Ten rules for external sector stress

There is wisdom from history in managing the rupee

There is considerable stress in the Indian external sector. Policymakers see information that we, as external persons, do not. From the outside, it is not useful to comment on the minutiae of tactical policy moves. Drawing on the experiences of crises in the Indian external sector over the past 25 years, we offer 10 principles that are universally useful in understanding the present situation and responding to it. 

1. Supply stability, not shocks. Policymakers must be a supplier of stability, not the originator — whether intended or otherwise — of shocks. We should plan every action of policymakers to be calm, reassuring, and predictable. The dharma of modern central banking is “say what you will do and then do what you just said”. Surprises should emanate from the external world — such as the October 14 Houthi attack upon Saudi Aramco in Dhahran — not from the authorities. 

2. Leave price discovery to private persons. Speculating about financial prices is the work of private persons, not the Indian state. There will always be legitimate disagreement about what values of the rupee will be, and state agencies should not be put in a position of having to take a stand on this. Getting into dogfights with speculators is problematic. Speculators are a formidable force. Tangling with them is daunting. In addition, policymakers lose strategic sense when they are enveloped in a fog of war. They should be above the fray of the practical details of what is happening in the market: The buying, the selling, and the price. 

3. Respect the scale of cross-border flows. The Indian economy is very big, and the money moving across the border is now vast. In 2025-26, gross flows on the current account were $2.18 trillion, while gross private flows on the capital and financial account were $3.21 trillion. Thus, over $5.39 trillion comes in and goes out of India every year. Every dollar out of this is in the command of self-interested and intelligent people who are watching the landscape and trying to earn a profit from currency speculation when opportunities present themselves. When currency speculation through financial instruments becomes difficult, this activity goes into the behaviour of foreign direct investment (FDI), imports, exports, and remittances. The adjustment that is prevented on the exchange rate is concentrated in domestic asset prices. 

4. Financial development has hysteresis. It cannot be turned off and on like a tap. A good financial system is ultimately about the emergence of capable teams in Indian and foreign financial firms. Those draw upon decades of investment and sustained knowledge building. When a market’s or a product’s life ends, we lose decades of culture. The threat of future bans lurks in the mind of decision-makers in private financial firms. They respond by investing less in organisational capabilities. This results in a less knowledgeable and less capable financial sector. This is harmful for India. It creates conditions of excess volatility in illiquid financial markets. 

5. Get on to the virtuous cycle. Good countries get on to the virtuous cycle of high financial development, high market liquidity, and reduced volatility. However, there can also be the opposite feedback loop: Government management of a price leads to damaged financial development, market illiquidity, greater volatility, and then pressure upon the government to intervene in prices. 

6. Treat cross-border friction in a unified way. Indian economic growth is made in the most productive firms, and the most productive firms are the internationalised ones. A firm does not experience each regulatory obstacle in isolation; rules across trade, capital, data, and payments interact as one connected system that shapes how investors judge Indian governance. When greater cross-border friction comes about — against the movement of money across the border, against currency trading, against currency-risk management, against internationalised business activities — these are harmful for Indian economic growth. When we make capital flows and risk management more difficult, this harms stock prices and the exchange rate, as the foreigner demands a higher risk premium. 

7. Avoid currency dominance. Every currency defence turns into an interest-rate defence. This induces a loss of autonomy in monetary policy. For decades, Indian economic policy worked to protect monetary policy from “fiscal dominance”, where the short-term interest rate was controlled by the fiscal deficit. We should not now relapse into “currency dominance”. The short-term interest rate should be shaped by inflation forecasts alone, and not get distorted by currency considerations. The 91-day bill went up by about 50 basis points in a month; we should ask whether this conduct was optimal from the viewpoint of the 4 per cent inflation target. 

8. Intellectual power beats coercive power. Policymakers are judged every day by the market for the internal consistency and feasibility of their efforts, and for their intellectual capabilities. Policymaking viewed as a power game works poorly as, ultimately, the global financial system is more powerful than the Indian policymaker. The soft power of respect in the eyes of the people who shape business and finance strategy worldwide matters more. 

9. Renew vows to the reform strategy. There is only one configuration that is consistent with Indian success: Inflation targeting, a floating exchange rate, and an open capital account. Policymakers need to renew their vows to this strategic picture of Indian economic reforms every few weeks. Reversals of reforms are generally avoidable, they should be accompanied by an apology, and they should concern minor things. 

10. Emulate the good countries. There are countries that are basket cases, like Russia or Turkey. India should aim to be like the good ones, like South Korea, Taiwan or Israel, which maintain low cross-border friction across trade, capital, technology, data, and finance. We need to self-consciously up our game and match their policy frameworks, their everyday stream of policy decisions and communication, and their body language.

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The writers are, respectively, a researcher at XKDR Forum; an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant; and former executive director, Reserve Bank of India