The rupee problem this time is different. The solution must be, too

The biggest lesson from this episode must be that attracting strong and stable FDI is an urgent macroeconomic imperative for India — both for macro stability and growth

Three months into the West Asia conflict, India has done well to avoid widespread energy shortages. Furthermore, the burden sharing of higher energy prices between the public and private sector has finally begun. Retail prices are being raised but will need to be raised more to elicit the necessary behavioral response from households and firms.

Instead, the key pressure point remains the Balance of Payments and the rupee. But there are two unique elements about this episode:

We haven’t seen this beast before and making the analytical distinction between the capital and current account as the source of pressures is crucial to formulating the right response.  

In turn, a collapse in FDI is at the heart of the capital flow story, with net FDI — which used to average 1.5 per cent — completely drying up since 2024. What’s driving this? Between 2010 and 2025, India’s net FDI is strongly correlated with US 10-Year Treasuries — a proxy for global financial conditions. When yields are low India tends to get a gush of FDI; when yields harden — like the last two years — net FDI has completely dried up. Recall, FDI is typically governed by both (global) “push” and (country-specific) “pull-factors.” What India’s FDI trajectory suggests it has largely been governed by push factors since 2010. The last time it was driven by pull-factors was in 2005-10 when a strong corporate capex cycle catalysed strong FDI. 

Why does this matter? Because near-term global financial conditions are likely to remain tight. Sticky inflation and the prospect of rate hikes in the US along with its precarious fiscal situation is likely to keep US yields elevated. Meanwhile, India’s CAD is on course to more than double. Oil analysts estimate that even if the Strait of Hormuz opens in June, crude prices will remain in triple digits all year as supply takes a while to come online and demand exceeds supply as inventories are replenished. If so, this would translate into India’s CAD widening close to $100 billion dollars this fiscal. The combination of higher bond yields and higher crude prices risk a pincer-like effect on the BoP.

The source of the problem, however, is a sustained slowing of capital flows amplified, more recently, by the terms of trade shock from higher energy prices. This must inform the policy response. 

The first line of defense is to let the rupee depreciate — as policymakers have done — and act as the initial shock absorber. A weaker rupee will disincentivise imports and boost export competitiveness and has the advantage of narrowing the CAD while boosting domestic activity (“expenditure switching”) Theoretically, too, a sharp slowdown in FDI compounded by a large negative terms-of-trade shock from crude prices would argue for a much more depreciated equilibrium rate. 

But while rupee depreciation is a necessary condition, will it be sufficient in the current environment? In theory, a weaker rupee acts as an automatic stabiliser on the capital account, too, because if it is deemed to have overshot, foreign capital should be attracted back. But what does overshooting mean in the current environment? To what extent will the rupee need to depreciate — if it is the only instrument being used — to close a large BoP gap? That is the question foreign investors will be grappling with and it’s not clear that any value of the rupee will be seen as being oversold.

In fact, if the rupee depreciates too rapidly, it increases the incentives for foreigners to hedge their existing stock of foreign assets in India (FPI, ECBs, FDI). That hedging, in itself, puts more pressure on the rupee further increasing the desire to hedge. There are signs that this self-fulfilling hedging spiral is beginning to take hold, and a circuit breaker is quickly needed to restore order.   

That circuit breaker should be capital augmentation measures. The objective must be to attract a large-enough quantum of near-term capital inflows across multiple avenues — even if it involves a subsidised swap — to change the narrative in the rupee market and change exporter, importer and investor behaviour. 

A weaker rupee and an influx of capital should hopefully help tide over BoP pressures this year. If not, “expenditure compression” — tighter fiscal and monetary policy — may be needed as a last resort. But this is not costless. Back in 2013 when the rupee was under pressure, it was clear the economy was overheating, and the obvious response was to tighten fiscal and monetary policy and release the pressure by narrowing the CAD. The current context is very different: core inflation has averaged just 2-3 per cent over the last 2 years suggesting the existence of slack and we are still awaiting a private capex cycle, which will likely be delayed amidst heightened geopolitical uncertainty. In this environment, fiscal compression that accommodates higher fuel and fertiliser subsidies by cannibalising public capex risks making policy pro-cyclical. 

All told, it’s important to realise that this BoP episode is different. The pressure point is the capital account not the current account. This will necessitate both a weaker rupee and capital augmentation. Simply squeezing the current account can, in fact, be counterproductive by slowing growth and turning-off growth sensitive capital inflows. 

The biggest lesson from this episode must be that attracting strong and stable FDI is an urgent macroeconomic imperative for India — both for macro stability and growth. This will require sustained economic reform that improves India’s structural competitiveness. There is no escaping that imperative.  

Sajjid Z Chinoy is Head of Asia Economics at J.P. Morgan. All views are personal