Rupee risks persist as oil shock could outpace policy response

The clock is ticking on the capital inflows that the recent measures of the government and the RBI are expected to garner

The Indian government has been mercilessly panned in recent weeks for its seeming inaction in the face of a falling rupee. There is an exodus of foreign institutional investor (FII) money and the government sits there twiddling its thumbs? So ran the mocking commentary. 

The barrage of measures unveiled by the government and the Reserve Bank of India (RBI) last week should serve to silence the critics and restore a measure of calm to the forex market. Bankers have been quoted as saying the measures announced can be expected to fetch around $50 billion in capital inflows. 

It may be premature, however, to breathe easy. The fate of the rupee hinges on two related imponderables: The magnitude of FII outflows in the coming months and the future course of the current stalemate in the Iran conflict. 

The template used by the RBI is similar to the one used during the taper tantrum of 2013-14. However, the underlying situations are very different. In 2013-14, the United States Federal Reserve announced that it would reduce its purchases of government debt. Interest rates in the US were expected to rise as a result. This triggered outflows of capital from emerging markets, including India.  

India saw outflows of debt and equity in the months of June, July and August 2013. Thereafter, FII equity flows turned positive. For 2013-14 as a whole, FII equity flows were ₹79,709 crore. There was a net debt outflow of ₹28,060 crore, giving an overall net FII flow of ₹51,649 crore. Both debt and equity inflows were hugely positive in the preceding year, 2012-13, as well as in the succeeding year, 2014-15.   

Today’s situation with respect to FII flows is far more adverse. There were enormous FII equity outflows for two years in a row,  ₹1.27 trillion in 2024-25 and ₹1.80 trillion in 2026. The latter was an all-time high, but the current year seems set to surpass it. Till June 8, this financial year has seen equity outflows of ₹1.45 trillion (about $15 billion), which exceeds the outflows seen in the whole of the pandemic year, 2021-22. Debt flows, too, have turned negative this year. 

We lack a convincing explanation for the exodus of FII equity over more than two years. Let us set aside the familiar wails — the lack of reforms, corruption, excessive regulation, among others — and look at a couple of explanations that seem more plausible. 

We are told that India’s valuations are too high relative to those of other emerging markets. The Indian market has always traded at a premium of 50-100 per cent relative to other emerging markets. Earnings growth was in the high double-digits until FY24. It fell to low single-digits in FY25 and FY26. At these valuations, FIIs are said to find other markets more attractive. 

But then, aren’t institutional equity investors supposed to take a long view — of at least three to five years? On that time horizon, India’s compounded earnings growth looks good, despite the slowdown of the last couple of years. Are we to believe that long-term equity investors are fleeing a market because earnings growth has slowed for a year or two?  

That is not all. Earnings growth is in single digits only in the limited universe of the Nifty 50. Expand the universe to the Nifty 100 and include small-caps and earnings growth is in the double digits. If valuations were the material factor, sensible equity investors should be shuffling their portfolios, not exiting wholesale. 

A new theme has come into play of late, namely, India lacks a good artificial intelligence (AI) story unlike competing emerging markets. This, too, is unconvincing. Global fund managers should be spreading their risk across markets with AI stories and those without AI stories but with strong economic growth. All the more so, given that AI stocks are believed to have the makings of a bubble. Moreover, there are experts who contend that India’s information technology (IT) sector will always be needed to provide the backup to the AI powerhouses of the world. If so, the AI theme should not be hurting the Indian market. 

Much of the commentary on FII outflows sounds suspiciously like stock market pundits trying to fit explanations to fact ex post — and we know how good they are at that. It is more likely that India’s FII outflows have had to do with adverse global conditions over the past three years. 

In 2024-25, yields in the US were high and global investors retreated from emerging markets, including India. In 2025-26, reciprocal Trump tariffs caused FII sentiment towards India to turn negative. FIIs seem to have become especially leery of the Indian market on account of the punitive tariffs imposed by the Trump administration.  Cumulative FII outflows on account of these factors created the momentum for a downward spiral of depreciation that is not easily arrested. 

To make things worse, crude oil prices rose sharply following the onset of the conflict in Iran last February. India’s current account deficit is expected to widen from 1.1 per cent of gross domestic product in 2025-26 to 2.5 per cent in 2026-27. This has added to the downward pressure on the rupee. 

It follows that how the stalemate in Iran unfolds and impacts oil prices has a crucial bearing on the prospects for the rupee. Several experts believe that oil prices have been contained at $92 per barrel at the moment mainly because companies have drawn on their inventories and governments have drawn on strategic reserves. They say we are fast approaching an inflection point, when oil prices will shoot up to $150 per barrel if the stalemate continues for long or there is a resumption of hostilities. Some say the inflection point is two weeks away; others say it is four to five weeks away. 

The clock is thus ticking on the capital inflows that the recent measures of the government and the RBI are expected to garner. It will take at least three to four months for the expected capital inflows to materialise. In that period, we must reckon with a reasonable probability that oil prices will shoot up. If that happens, the current measures to contain the rupee’s depreciation may not suffice.  

In the exceptional circumstances we are passing through, it is worth asking whether we should be putting off an interest rate hike until such time as the inflation rate rises above the 6 per cent upper band. In the race between capital inflows and a surge in oil prices, the latter may win. There is merit in complementing the measures announced thus far with a hike in the policy rate in order to mount a robust defence of the rupee in the uncertain times ahead. 

ttrammohan28@gmail.com