Context:

• The Reserve Bank of India (RBI) is navigating a complex macroeconomic environment marked by persistent inflationary pressures, a strengthening US dollar, portfolio capital outflows, and depreciation of the rupee.
• While its primary mandate remains price stability under the inflation-targeting framework, it has adopted calibrated measures to stabilise the foreign exchange market by encouraging capital inflows and managing exchange rate volatility.

Why the Rupee Matters?

• India is a highly open economy, with trade in goods and services accounting for 45.8% of GDP.
• Exchange rate movements directly affect import costs (especially crude oil and fertilisers), inflation, export competitiveness, external debt servicing and overall economic growth.
• The rupee’s depreciation is part of a broader global trend, as currencies such as the Japanese yen, Indonesian rupiah and South Korean won have also weakened against the strengthening US dollar. 

Drivers of Rupee Depreciation:

• Portfolio capital outflows:
  • Exchange rate movements are largely influenced by net capital flows, particularly Foreign Portfolio Investment (FPI).
  • Since 2025, the interest rate differential between Indian and US government securities has narrowed, reducing India's attractiveness for global investors.
• Global risk aversion:
  • Despite India's improved sovereign credit profile following the S&P sovereign rating upgrade, investors shifted towards US assets due to heightened global uncertainty and trade tensions.
  • This "flight to safety" intensified pressure on the rupee and reduced India's foreign exchange reserves during May–June.

RBI’s Strategy - Managing Volatility, Not a Fixed Exchange Rate:

• Rather than defending a particular exchange rate, the RBI has -
  • Intervened selectively to reduce excessive volatility.
  • Avoided committing to a fixed value of the rupee.
  • Ensured that despite higher volatility during 2021–25, the rupee has remained relatively stable in 2026 compared to several Asian currencies.
• This reflects India's managed float exchange rate regime.

Measures to Attract Capital Inflows:

• Revival of FCNR(B) deposits: Drawing lessons from the 2013 Taper Tantrum, the RBI has liberalised Foreign Currency Non-Resident [FCNR(B)] deposits by:
  • Absorbing most hedging costs,
  • Making deposits more attractive for banks and overseas investors.
• Outcome: Around USD 17.4 billion flowed in during the initial months. By comparison, the 2013 scheme mobilised USD 26 billion over its entire duration.
• Concerns:
  • FCNR(B) deposits are temporary liabilities.
  • Large-scale withdrawals at maturity (2–3 years) could recreate pressure on the rupee, as witnessed during 2016.

Encouraging Foreign Investment in Government Securities:

• The RBI has expanded investment avenues by -
  • Including more long-term government securities under the Fully Accessible Route (FAR).
  • Supporting fiscal incentives such as capital gains tax exemptions, and withholding tax concessions.
• Recent trends:
  • FPIs purchased government securities worth ₹21,652 crore under FAR in June.
  • However, inflows weakened in July, highlighting the uncertain nature of global capital movements.

Forex Market Operations:

• The RBI has also relied on forward contracts for calibrated intervention. Since October 2023, it has become a net seller of US dollars in the forward market.
• Market perception:
  • The build-up of forward positions has been interpreted as signalling a weaker outlook for the rupee.
  • Restrictions on domestic participation in Non-Deliverable Forward (NDF) markets to curb speculation were viewed negatively by market participants.

The Structural Policy Debate:

• A larger policy question remains unresolved -
  • Option 1 - Greater capital account openness: Liberalise capital flows similar to economies such as South Korea. Benefits - Deeper financial markets, higher foreign investment, and better liquidity.
  • Option 2 - Maintain capital controls: Retain safeguards against volatile capital movements. Benefits - Protect financial stability, reduce vulnerability to sudden capital flight, and preserve monetary policy autonomy.
• The RBI must balance these competing objectives while ensuring macroeconomic stability.

Key Challenges Ahead:

• Sustaining foreign capital inflows amid global uncertainty.
• Managing depreciation without exhausting foreign exchange reserves.
• Preventing inflation arising from imported commodities.
• Addressing risks associated with the eventual maturity of FCNR(B) deposits.
• Balancing exchange rate stability with an independent monetary policy.

Conclusion:

• The RBI should pursue a calibrated mix of prudent monetary policy, diversified and stable long-term capital inflows, adequate foreign exchange reserve buffers, and gradual capital account liberalisation while strengthening domestic financial markets.
• Simultaneously, structural reforms to enhance export competitiveness, improve external sector resilience, and reduce dependence on volatile portfolio flows will be crucial for ensuring a durable exchange rate and macroeconomic stability.