The recent intervention by the Reserve Bank of India, which briefly strengthened the rupee by selling US dollars in the market, has once again drawn attention to a deeper puzzle: why is the rupee weakening despite strong macroeconomic fundamentals and even when the US dollar itself is losing strength globally?
What happened and why it caught attention
On December 17, the sold a large amount of dollars in the foreign exchange market, increasing dollar supply and pushing the rupee up by nearly a percentage point in a single move. Such sharp, intervention-led appreciation underlines how fragile the rupee’s underlying position has become in recent months.
Despite this episode, the broader trend remains clear: over the past year, the rupee has depreciated by nearly 6 per cent against the dollar.
Why the rupee ‘should’ have been stronger
On paper, India appears well placed for a stronger currency. It remains the fastest-growing major economy, inflation has moderated, and key external indicators such as foreign exchange reserves and external debt ratios are relatively stable. Traditionally, these factors support currency appreciation by attracting capital and improving confidence.
This makes the rupee’s weakness puzzling, especially since it is occurring even when the dollar itself has softened against other major and emerging market currencies.
From “strong dollar” to a genuine rupee problem
Earlier, the government had argued that the rupee was not uniquely weak, but merely reflecting a globally strong dollar. Finance Minister had noted that most currencies were depreciating against the greenback.
That explanation no longer fully holds. For several months now, the rupee has continued to weaken even as other currencies stabilised or strengthened, pointing to India-specific pressures rather than just global dollar dynamics.
Trade, tariffs, and diplomatic uncertainty
One structural factor is India’s trade imbalance. When imports exceed exports in value terms, demand for dollars rises relative to the rupee, exerting downward pressure on the exchange rate.
This has been exacerbated by higher US tariffs on Indian goods, which reduce export competitiveness and dampen foreign demand for Indian products. Compounding this is uncertainty surrounding an India–US trade agreement, which has kept investors cautious and limited fresh inflows.
Capital flows and investor sentiment
The rupee’s weakness is closely linked to subdued capital inflows. Global investors have, in recent months, favoured other markets over India. While US, Chinese, Japanese, and several Asian equity markets have posted strong gains, Indian equities have significantly underperformed.
This relative underperformance suggests either valuation concerns or doubts about near-term corporate earnings, both of which reduce foreign portfolio investment and weaken currency support.
The RBI’s role in shaping the exchange rate
Central bank actions have also played a decisive role. The RBI’s buying and selling of dollars — both in the spot market and through forward contracts — directly influence the rupee’s trajectory, sometimes overriding macro fundamentals in the short run.
A detailed study by Bank of Baroda, analysing data from October 2020 to November 2025, found that three factors explain most short-term movements in the rupee:
- RBI’s spot market intervention
- Changes in RBI’s forward market positions
- Foreign portfolio inflows
Interestingly, the study found forward market interventions to be more influential than spot sales, as they send stronger signals to markets about the central bank’s intent.
Why trade deficit alone doesn’t explain rupee moves
Contrary to popular belief, the trade deficit showed little direct correlation with short-term rupee movements in the study. One reason is that trade data reflect accounting entries rather than immediate dollar flows. Exporters, for instance, are allowed to retain earnings abroad for a period, delaying actual currency conversion.
This weakens the direct link between trade numbers and exchange rate movements.
Beyond economics: the role of sentiment
Crucially, none of the identified variables explained more than 13–14 per cent of the rupee’s total variation. This suggests that factors beyond conventional economics — such as global risk sentiment, geopolitical signals, and investor psychology — play a significant role.
In the immediate term, foreign portfolio investors emerge as the most powerful drivers of rupee movement, making the currency particularly sensitive to shifts in global confidence.
What to note for Prelims?
- RBI’s tools for forex market intervention
- Difference between spot and forward forex markets
- Role of FPIs in balance of payments
- Concept of exchange rate determination
What to note for Mains?
- Why strong macro fundamentals may not ensure currency stability
- Effectiveness and limits of central bank intervention in forex markets
- Link between capital flows, investor sentiment, and exchange rates
- Policy challenges in managing rupee volatility in an open economy
