[Answered] Analyze the role of economic diplomacy in mitigating currency volatility. Evaluate whether a strategic Indo-US understanding is essential to curb persistent capital outflows and stabilize the rupee in an era where global finance is increasingly tethered to geopolitics.

Introduction

Despite robust macro-fundamentals—7.4% growth, low inflation, and a modest current account deficit—the rupee’s 6% fall in 2025 highlights how geopolitics, not economics alone, now drives currency volatility.”

Economic Diplomacy and Currency Stability: From Monetary Economics to Geopolitical Finance

1. Traditionally, exchange rates responded to inflation differentials, trade balances, and interest rates.
2. However, in a fragmented global order marked by weaponised tariffs, sanctions, and financial coercion, currencies increasingly reflect geopolitical risk premia.
3. The IMF (2023) notes that capital flows to emerging markets are now more sensitive to political alignment than domestic fundamentals.

Capital Outflows as the Core Driver of Rupee Depreciation

1. The Capital Account Shock: India’s trade deficit, at $96.6 billion (April–December 2025), remains manageable. The real stress originates from the capital account: net capital inflows swung from +$10.6 billion (2024) to –$3.9 billion (2025). This reversal coincided with U.S. tariff escalation against India, underscoring the non-economic origins of capital flight.
2. Risk Perception and the ‘Flight to Safety’: Heightened Indo-U.S. tensions have raised India’s perceived country risk, prompting Foreign Portfolio Investors (FPIs) to rebalance towards U.S. Treasuries amid high yields. Such “sudden stops,” as described by Calvo, are self-reinforcing—currency depreciation fuels further outflows, weakening both equity markets and investor confidence.

Economic Diplomacy as a Monetary Stabiliser

1. Tariffs as Geoeconomic Weapons: The imposition of 50% U.S. tariffs on Indian exports—linked to Russia and Iran trade—illustrates how trade policy is now embedded in strategic rivalry. In such a context, RBI intervention via forex reserves can only smooth volatility, not reverse sentiment-driven capital exits.
2. Strategic Indo-US Understanding: A diplomatic rapprochement could restore investor confidence by lowering policy uncertainty. Historical precedents—such as the 1991 balance of payments crisis, where IMF support followed diplomatic engagement—demonstrate that external confidence hinges on political credibility as much as economic reform.
3. Transforming ‘Hot Money’ into ‘Patient Capital’: Through frameworks like iCET and friend-shoring, diplomacy can redirect volatile FPI flows into stable FDI in semiconductors, defence, and green energy. Such capital is less sensitive to short-term shocks, strengthening the rupee’s medium-term fundamentals.

Limits of Diplomacy: The Economic Reality Check

1. Preserving Monetary Sovereignty: Over-reliance on diplomatic alignment risks constraining India’s strategic autonomy. As Raghuram Rajan argues, credibility ultimately rests on domestic macro-discipline—fiscal prudence, inflation control, and productivity growth.
2. Why Devaluation Is Not the Answer: Competitive devaluation offers limited export gains due to high import content and U.S. tariff barriers, while raising import-led inflation—especially in crude oil, which forms 25% of India’s merchandise imports. REER stability, not nominal depreciation, remains the appropriate benchmark.

Way Forward: A Diplomatic–Macroeconomic Hybrid

Financial Diplomacy Instruments: Inclusion in global bond indices, currency swap arrangements, and a dedicated Rupee-Dollar dialogue within the 2+2 framework can anchor expectations and dampen speculative pressures.

RBI’s Complementary Role: The RBI must continue asymmetric intervention to smooth shocks, while transparently clarifying its interpretation of ‘volatility management’ in an era of non-economic pressures.

Conclusion

Echoing Dr. Manmohan Singh, economic strength now demands diplomacy—without it, even sound fundamentals cannot anchor the rupee.