The rupee's problem runs deeper than West Asia war and oil price surge

On June 5, the Indian authorities took out a bazooka to rescue the rupee. The Reserve Bank of India (RBI) announced a series of measures, providing subsidies to state-owned companies taking overseas loans, introducing a new version of the dollar-deposit scheme for non-resident Indians — last seen in 2013 — and removing restrictions on foreign investment in bonds and equities. At the same time, the government exempted foreign investment in government bonds from tax on interest and capital gains. The announcements are ambitious in scope. But will they be effective? There are reasons to be sceptical. 

To begin with, it is important to recognise that the rupee’s weakness has not been caused solely by the war in West Asia. In fact, the rupee was the worst-performing currency in Asia last year, depreciating by more than 6 per cent against the dollar. This suggests that there is more to the story. The obvious question is: Why have foreign investors been taking money out of an economy that, according to the latest official data, is growing at nearly 8 per cent, faster than any major economy in the world?

The answer lies in two other shocks that India has been facing. These shocks have received less attention but are likely to have a longer-lasting impact. What are these shocks and how should the economy adjust? 

The first of these could be termed the China shock. Until recently, the dominant narrative among investors was that India would gain significantly from the shift of global manufacturing out of China. The logic seemed compelling: A vast pool of low-cost labour, the government’s incentive schemes for the manufacturing sector, and a rapidly expanding domestic market. Since 2008, India’s gross domestic product (GDP) has risen fourfold, from about $1 trillion to $4 trillion, reinforcing the perception that the country offered both a production base and a sizeable consumer market. 

However, things have not turned out as expected. For a start, the shift out of China has been smaller than anticipated. China continues to be the workshop of the world, even expanding into new sectors (such as automobiles) where it previously did not have any major international presence. Moreover, the manufacturing that has shifted out of China has generally not come to India. Gross foreign direct investment (FDI) in India has in fact fallen from 3.6 per cent of GDP in 2008 to less than 1 per cent in 2024. The major beneficiaries of the China+1 shift have been in East Asia, with Vietnam in particular seeing its FDI ratio surge to more than 5 per cent.  While foreign firms have been reluctant to invest in India, Indian firms have been expanding their investment abroad. Outward FDI has doubled over the past two years from roughly $15 billion to more than $30 billion in 2025-26, even as domestic investment has remained sluggish. In other words, India has not been able to present itself as an attractive manufacturing location, either to foreign or to domestic firms. 

In addition to this, the economy is facing a second major shock: Artificial intelligence (AI), which is threatening the country’s flagship information-technology (IT) sector. Despite India’s software prowess, it is lagging well behind the United States (US) and China in developing AI platforms and shaping global AI development. The Nifty IT index has fallen roughly by 22 per cent over the past year. This, in turn, has forced IT firms to retrench. Hiring has fallen sharply, while anecdotal evidence suggests that the top IT firms have laid off 40,000-50,000 employees since 2024. 

Taken together, these two shocks have exposed the vulnerabilities in India’s growth narrative. If the twin drivers of manufacturing and IT services are under strain, where will sustained, high growth come from? New pillars can certainly emerge; they have in other Asian economies. China, South Korea, and Taiwan have proved their potential to move up the value chain and establish a global presence in frontier industries such as AI hardware and electric vehicles. The Indian manufacturing sector, however, has yet to make a similar transition. 

The takeaway is straightforward. As expectations of India’s growth prospects have moderated, both FDI and portfolio flows have weakened to the point where they are no longer sufficient to finance even a modest current-account deficit. This implies that short-term dollar inflows triggered by the recently announced measures are unlikely to solve the problem. Instead, the economy needs to adjust. 

There are two ways this could play out. One way is for investors to mark down the prices they are willing to pay for Indian assets, to reflect the economy’s weaker growth prospects. In this scenario, share prices would correct, pulling market valuation down from its lofty 20-23 price to earnings ratio to the 12-17 range, which is more typical of emerging economies. Alongside this, the rupee would depreciate further. As Indian assets become less expensive, foreign capital will eventually be enticed to return, in sufficient quantity to finance the current-account deficit, now running around $100 billion a year. 

Such a scenario would not be particularly appealing because those who have invested in Indian assets would lose considerable amounts of money. 

The alternative is to restore confidence in the economy’s growth prospects. This is a better option but it is also harder to achieve. It would require decisive measures to address the factors holding back investment — both domestic and 

foreign. It would also require something that has so far been in short supply: A willingness to recognise that the concerns being expressed by investors may not be entirely misplaced.

The author is associate professor of economics, IGIDR, Mumbai. The views are personal