RBI's rupee challenge: Policymakers should not be swayed by absolute levels

United States (US) President Donald Trump’s address to the nation on Wednesday failed to outline a clear pathway for ending the Iran war. In fact, Mr Trump used this opportunity to issue threats that Iran could be bombed back to the Stone Age. He also said that discussions with Iran were going on — something the Iranian authorities have repeatedly denied. Thus, even after more than a month into the war, it remains unclear when it will end and what the US and Israel aim to achieve. This leaves the rest of the world with enormous uncertainty. It is also unclear how the war will reshape the geopolitical order in the region. Excessive uncertainty has pushed up prices of crude oil globally and is also hurting trade in general in the region. India is particularly exposed to these unknowns because of its dependence on the region for oil, trade, and remittances.

 

While the war is affecting macroeconomic dynamics in various ways, requiring intervention, economic management has become significantly complex for the Reserve Bank of India (RBI). Volatility in the currency market is one of the most visible fallouts of the crisis, which the RBI manages. The rupee depreciated by over 4 per cent in March. In fact, the financial year 2025-26, which ended earlier this week, was a difficult one for the rupee. It fell about 10 per cent against the dollar. The rupee was under pressure because of trade-related incertitude, which also resulted in large capital outflows. Foreign portfolio investors (FPIs) in 2025 sold Indian stocks worth about $19 billion. The pressure continued into 2026, and the Iran war has made the challenge for the rupee even more complex.

 

Aside from selling dollars, the RBI in recent days took other measures to contain the fall. Last week, it asked banks to limit their daily net open positions on the rupee in the foreign-currency market to $100 million. It has now prohibited banks from offering non-deliverable derivative contracts involving the rupee. That on Thursday resulted in a sharp pullback in the Indian currency. Clearly, these steps aim to contain speculation. However, it is worth highlighting that the problem is more fundamental. India ran a balance-of-payments deficit worth over $30 billion during April-December 2025. Likely, things did not change in the March quarter. Thus, the rupee is adjusting to the possibility of a sustained net outflow of foreign exchange, at least in the near term. Thus, curbing trading activity may not help much. Policymakers should not be swayed by the absolute levels in the currency market.

 

The rupee has also depreciated in real terms. The index for the 40-currency real effective exchange rate showed that it was undervalued by about 6 per cent in February. Some level of undervaluation would help Indian exporters in this difficult economic environment. Once there is clarity on war, it will not only benefit exporters to regain markets but also attract capital inflows, as Indian assets become cheaper for foreign investors, thereby improving the balance of payments. Thus, the RBI’s moves in the currency market need to be carefully calibrated. To be fair, it also has to deal with other implications of the war. Even though selectively passed to end users, the increase in global crude-oil prices will push up the inflation rate. Bond yields have increased, though partly because of the RBI’s intervention in the currency market. More clarity on the RBI’s approach will emerge next week after the Monetary Policy Committee meeting.