Why the Rupee Has a Capital Account Problem

Introduction

India’s rupee is under pressure mainly because the capital account has weakened even though the current account deficit remains manageable. Merchandise trade deficits have widened, but rising invisibles have prevented a sharp external imbalance. The real stress today comes from declining foreign investment, persistent portfolio outflows, a strong global dollar, delayed trade decisions, high import demand, and reduced RBI intervention. These forces have lowered capital inflows, raised dollar demand, and pushed the rupee into a prolonged depreciation cycle.

What Is the Capital Account?

The capital account records cross-border money flows for investment and financial purposes. It covers foreign investment, external loans, banking capital, and changes in foreign assets and liabilities.

A capital account problem means these inflows are unstable, too small, or very volatile, making the economy dependent on uncertain foreign money.

Role in Financing and the Rupee: Capital inflows help finance the current account deficit and can add to foreign exchange reserves when they exceed this gap. When inflows are strong and steady, the supply of foreign currency rises, which supports the rupee.

Sensitivity to Global and Domestic Conditions: These flows react quickly to global interest rates, risk appetite, geopolitics, and domestic signals. Even high GDP growth cannot prevent outflows if investor sentiment turns cautious.

Why Does India Have a Capital Account Problem?

1. Steep Fall in Net Capital Inflows: Net capital inflows have dropped to $18 billion in 2024–25, the lowest in sixteen years and below the $23.1-billion CAD, creating a clear financing gap. When inflows fail to match the CAD, dollar demand exceeds supply, putting direct pressure on the rupee.
2. Sharp Decline in Foreign Investment

• Foreign investment has weakened sharply. Net inflows fell from $54.2 billion (2023–24) to $4.5 billion (2024–25) and further to $3.6 billion in the first half of 2025–26.
• FDI also collapsed from $44 billion in 2020–21 to just $959 million in 2024–25.
• Persistent FPI outflows across 2024–25 and 2025–26 have amplified this decline, reducing capital availability and weakening the currency.

3. Global Dollar Cycle and Risk Aversion: Higher US interest rates and geopolitical uncertainty have strengthened the dollar, pulling funds toward safe-haven assets. This global shift reduces flows to emerging markets, including India, leading to higher dollar demand despite strong domestic GDP growth.
4. Uncertainty Around the India–US Trade Deal: Repeated delays in the proposed trade agreement have created doubts about tariff outcomes. This uncertainty discourages foreign investors and adds to the weakness in capital inflows, intensifying pressure on the rupee.

What Is the Current Account Deficit?

The current account shows all economic transactions between a country and the rest of the world related to trade, services, income, and transfers.

In the Balance of Payments, the current account has two main parts: merchandise trade (goods) and invisibles, which include services, remittances, interest, dividends, and transfers.

A Current Account Deficit (CAD) occurs when payments abroad exceed receipts.

A persistent CAD means the country must rely on foreign capital inflows or external borrowing to meet this gap.

Why Does India Face a Persistent CAD?

1. Widening Goods Trade Deficit

• The goods trade deficit increased from $91.5 billion (2007–08) to $286.9 billion (2024–25). The current fiscal may cross $300 billion, as seen from April–September trends.
• The deficit widens because India imports large volumes of energy, electronics, and machinery, which increases dollar demand and contributes to CAD persistence.

2. Rising Import Demand During High Growth

• High growth increases demand for fuel, electronics, metals, and machinery. Elevated global metal and bullion prices raise the import bill further.
• This combination drives continuous outflows of foreign currency, tightening external balances and complicating rupee stability.

3. Invisibles Surpluses Offset but Do Not Eliminate Pressure

• Invisibles surpluses rose from $75.7 billion (2007–08) to $263.9 billion (2024–25) and may cross $280 billion this year.
• These surpluses reduce CAD severity but cannot neutralise surges in goods imports. They prevent crisis-level CAD but do not fully shield the rupee when capital inflows weaken.

4. Structural nature of the CAD: India has recorded current account surpluses in only four years in more than two decades. Most fiscal years show deficits because imports of goods, services and payments exceed corresponding receipts. This long pattern shows that the CAD is structural and not limited to temporary economic shocks.
5. Limited relief from temporary improvements: Periods of narrower deficits, such as 2016-17 or 2020-21, did not result in a lasting change. The strong rebound in imports during recovery phases pushed the deficit back to high levels. This cyclical pattern reinforces the wider structural challenge in goods trade.
6. Role of external transfers and payments: India continues to make payments in interest, dividends, and royalty to foreign investors and lenders. These outflows place pressure on the current account, even though they are smaller than receipts from remittances and services. Spending by Indian students abroad also adds to this burden.

Why Is the Rupee Under Pressure?

1. Heavy Capital Outflows and Weak Inflows: Foreign portfolio investors sold ₹1.52 lakh crore worth of equities in 2025 (up to December 3). This follows a year of weak inflows in 2024. FPI withdrawals reduce rupee demand and raise dollar demand, directly weakening the currency.
2. Dollar Strength and Safe-Haven Movements: A strong dollar cycle, driven by shifting expectations of US rate cuts and elevated geopolitical risks, weakens emerging-market currencies. India’s rupee has depreciated from 84.73 to 90 against the dollar in one year, with similar declines against the euro, pound, yen, and yuan.
3. Trade Deficit Shock and CAD Repricing: In October, India recorded a trade deficit of $41 billion, the highest ever for a single month. Before this, most economists thought the CAD would be around 0.7% of GDP. After seeing the October data, they raised their CAD estimate to 1.2–1.4% of GDP. Markets were not prepared for this jump, so the news hurt rupee sentiment and made its fall faster.
4. Reduced RBI Intervention and Tariff Link: RBI intervention has slowed. It sold $36.7 billion during June–December 2024 but only $20 billion during January–September 2025. Analysts suggest the RBI may be allowing gradual depreciation as a defensive response to the 50% US tariff on Indian exports. This approach helps preserve reserves while smoothing volatility.
5. High US Tariffs and Export Concerns: India faces a 50% tariff on goods sold to the US, far higher than China (30%), Vietnam (20%), Indonesia (19%), and Japan (15%). About $45 billion of exports are affected. This hurts competitiveness, reduces expected inflows, and worsens rupee sentiment.
6. Structural Vulnerabilities and Import Dependence: India depends heavily on imported energy, electronics, gold, and intermediate goods. High import dependence increases dollar demand regardless of global conditions. This structural feature amplifies rupee pressures when capital inflows slow.

Conclusion

India’s rupee weakness is driven mainly by a capital account slowdown rather than an overstretched current account. Declining foreign investment, large portfolio outflows, tariff uncertainty, dollar strength, and high import dependence have combined to weaken the currency. Strengthening capital flows, improving export competitiveness, and reducing structural vulnerabilities are essential to restore external balance and build long-term rupee resilience.

Question for practice

Examine why the rupee is facing pressure despite a manageable current account deficit.

Source: Indian Express