Given that many of India’s export sectors are heavily dependent on imported inputs and that higher energy import costs ripple across supply chains, how much export competitiveness can India realistically gain through currency depreciation alone?
When India’s REER [real effective exchange rate] depreciates, India’s exports, when priced in foreign currencies, become cheaper and, therefore, more competitive. It is true that the larger the imported content, the less the competitive edge from a weaker currency. But as long as there is some domestic value-add, exports become more competitive. Much formal research on India’s exports, including some work RBI has done and we have done, has found that REER depreciation boosts India’s exports.
Furthermore, a weaker rupee also makes imports more expensive and India’s domestic substitutes more competitive. Both of these forces, over time, help narrow the current-account deficit. More importantly, they do so without hurting growth. In fact, growth gets a boost from stronger exports and domestic substitutes expanding. This is known as ‘expenditure switching’ in economics parlance, but it takes time and does not happen instantaneously.
Given the pro-cyclical nature of capital flows where they are attracted to higher growth, is there a risk of a feedback loop where a depreciating rupee raises input costs for Indian firms, impacts output growth, weakens foreign investor sentiment once again, and leads to further capital outflows and currency pressure?
As I said before, rupee depreciation is expansionary. It boosts growth. Stronger growth, in turn, should catalyse capital flows. But this is a medium-term phenomenon. In the near term, too, the rupee has stabilising properties on the capital account. Currencies tend to overshoot and if rupee depreciation is deemed to be overdone by foreign investors, it will attract foreign capital in the belief that the rupee will appreciate.
It’s important, however, that rupee depreciation does not happen too rapidly. When it does, it tends to spook foreign investors. They rush to hedge their existing stock of foreign assets in India such as foreign portfolio investments, external commercial borrowings and foreign direct investments [FDIs] and, in so doing, put more pressure on the rupee. Increased rupee depreciation pressures, in turn, further increases the desire to hedge, risking a self-fulfilling spiral. So, gradual depreciation is often the most effective.
The CAD has been very benign over the past three years. Instead, rupee pressures have originated from a sharp slowing of capital flows
How would you view the role of the rupee in the current scenario?
It’s important to realise that this BoP [balance of payment] episode is different from the previous ones. In earlier episodes, pressures started with a widening of the current account deficit [CAD] and the trigger was a sudden retrenchment of capital flows to finance a ballooning CAD. The sequence has been reversed this time.
The CAD has been very benign, averaging less than 1% of GDP over the past three years. Instead, rupee pressures have originated from a sharp slowing of capital flows, especially FDI, over the past three years. Against this background, expectations of a much wider CAD, in the wake of the West Asia war, are acting as a force multiplier, rather than the original cause.
It's important to make this analytical distinction, whether the source is the current or the capital account, because it informs the policy response.
In both cases rupee depreciation is desirable and inevitable for the reasons mentioned earlier. Theoretically, 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 REER. So, policymakers should be commended to letting the rupee find its new equilibrium.
But while the rupee depreciation is a necessary condition, it may not be a sufficient condition in the current environment. The rupee will go some ways in closing the BoP gap but given the perceived size of the gap—if crude prices remain elevated—some foreign capital augmentation will also be needed to alleviate BoP pressures.
So, we will need multiple instruments in the current episode: rupee depreciation, foreign capital augmentation and, as a last resort, current-account compression.
1 May 2026
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India’s merchandise exports when combined with the country’s long-standing surplus in services trade and remittance inflows, have not been enough to contain CAD. If concerns around artificial intelligence eventually translate into weaker growth in India’s services exports, could that become a concern from the perspective of external and currency stability?
At the most fundamental level, India’s CAD is the economy’s investment-savings gap. It’s a way of financing our higher investment rates through foreign savings. At our level of development, we want a higher investment rate, so there is no harm in running a sustainable current-account deficit.
A very low CAD or a current-account surplus is not desirable because it would suggest investment rates are not as high as they could be and, in the case of the latter, that we are exporting capital to the rest of the world! So, a moderate CAD is healthy and desirable.
But to finance that safely, we need to meaningfully increase the net FDI rates that we attract.
You are right about exports. History has shown that no country has grown at 7–8% for decades—as India must—without harnessing exports. So, we need both services and good exports to do well, to help offset the risks that the other might face.
The challenge will be to grow exports in an increasingly protectionist and economically Balkanised world which, in turn, will necessitate a relentless focus on productivity-enhancing reforms that improve India’s competitiveness.
