Why in news?

Recently, the Reserve Bank of India sold large amounts of US dollars, boosting dollar supply and leading to a nearly 1% appreciation of the rupee. However, despite this intervention, the rupee has generally been weakening against the dollar over recent months.

What’s in Today’s Article?

• A Year of Persistent Rupee Weakness
• Why the Rupee Is Weakening Despite Global Currency Strength
• Key Determinants of the Rupee’s Movement

A Year of Persistent Rupee Weakness

• Despite the intervention, the broader trend over recent months has been rupee depreciation.
• Over the past year, the rupee has lost nearly 6% of its value against the US dollar, indicating sustained pressure on the Indian currency.
• Why the Weakness Is Puzzling?
  • Strong Domestic Fundamentals - On paper, the rupee should have strengthened. India remains the fastest-growing major economy, inflation is under control, and external sector indicators such as trade deficit and external debt are relatively stable.
  • Weakening Despite a Soft Dollar - Earlier, the rupee’s fall could be attributed to a globally strong dollar, as other currencies were also depreciating. However, in recent months, the dollar itself has weakened, yet the rupee has continued to slide.
  • Clear Signs of Currency Pressure - The rupee’s depreciation even during phases of dollar weakness removes the argument that global factors alone are responsible. This points to specific pressures on the Indian currency, underlining deeper challenges beyond temporary market interventions.

Why the Rupee Is Weakening Despite Global Currency Strength?

• The rupee’s depreciation stands out at a time when most major and emerging-market currencies are strengthening.
• Multiple economic and financial factors explain this divergence.
• Persistent Trade Deficit Pressures - India continues to import more than it exports in value terms. Higher imports raise demand for US dollars relative to the rupee, pushing down the rupee’s exchange rate.
• Impact of High US Tariffs on Indian Exports - The US has imposed some of the highest tariffs on Indian goods, making them less competitive abroad. Reduced export demand lowers demand for rupees, further weakening the currency.
• Uncertainty Over the India–US Trade Deal - The prolonged uncertainty surrounding the India–US trade agreement, despite official optimism of resolution in 3–4 months, discourages investors. Diplomatic tensions that triggered punitive tariffs amplify this risk aversion.
• Weak Capital Inflows and Investor Apathy - Global investors have largely avoided Indian markets in favour of others. Data show strong gains elsewhere—US indices up 17–23%, China 16–27%, Japan 22–27%, FTSE 18%, Euro area 16%, Hong Kong 27%, Korea 72%—while India’s Sensex rose only about 8%.
  • This suggests investors view Indian equities as either overvalued or less profitable compared to global peers.
• Role of RBI’s Forex Interventions - The Reserve Bank of India’s buying and selling of dollars significantly influences the rupee’s exchange rate. Such interventions can affect currency movements independent of underlying macroeconomic fundamentals.

Key Determinants of the Rupee’s Movement

• A recent Bank of Baroda (BoB) study examined the key factors influencing the rupee’s exchange rate using monthly data from October 2020 to November 2025.
• The study found that three factors explain most of the rupee’s exchange rate fluctuations:
  • RBI’s Spot Market Intervention
    • Direct buying or selling of dollars by the RBI affects short-term currency movements.
    • However, its impact is less significant than forward market operations.
  • RBI’s Position in Forward Contracts
    • Changes in the RBI’s forward dollar positions play a more influential role than spot interventions.
    • Forward market intervention sends a strong signal to markets, making it a more effective tool when the rupee is under pressure.
  • Foreign Portfolio Investment (FPI) Flows
    • In the immediate term, FPI inflows or outflows are a major driver of the rupee’s movement.
    • Investor sentiment and capital flows significantly affect exchange rate dynamics.
• Why Trade Deficit Matters Less Than Expected?
• Surprisingly, the trade deficit showed little direct impact on short-term rupee movements.
• This is because trade data reflect accounting entries rather than actual dollar flows in the same period.
• Exporters are allowed to retain dollar earnings overseas for a stipulated time before repatriation, weakening the immediate link with exchange rates.
• Limits of Economic Variables
  • No single factor explained more than 13–14% of the total variation in the rupee’s exchange rate.
  • This indicates that non-economic factors—such as market psychology, geopolitical developments, and policy signals—also play a significant role.
  • While RBI interventions and forward positions matter, foreign portfolio flows dominate short-term rupee movements, and exchange rates are influenced by factors beyond traditional economic fundamentals.