By Kuntala Karkun & Samriddhi Prakash
At first glance, the Indian Rupee’s recent slide looks counter-intuitive. India’s current account deficit (CAD) is narrowing, services exports remain resilient, inflation is unusually well-behaved, and foreign exchange reserves are ample. Yet the rupee breached ₹91 to the dollar earlier this month before the Reserve Bank of India (RBI) intervened to smooth volatility.
The explanation lies not in trade fundamentals, but in capital flows, policy choice, and the structural limits of real-time external-sector data.
The numbers that don’t add up, until they do
India’s current account deficit (CAD) narrowed to $12.3 billion (1.3% of GDP) in Q2 FY 2025-26, down from 2.2% of GDP a year earlier. In November 2025, the merchandise trade deficit fell to $24.5 billion, the lowest in five months, while net services exports contributed ~$18 billion in the same month, led by software and business services (MOSPI, RBI).
Under textbook macroeconomics, a shrinking CAD should ease pressure on the currency. For long stretches of India’s post-reform history, that relationship broadly held. But markets do not trade balance-of-payments identities; they trade flows, expectations, and timing mismatches. And this is where the rupee story changes.
The capital account is doing the damage
The rupee’s weakness is best explained by what we cannot yet fully observe. Data on foreign direct investment equity inflows are released on a quarterly basis, with the latest available up to October 2025. This creates a visibility gap precisely when capital flows appear to be turning.
High-frequency indicators fill in the picture. Foreign portfolio investors (FPI) have turned net sellers of Indian equities in recent months. NSDL data estimates net FPI equity sales at $18.4 billion as of 12 December 2025, already exceeding the $16.5 billion outflow recorded in 2022. Pressure has extended to debt markets as well: foreign investors sold more than ₹54 billion of bonds in the first two weeks of December 2025, with foreign banks alone accounting for roughly ₹30 billion of that selling (Reuters). Global investors, facing a strong US dollar and tighter financial conditions, are reallocating away from emerging markets more broadly.
The result is a familiar asymmetry: capital inflows have weakened faster, and more abruptly, than the current account has improved. This matters because capital flows move faster than trade flows. While the current account adjusts gradually, portfolio flows reprice currencies almost instantly. It is this asymmetry that explains why a narrowing CAD has not translated into rupee strength.
Why this episode is different from past rupee slides
In earlier cycles, the Rupee depreciation usually coincided with macro stress; widening CADs, high inflation, or dwindling reserves. None of those conditions apply today. India’s macro buffers are stronger, inflation expectations are anchored, and reserves are near $690 billion (RBI).
Which brings us to the conclusion: part of the rupee’s depreciation is being consciously tolerated.
A weaker rupee is a policy choice, not an accident
Exporters are operating in an increasingly hostile global environment. Trade fragmentation, tariff escalation, and weak external demand have squeezed margins across manufacturing and tradable services. With fiscal tools constrained and trade remedies slow-moving, the exchange rate becomes one of the few remaining adjustment mechanisms.
Allowing the rupee to weaken modestly helps preserve export competitiveness and offsets part of the pressure created by tariff barriers; without explicit subsidies or retaliatory trade actions. RBI’s recent behavior reinforces this reading. Interventions have been aimed at preventing disorderly moves, not at defending any particular level.
This tolerance is possible because inflation, or the lack of it, has given policymakers room to manoeuvre. CPI inflation stood at 0.71% y/y in November 2025, and FY 2025-26 inflation expectations are close to 2%, well below historical averages (MOSPI, RBI). Imported inflation risks, especially from energy, are limited. This creates policy space that simply did not exist in earlier cycles. Today, a “CAD down, rupee down” configuration is not a paradox. It is the outcome of a capital account under pressure and a policy regime that sees limited near-term costs in allowing depreciation.
Why capital outflows still demand a response
Tolerance, however, is not a free pass.
There is a fundamental difference between depreciation driven by competitiveness considerations and depreciation driven persistently by capital outflows. Portfolio flows are volatile, pro-cyclical, and sentiment-driven. If left unchecked, they can amplify currency swings, tighten domestic financial conditions and eventually force policy responses that policymakers would rather avoid.
This risk is not theoretical. Reuters described the Rupee as Asia’s worst-performing currency in 2025, down nearly 6% year-to-date by mid-December 2025.
The answer is not heavy-handed currency defence or targeting a specific exchange rate. Instead, the focus must be on improving the quality, stability, and depth of capital inflows. Three priorities stand out.
First, restore confidence in portfolio flows through predictability. Clear signalling on fiscal consolidation, continued inflation management, and regulatory stability matters enormously to global investors reallocating across emerging markets.
Second, tilt the capital account toward more stable inflows. India remains overly reliant on portfolio capital at the margin. Accelerating high-quality FDI, particularly in manufacturing, energy transition, and export-oriented services, would reduce the rupee’s sensitivity to global risk cycles.
Third, deepen domestic financial markets. A deeper corporate bond market, broader access to forex hedging, and stronger domestic institutional participation would absorb external shocks more effectively and limit the currency impact of sudden foreign exits.
None of this requires abandoning exchange-rate flexibility. But flexibility works best when backed by resilient capital structures.
It is worth emphasizing what this episode is not. This is not a balance-of-payments problem. India’s reserve buffer gives the RBI ample firepower to lean against excess volatility, as recent interventions demonstrate. These actions should be read as liquidity management, not panic.
Conclusion: Flexibility is the new strength
The rupee’s recent depreciation reflects choice, not compulsion. It is being allowed because inflation is low, reserves are ample, and exporters need relief in a hostile global trade environment.
That choice is defensible and, arguably, sensible. But tolerance must be paired with action. If capital outflows persist unchecked, the narrative can flip quickly, from strategic flexibility to external vulnerability. Managing that risk, not defending a number on the screen, is the real policy challenge ahead.
In that sense, the rupee is not testing India’s macro fundamentals. It is testing whether India can convert macro stability into durable, high-quality capital inflows in an increasingly unforgiving global financial cycle.
(Kuntala Karkun is a Senior Visiting Fellow, and Samriddhi Prakash is a Research Associate with New Delhi-based Pahle India Foundation)
The views expressed are not necessarily those of The South Asian Times
