to explain the sharp depreciation.
• Reversal of Capital Flows: Net capital inflows of $10.6 billion in April–December 2024 turned into net outflows of about $3.9 billion during the same period in 2025.
• Sustained Capital Exit: Continuous portfolio capital outflows have placed persistent downward pressure on the rupee.

Impact of U.S. Trade Actions

• Escalation of Tariffs: The United States imposed a 25% reciprocal tariff on Indian exports and an additional 25% tariff linked to India’s Russian crude oil imports.
• Further Tariff Threats: The U.S. has threatened another 25% tariff on countries trading with Iran, including India, even though such trade accounts for only 0.15% of India’s total trade.
• Unresolved Negotiations: Despite prolonged India–U.S. trade negotiations, no agreement has been reached, sustaining policy uncertainty and capital outflows.

Shift from Economic to Diplomatic Pressures

• Contrast with 2022 Depreciation: In 2022, the rupee’s nearly 10% depreciation was driven by U.S. Federal Reserve interest rate hikes and global monetary tightening.
• Absence of Economic Triggers in 2025: The current depreciation lacks a clear economic explanation, with stable inflation, growth, and external balances.
• Geopolitical Uncertainty: The rupee is now being affected by investor fears arising from a perceived hostile U.S. trade stance, shifting the issue from economics to diplomacy.

RBI’s Role in Managing Volatility

• Market-Determined Exchange Rate Regime: Since 1993, India has followed a flexible exchange rate system allowing RBI intervention.
• Objective of Intervention: The RBI does not aim to peg the rupee, but seeks to reduce volatility in the foreign exchange market.
• Moderating Sharp Depreciation: In practice, reducing volatility has included moderating the pace of rupee depreciation to limit the costs of sudden shocks.
• Limits of Monetary Action: The RBI cannot prevent depreciation driven by non-economic pressures and can only smoothen the adjustment.

Why Devaluation Is Not a Solution

• Rising Import Content of Exports: Increasing import intensity of exports weakens the competitiveness gains from devaluation.
• Tariff-Constrained Export Markets: High U.S. tariffs limit export expansion even with a weaker currency.
• Inflationary Impact on Imports: A weaker rupee raises the cost of essential imports, particularly crude oil, which accounts for about 25% of merchandise imports.
• No Inflation Differential: India’s inflation is not significantly higher than that of advanced economies, reducing the case for adjustment through the Real Effective Exchange Rate (REER).
• Currency Manipulation Concerns: Deliberate undervaluation of the rupee would invite charges of currency manipulation.

Check Out UPSC CSE Books

Visit PW Store

Risks from Continued Capital Outflows

• Self-Reinforcing Depreciation Cycle: Each fall in the rupee can accelerate capital outflows.
• Higher Investor Return Expectations: Depreciation raises the rupee-denominated returns demanded by foreign investors.
• Equity Market Spillovers: Capital outflows through stock market sales directly impact domestic equity markets.

Conclusion

The recent depreciation of the rupee is primarily driven by capital outflows caused by geopolitical uncertainty, rather than economic weakness. While the RBI can manage volatility, a durable stabilisation of the currency depends on an early diplomatic understanding between India and the United States.

DOWNLOAD PDF