The solution to the falling rupee lies in diplomacy

UPSC GS-3: Indian Economy

Introduction

The recent fall in the value of the rupee has unsettled people and markets. This decline appears unusual because India’s economy is performing well, with strong growth, low inflation, and a manageable current account deficit. The situation has raised concerns about the real causes behind the rupee’s weakness and whether economic tools alone can address the problem.

India’s Macroeconomic Fundamentals

1. Strong economic growth: India’s growth rate for the current year is estimated at 7.4%, showing stable economic expansion.
2. Low inflation environment: CPI inflation ended 2025 at 1.33%, remaining below the RBI’s lower target band for four consecutive months.
3. Comfortable 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.
4. Contradiction in currency movement: Despite strong indicators, the rupee has fallen by nearly 6% since April 2025, creating confusion in the markets.

Reason for Rupee Depreciation

1. Trade deficit not the main reason: The combined merchandise and services trade deficit rose from $88.43 billion to $96.58 billion, which is not large enough to trigger sharp depreciation.
2. Capital outflows as the core issue: The major reason behind the rupee fall is persistent capital outflows rather than trade imbalance. For example, net capital inflows of $10,615 million in April–December 2024 turned into a net outflow of $3,900 million during the same period in 2025.
3. Impact of U.S. tariff actions:

The U.S. imposed a 25% reciprocal tariff on Indian exports and an additional 25% tariff due to India’s crude oil imports from Russia.

4. Threat of further tariffs: The U.S. has warned of another 25% tariff on countries trading with Iran, even though such trade forms only 0.15% of India’s total trade.
5. Unresolved trade negotiations: Despite months of discussions, no agreement has been reached between India and the U.S., increasing market uncertainty.
6. Strengthening of USA Dollar: Despite the US Fed Reserve beginning its rate-cut cycle, the US Dollar has maintained persistent strength, reflecting its status as global reserve currency & a safe haven asset during a period of geopolitical uncertainty. Strengthening of US dollar against major currencies puts pressure on INR.
7. High Crude Oil Demand & Import Bill: India imports almost 80-85% of its crude oil. The rise in the crude oil prices & that of the important commodities imported by India like gold – lead to widening of India’s trade deficit & weakening of INR.
8. Monetary Policy Factors:

• Unfavourable Interest Rate Differentials: Even though the US Fed Reserve has begun its rate-cut cycle at a modest rate (e.g. 25 basis point cut in the late 2025), the cumulative interest rate differential remains attractive for the US Dollar relative to Rupee’s real yield – driving the capital away from India.
• RBI’s Stance: The RBI has chosen a Neutral Policy Stance & kept the repo rate unchanged for most part of the year 2025 – prioritizing domestic liquidity management & growth oven an aggressive defense of the Rupee.

Impacts of Rupee Depreciation

1. Impact on Consumers:
2. Inflationary Pressure: As the INR weakens, the Oil Marketing Cos. have to pay more Rupees for the same barrel of oil. This increased cost is eventually passed on to the consumers through higher prices for petrol, diesel, and natural gas. This high fuel cost then triggers a cascading effect – contributing to broader consumer price inflation.
3. Cost of Goods: The price of other key imports, such as electronics, gold, industrial chemicals, and fertilisers, also rise – intensifying the inflationary pressure & eroding the purchasing power & savings of the average household.
4. Foreign Travel & Education: Foreign travel & education will become significantly expensive.
5. Impact on Trade (Imports/Exports):
6. The WINNERS:

• Increased Competitiveness: A weaker rupee makes the Indian goods & services cheaper for foreign buyers who pay in Dollars. This can boost the competitiveness of Indian exports in global market.
• High Profitability for Exporters: Indian exporters, particularly the IT Service Sector, benefit significantly. Weakening of the INR directly boosts their profit margin & revenue growth.
• Boost to Domestic Investment: Rise in export revenue can lead to increased domestic investment as exporters look to expand capacity to meet the higher demand.

1. The LOSERS

• Higher Import Bill: Weakening of the Rupee against Dollar puts upward pressure on the net import bill.
• Wider Trade Deficit: The cost of essential imports outweighs the revenue gain from exports. A significant rise in import bill can lead to a widening of the Trade deficit.

3. Impact on Corporates (External Debt):
4. Increase in Debt Servicing Cost: The Indian Corporates who have taken ECBs denominated in USD & have not fully hedged their exposure, face a major risk. A weaker rupee means that a company has to pay more amount of INR for the USD-denominated debt.
5. Divergent Fortunes: The corporate sector witnesses a divergence – while the export-oriented cos. see higher profits, the import-dependent cos. & highly indebted cos. face significant financial strain.
6. Macroeconomic Impact:
7. Forex Reserves Drawdown: The RBI often intervenes (spot intervention) in the forex market to prevent excessive depreciation of the Rupee. The RBI sells USD to absorb the excessive Rupee liquidity. However, it leads to reduction in the national reserve buffer.
8. Capital Flight: Withdrawal of funds by FIIs is one the causes for the weakening of the INR. If the Rupee continues to weaken, it could signal greater macroeconomic instability which may increase the rate of capital flight from India – creating a self-perpetuating cycle of depreciation.

RBI Intervention and Exchange Rate Management

1. Market-based regime: India shifted to a market-determined exchange rate system in 1993, where the value of the rupee is decided by market forces.
2. Scope for intervention: The new system does not prevent the Reserve Bank of India from intervening in the foreign exchange market when required.
3. No rupee pegging: All RBI Governors have clarified that intervention is not meant to fix or peg the value of the rupee.
4. Meaning of volatility: RBI actions show that reducing volatility includes limiting sharp fluctuations and moderating sudden falls in the rupee.
5. Smoothing the fall: The objective is not to stop depreciation but to allow the rupee to slide smoothly to its required level.
6. Cost of shocks: Sudden rupee movements create economic costs, and intervention aims to minimise these shocks.
7. Non-economic pressure: The current rupee fall is influenced by non-economic factors, and an understanding with the U.S. can lead to appreciation.

Why Devaluation Is Not a Solution

1. Rising import content: The import content of India’s exports is increasing, which reduces the export stimulus normally expected from rupee depreciation.
2. Tariff-restricted exports: High tariffs in the U.S. market limit Indian exporters’ access, making currency depreciation less effective in boosting exports.
3. Essential imports: Most of India’s imports are essential goods, with crude oil alone accounting for about 25% of total merchandise imports.
4. Inflation risk: A fall in the value of the rupee increases import prices, which can fuel domestic inflation.
5. No inflation gap: India’s inflation is not higher than that of developed Western economies, removing the basic justification for devaluation.
6. REER relevance: Devaluation is required only when inflation differences are wide, which is measured through the real effective exchange rate (REER).
7. Manipulation concern: Keeping the currency undervalued, as attempted by some countries, amounts to currency manipulation and remains controversial.

Conclusion

The fall in the rupee is not due to weak economic fundamentals but due to capital outflows driven by geopolitical and trade tensions. Tariff actions have shifted the issue from economics to diplomacy. While the RBI can only smooth volatility, a lasting solution lies in an early diplomatic understanding between India and the United States.

Question for practice:

Examine the reasons behind the recent fall of the Indian rupee and explain why diplomacy is considered the key solution.

Source: The Hindu