The rupee problem this time is different. The solution must be, too

First, pressures have long pre-dated the West Asia conflict. For the first time in decades, the Balance of Payments has been in deficit for two consecutive years and we are on course for a third successive deficit. This suggests a more chronic underlying phenomenon that needs to be addressed.

Second, pressures are emanating from the capital account, not the current account. In past episodes there was a prototypical evolution: the Current Account Deficit (CAD) widened, became more dependent on fickle capital inflows to finance it which ultimately dried-up. This put pressure on the Rupee and necessitated compressing the CAD. This episode is very different. The current account deficit has remained very benign — averaging less than 1 per cent of GDP over the last three years. Instead, pressures have been driven squarely by the capital account. Capital inflows — which used to average 2.5 per cent of GDP pre-pandemic — have consistently slowed since 2023, completely dried up in 2025 and have exerted pressure on the Rupee.

Making the analytical distinction between the capital and current account as the source of pressures is crucial to formulating the right response.

In turn, a collapse in FDI is at the heart of the capital flow story, with net FDI – which used to average 1.5 per cent — completely drying up since 2024. What’s driving this? Between 2010 and 2025, India’s net FDI is strongly correlated with US 10 Year Treasuries — a proxy for global financial conditions. When yields are low India tends to get a gush of FDI; when yields have hardened — like the last two years — net FDI has completely dried up. Recall, FDI is typically governed by both (global) “push” and (country-specific) “pull-factors.” India’s FDI has largely been governed by push factors since 2010. The last time it was driven by India-specific pull-factors was in 2005-10 when a strong corporate capex cycle catalysed FDI. In contrast, Vietnam has consistently been able to attract above 4 per cent of GDP in FDI irrespective of global financial conditions.

Why does this matter? Because global financial conditions are likely to remain tight. Sticky inflation and a precarious fiscal situation are likely to keep US yields elevated. Meanwhile, India’s CAD is on course to more than double because of the West Asia conflict. Even if the Strait of Hormuz opens immediately, it is estimated crude prices will remain in triple digits all year as supply takes a while to normalise while demand remains strong to replenish inventories. If so, this would translate into India’s CAD widening close to $100 billion dollars this fiscal. The combination of higher bond yields and higher crude prices risks a pincer-like effect on the BoP.

The genesis of the problem, however, is a sustained slowing of capital flows amplified, only recently, by the terms of trade shock from higher energy prices. This must inform the policy response.

The first line of defense is to let the Rupee depreciate — as policymakers have correctly done -to act as a shock absorber. A weaker Rupee will disincentivise imports, improve export competitiveness and thereby simultaneously narrow the CAD and boost domestic activity (“expenditure switching”). Theoretically, too, a sharp slowdown in FDI compounded by a large negative terms-of-trade shock from crude prices would argue for a much more depreciated equilibrium exchange rate.

But while Rupee depreciation is a necessary condition, will it be sufficient? In theory, a weaker Rupee acts as an automatic stabiliser on the capital account, too, because if it is perceived to have overshot, foreign capital should be attracted back. But what does overshooting mean in the current environment? To what extent will the Rupee need to depreciate — if it is the only instrument deployed — to close a large BoP gap? That is the question foreign investors are grappling with and it’s not clear that any value of the Rupee will be seen as being oversold given the perceived size of the BoP gap.

In fact, if the Rupee depreciates too rapidly, it increases the incentives for foreigners to hedge their existing stock of assets in India (FPI, ECBs, FDI) compounding BoP pressures. That hedging puts more pressure on the Rupee, further increasing the desire to hedge, thereby creating a self-fulfilling spiral – signs of which have emerged. This risks pushing the Rupee far away from its fundamentals and warrants a circuit breaker to restore order.

That circuit breaker should be foreign capital augmentation measures. The objective must be to attract a large-enough quantum of near-term capital inflows across multiple avenues — even if it involves a subsidised swap — to change exporter, importer and investor behaviour, and prevent a destabilising overshooting of the Rupee.

A weaker Rupee and an influx of capital should hopefully stem the tide. If not, “expenditure compression” — tighter fiscal and monetary policy — may be needed, but only as a last resort. Back in 2013 when the Rupee was under pressure, it was clear the economy was overheating, and the obvious response was to tighten fiscal and monetary policy to narrow the CAD. The current context is very different: core inflation has averaged just 2-3 per cent in recent years suggesting the existence of slack and we are still awaiting a private capex cycle that is likely to be further delayed amidst heightened geopolitical uncertainty. In this environment, fiscal compression that accommodates higher fuel and fertiliser subsidies by cannibalising public capex risks making policy pro-cyclical.

All told, it’s important to realise that this BoP episode is different. The pressure point is the capital account not the current account. This will require both a weaker Rupee but also foreign capital augmentation measures. Simply squeezing the current account through demand compression can, in fact, be counterproductive by slowing growth and turning-off growth sensitive capital inflows.

More generally, the biggest lesson India must draw from this episode is that attracting strong and stable FDI needs to be an urgent macroeconomic imperative — both for macro stability and growth. This will require sustained economic reform that improves India’s structural competitiveness. There is no escaping that imperative.

Sajjid Z. Chinoy is Head of Asia Economics at J.P. Morgan. All views are personal