India's policy mix needs a rethink on capital flows and rupee stability

One root cause of rupee weakness is distortions that deter capital flows

Recent movements in the rupee warrant attention, but not overreaction. Even after the sharp rise in energy prices, economists expect India’s current account deficit in FY27 to settle at around 2-2.5 per cent of gross domestic product (GDP). 

 

This is manageable by historical standards. The Reserve Bank of India (RBI) also holds foreign exchange reserves of around $580 billion net of forward foreign currency sales. 

 

However, there are important policy takeaways. India needs sustained net foreign capital inflows, which ultimately require growth and innovation. But we must also recognise the linkages between interest rates, taxation, and the external balance — and how they shape capital formation. 

Sentiment, fear, greed

For some time now, the rupee has been weighed down by negative sentiment. Across FY25 and FY26, the RBI sold $192 billion of foreign exchange in spot and forward markets. 

 

Yet India’s ‘core’ balance of payments deficit, across current account deficit, net foreign direct investment, and net equity foreign portfolio investment, was only around $80 billion. Around $112 billion of RBI foreign exchange sales therefore supported not the core deficit, but additional hedging and speculative demand for foreign currency. 

 

There was a spiraling ‘fear-plus-greed’ trade against the rupee. Any moderation in oil prices and geopolitics can trigger a short-term recovery in the rupee. However, there are broader issues that predate the Iran conflict. Durably reversing the negative sentiment is a prerequisite to attracting sustained capital flows. How free are our debt markets? 

 

Ultimately, capital flows will chase credible growth and innovation in manufacturing and services. Much will also depend on the global environment. But there are important lessons for macroeconomic policy. Interest rates, currency markets, and capital flows are deeply interconnected, though policy debates often treat them as separate silos. 

 

There is much debate on whether the rupee should act as a free “shock absorber”, but far less on how free our interest rate markets are. Consider the policy mix over the last two years. 

 

Net external outflows drained deposits and liquidity from the banking system. Ordinarily, in response, interest rates would have risen to retain deposits. Instead, with inflation moderating, policy rates were cut by 125 basis points since early 2025 to 5.25 per cent. 

 

Simultaneously, the RBI injected enormous durable liquidity through large government bond purchases and a reduction in the cash reserve ratio, and not just through short-term measures. In FY26 alone, RBI net bond purchases amounted to a record ₹8.8 trillion, or 85 per cent of net Central government borrowing. 

 

Aided by this, despite record high gross Central and state borrowing of ₹27 trillion, the 10-year government bond yield briefly fell to 6.25 per cent. The India-US 10-year yield spread compressed to a low 1.5-2.5 percentage points. Effectively, RBI bond purchases helped refill a banking system that was losing deposits to the external sector, while keeping rates low. The policy intent was understandable: Support growth amid low inflation. 

 

But with the external balance under pressure, money kept leaking out, leaving banks still scrambling for durable deposits.

From interest rate to currency markets

Lower interest rates worsened the external imbalance in at least three ways. First, narrower interest rate differentials between the rupee and the US dollar made it harder to attract foreign debt flows, given the balance of payments was already under pressure. 

 

Instead, domestic investors were incentivised to move money into foreign assets. Second, amid increasing awareness of equity markets, persistently low post-tax interest income pushed discretionary household savings away from debt into equities. This has stunted the development of debt markets, much as price controls suppress supply responses in any market. Simultaneously, strong domestic flows into equities from retail investors outpaced fresh supply, creating pockets of overvaluation. Given such overvaluation, foreign investors remained net sellers of equity, further worsening the external balance. Third, lower interest differentials compressed dollar-rupee forward premia. 

 

During much of 2024 and 2025, one-year dollar-rupee forward premia fell to a historically low 1.5-2.5 per cent. Hedgers and speculators could then buy dollar one-year forward against the rupee by just paying 2 per cent over the prevalent dollar-rupee spot rate. With actual rupee depreciation rapidly outpacing that, this fueled the spiraling ‘fear-plus-greed’ trade against the rupee. None of this is to imply that intervention in markets is wrong. Markets generate crucial price signals and adjustment incentives, but in a world of frequent market failures, policymakers cannot be dogmatic. 

 

But every intervention has its inevitable side-effects. As argued earlier, even with low inflation, intervention to keep interest rates low at a time of external imbalance and negative sentiment can end up weakening capital formation — the opposite of what was intended. Any sizeable intervention, therefore, must be preceded by a holistic consideration of consequences, and modulated if unintended outcomes emerge. 

 

The current monetary policy framework does not undertake such a holistic consideration of ‘impossible trinity’: The deep connect between interest rates, capital flows, and exchange rates.

What should be done now?

First, there is no cause for panic. Resorting to capital controls, even if temporary, risks damaging investor confidence. Far better to use our meaningful buffers to positively address root causes. 

 

Second, India’s taxation needs reform. India is an outlier in taxing foreign investors on source-based capital gains. Moving towards a residence-based regime would align India with global practices and remove a major irritant for much-needed foreign capital. Third, a less punitive tax regime on domestic fixed income would allow for low interest rates, while drawing more savings into debt. This would help grow India’s underdeveloped debt markets, reduce unbalanced financialisation, and moderate any equity overvaluation. All this should help draw foreign investors into both debt and equity markets. 

 

Finally, India’s monetary policy framework must engage holistically with the ‘impossible trinity’ across interest rates, capital flows, and exchange rates. These trade-offs do not arise only during crises. Even in normal times, intervention choices in one market inevitably shape outcomes in others. Complexity in markets cannot be wished or legislated away.  

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(The writer is a former whole-time member of Sebi. The views are personal)