The Indian rupee faced pressure in May 2025 due to escalating tensions between India and Pakistan. Following India’s military actions against terror hubs, the currency experienced its worst decline in over two years. This situation marks the impact of geopolitical events on financial markets.
Geopolitical Context
The ongoing military operation, dubbed ‘Operation Sindoor’, has intensified risks in the region. India’s precision strikes aimed at Pakistan have raised concerns about potential escalation. Pakistan’s retaliatory drone attacks on Indian military sites further exacerbated tensions. Such geopolitical instability typically leads to increased risk aversion among investors.
Market Reactions
The rupee closed at 85.72 against the US dollar, a drop of 89 paise. This marked depreciation, over 1 per cent, since the previous day. Analysts noted that the combination of military tensions and a stronger US dollar contributed to this decline. Investors reacted quickly to the heightened uncertainty, resulting in a sharp sell-off in the currency markets.
Impact of External Factors
In addition to geopolitical risks, external factors also influenced the rupee. Rising crude oil prices added to inflationary pressures in India. A stronger US dollar further weighed on the rupee’s performance. Analysts suggested that if tensions continue, the rupee could face further declines, potentially reaching levels between 86.00 and 86.50.
Investor Sentiment and Volatility
The India VIX, an indicator of market volatility, surged by 10 per cent, reflecting heightened anxiety among investors. This increase indicates a growing fear of market instability. The volatility was compounded by the typical fluctuations associated with weekly index expiry.
Foreign Investment Trends
Despite the current pressure, there are signs of potential recovery. Recent foreign institutional investor (FII) inflows into the Indian stock market provided some support for the rupee. After a period of withdrawal, FIIs invested Rs 9,647 crore by early May 2025. This influx could help stabilise the currency if the geopolitical situation improves.
Future Outlook
The rupee’s future remains uncertain. Analysts predict that ongoing military tensions and a strong US dollar will continue to exert pressure. However, potential tailwinds such as easing policies from the Reserve Bank of India, better-than-expected corporate earnings, and stabilising oil prices may provide some support. The overall sentiment in global equities could also influence the rupee’s performance moving forward.
Questions for UPSC:
- Examine the impact of geopolitical tensions on currency markets, using the recent India-Pakistan situation as an example.
- Discuss the role of foreign institutional investors in stabilising emerging market currencies during periods of volatility.
- Analyse the effects of rising crude oil prices on the Indian economy and its currency valuation.
- Critically discuss the relationship between market volatility indicators and investor sentiment in financial markets.
Answer Hints:
1. Examine the impact of geopolitical tensions on currency markets, using the recent India-Pakistan situation as an example.
- Geopolitical tensions often lead to increased risk aversion among investors, causing currency depreciation.
- The recent military actions by India against Pakistan resulted in drop in the rupee’s value.
- Market reactions to geopolitical events can cause sharp sell-offs in currency markets, as seen with the rupee’s decline.
- Increased uncertainty can lead to fluctuations in currency valuations, reflecting investor sentiment.
- Historical examples show that similar tensions have previously impacted currency stability in the region.
2. Discuss the role of foreign institutional investors in stabilising emerging market currencies during periods of volatility.
- Foreign institutional investors (FIIs) provide essential capital inflows, which can support currency stability.
- In periods of volatility, FIIs can help mitigate depreciation by investing in local markets, as seen with recent inflows into India.
- FIIs’ confidence in the market can enhance the perception of stability, attracting further investments.
- Conversely, withdrawal of FII funds can exacerbate currency declines, denoting their dual impact.
- Effective policies and economic conditions can influence FII behavior, affecting currency performance in emerging markets.
3. Analyse the effects of rising crude oil prices on the Indian economy and its currency valuation.
- Rising crude oil prices increase inflationary pressures, negatively impacting the Indian economy.
- Higher oil prices lead to increased import costs, widening the trade deficit and weakening the rupee.
- The Indian economy, being heavily reliant on oil imports, is particularly sensitive to price fluctuations.
- Rising oil prices can reduce investor confidence, leading to currency depreciation amid economic concerns.
- Conversely, falling oil prices can provide relief and support currency stabilization by improving trade balance.
4. Critically discuss the relationship between market volatility indicators and investor sentiment in financial markets.
- Market volatility indicators, like the India VIX, reflect investor anxiety and expectations of future market movements.
- A surge in volatility typically indicates increased uncertainty, often leading to risk-off sentiment among investors.
- Investors may react to volatility by reallocating assets, impacting currency and stock market performance.
- Historical data shows that spikes in volatility often coincide with geopolitical tensions or economic instability.
- About volatility can help investors gauge market sentiment and make informed investment decisions.
