A wrong tool for the rupee and serious side effects on growth prospects

With the rupee under severe pressure due to rising oil prices and portfolio outflows, there have been suggestions in the media that the Reserve Bank of India (RBI) should defend the currency by raising interest rates. 

The key argument for using interest rates to stem a rupee fall is that higher rates raise the cost of borrowing in the domestic currency, making speculation more expensive and attracting foreign inflows. The interest rate instrument is assigned to achieve the RBI’s price stability mandate. There is the well-known Tinbergen principle, according to which one instrument should be assigned to only one target. Using the interest rate to target the exchange rate risks confusing markets and could undermine the credibility of inflation targeting.  

Secondly, it is not certain whether an interest rate defence will be effective. During the taper tantrum in 2013, the interest rate defence did not stabilise the rupee on its own; the turnaround came instead from other measures, notably the $34 billion raised through the RBI’s concessional foreign currency non-resident (bank) deposit swap window for banks.  

Empirical evidence suggests that defending an exchange rate with interest rates rarely works except in a full-blown panic, and even then, it requires very sharp hikes. This is not the case in India. The rupee is under pressure primarily because rising oil prices are widening the current account deficit, while foreign portfolio investment (FPI) outflows are making it harder to finance. 

To defend the exchange rate through the policy rate, the Monetary Policy Committee may have to raise it significantly, which would harm the real economy. Using interest rates to counter currency weakness has serious side effects. That’s why most central banks today are cautious about using this instrument, if at all.   

The policy rate is an instrument for inflation control. Since exchange rate depreciation impacts inflation, the policy rate should be raised only if inflation breaches the target. That is, the MPC should only be concerned with exchange rate pass-through to inflation. The situation today is much like the one in 2018. The rupee was under pressure due to portfolio outflows caused by the normalisation of monetary policy by the United States Federal Reserve and rising current account deficit due to rising oil prices. Even then, some in the media argued for an increase in interest rates to stem the fall in the rupee. There was speculation that the MPC would meet off-schedule in September 2018 (scheduled meeting was on October 3-5) to raise rates. 

However, market participants were disappointed when the MPC kept rates unchanged at its scheduled October meeting. The rupee depreciated sharply, falling by one per cent over the next three days after the policy, as it became clear the MPC would not use interest rates to defend the exchange rate. Significantly, the rupee recovered by one per cent soon after (between October 10 and 12) when oil prices declined. 

Crucially, FPI outflows have been concentrated in equities. Since rate hikes typically compress equity valuations and raise the cost of capital for corporations, using interest rates to defend the rupee could potentially accelerate outflows rather than stem them.   

The rupee’s stress is evident. However, using the policy repo rate to defend it conflates monetary policy with exchange-rate management. The real task is to deploy measures that stem FPI outflows and encourage capital flows to return. 

After remaining net buyers of Indian stocks in every year from 2009 to 2024 except 2011, 2018, and 2022, FPIs turned sustained net sellers in 2025 and 2026. Outflows were about $19 billion in 2025 and $24 billion in 2026 so far. FPIs have been net sellers every month this year, barring February. 

In this context, it is important to understand why FPIs are pulling money out of India. With US government bonds now offering over 4.6 per cent and the rupee under severe pressure, FPIs need much higher returns from Indian assets just to match what they can earn elsewhere in dollar terms. Including country and equity risks, FPIs need a significantly higher after-tax return from Indian stocks than they do from most other markets. That makes India less attractive when global risk appetite is low. 

A key factor is India’s capital gains tax. Foreign investors pay 20 per cent tax on short-term gains and 12.5 per cent on long-term gains from Indian stocks. Meanwhile, competing markets like Singapore, Hong Kong, Malaysia, and Thailand don’t tax foreign investors’ capital gains at all. When returns are already under pressure from a weaker rupee and high US rates, this tax difference further tilts FPI allocations away from India towards more tax-friendly destinations. 

Domestic investors have cushioned the equity market against heavy FPI selling pressure. However, the rupee has depreciated by 5.4 per cent in five months, touching new lows despite RBI intervention. The risk is a vicious cycle: Fears of further depreciation result in more FPI outflows, which, in turn, weaken the rupee further. 

While the feedback loop itself is worrying, a weaker rupee also stokes inflation by raising the cost of oil and other imports. To break this, policy should focus on stemming capital outflows. One option is to rationalise capital gains tax: Higher post-tax returns would improve FPIs’ risk-return perception of India. 

A stable rupee also lowers the currency-risk premium FPIs demand, reducing both required returns and inflation risk. Other measures to attract capital also need to be pursued in parallel. Once the rupee stabilises, current valuations and lower currency risk could help bring FPIs back.

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The author is a senior fellow at CSEP, a former executive director of the RBI, and a former member of its Monetary Policy Committee. The views are personal