Rupee volatility is a signal

The Reserve Bank of India (RBI) is fighting a difficult battle to keep the rupee stable. It is intervening in the foreign exchange market and has imposed several restrictions on currency derivatives to curb speculation. It also raised foreign currency through special swap schemes, including the one for non-resident Indians. The response to the scheme was encouraging, with banks mobilising about $133 billion through Foreign Currency Non-Resident (Bank), or FCNR (B), deposits. This helped take India’s foreign exchange reserves to a record high of $785.71 billion in the week ended September 4.

 Some saw the mobilisation as an effort to build buffers in an uncertain economic environment, though the RBI had reserves worth over $680 billion when it announced the step. As things stand, the reserves have declined by about $60 billion from the record highs. Part of the decline can possibly be explained by revaluation to reflect the actual value of the assets the central bank holds. But it also suggests that the RBI is intervening aggressively in the market.

 The RBI’s stated policy is that it intervenes in the market only to address excess volatility and does not target any level. However, in the present circumstances, it does appear to be chasing other objectives as well, perhaps to prevent the rupee from breaching a certain level. The rupee at 100 against the dollar, for instance, would make headlines and become a political issue. However, for economic policy managers, this number should not matter much. In fact, what should matter is that at the current rate of decline in reserves, the FCNR (B) buffer will quickly disappear. The FCNR (B) mobilisation showed that India can quickly raise significant amounts of foreign funds in a short period of time, but such an option cannot be used again in the near term.

 At the fundamental level, what is needed is a dispassionate assessment of the situation and appropriate adjustments in domestic policies. One explanation for currency market volatility is the West Asia crisis and its sustained impact on crude-oil prices. This is a reasonable concern. With no clear resolution road map in sight, higher energy prices will continue to influence sentiment in the currency market. However, it is worth highlighting that India faced a balance of payments (BoP) deficit in the previous two financial  years as well.

 India usually runs a current account deficit (CAD), which is financed by global capital flows. There is nothing inherently wrong with running a reasonable CAD. Foreign capital supplements domestic savings and is an important part of India’s broader macroeconomic management structure. Even the fiscal responsibility and budget management (FRBM) framework took into account the availability of foreign savings.

 However, what has happened in recent periods is that India has not been able to attract and retain enough foreign capital. Foreign portfolio investors, for instance, have sold Indian financial assets worth over $26 billion so far in 2026. Thus, the issue is not limited to the CAD. In fact, professional forecasters’ projection— published in the latest Monetary Policy Report of the RBI— for CAD in the current financial year is 1.2 per cent of gross domestic product (GDP), which cannot be termed as alarming in normal circumstances. The bigger problem is the capital account.

 So why is India not attracting enough capital? There are at least two explanations. First, increasing investment in artificial intelligence (AI) and related areas is absorbing capital from around the world. Since India is not in the AI play in any significant manner, it is unable to draw foreign flows. The AI boom is also one of the reasons Indian stock markets have underperformed and are witnessing outflows of foreign funds. Reports suggest that AI investment may be slowing. It is also being argued globally that investment in AI and the valuations of related companies are showing signs of a bubble. There is a view that once this bubble bursts, funds will get redirected to markets like India.

 This sounds more like hope, and Indian policy managers must not buy such arguments. On the contrary, a burst or a significant correction in valuations could lead to considerable global financial instability, if not a crisis. Trillions of dollars are being invested in AI infrastructure, and an increasingly large proportion of this investment is being financed through debt and other complex instruments that are difficult to track. Experience shows that a substantial increase in global financial uncertainty results in capital shifting to safe assets, not emerging markets. Thus, a burst could end up putting more pressure on capital flows, at least for a while, and India must be prepared for it.

 Second, higher bond yields in the developed world are affecting flows. If a global fund manager can earn over 5 per cent annually by simply holding US government bonds, considered to be the safest in the world, why take the risk of investing in emerging markets? However, this should have been anticipated. Public debt has increased substantially in the developed world, including the US, where it is moving up structurally. According to the International Monetary Fund, government borrowing requirement in advanced economies this year will be worth about 5.2 per cent of GDP, the highest since Covid. Public debt stock in the US is expected to increase to over 142 per cent of GDP by 2031 — up from about 109 per cent in 2019.

 Thus, the world is changing structurally, and India needs to adjust. The playbook on both the current and capital accounts is well known. Leaving the adjustment reluctantly to the currency market alone could become painful beyond a point.