Capital Flows Key to Rupee Appreciation

RBI Norms Bring Relief to Rupee, But Structural Challenges Remain

The recent relaxation of guidelines by the Reserve Bank of India (RBI) on risk management and inter-bank dealings has led to significant volatility in the currency market. The measures, announced on March 27th and April 1st, 2026, resulted in a sharp 2.20% appreciation of the rupee up to April 10th. However, the currency has since retraced around 1.5% to trade close to its pre-measure levels.

The RBI's revision of norms removed most restrictions, except for net open position limits and related party dealings. This has not affected the ability of onshore banks to offer hedging for trade and other economic exposures. While the measures were intended to deter speculative pressures on the currency, the RBI's REER (Real Effective Exchange Rate) indices data for February 2026 suggests that the currency remains undervalued by about 8%.

The balance of payments data over the past two financial years reveals a cumulative deficit of nearly $60 billion, with about $14 billion in FY25 and over $40 billion expected for FY26. The RBI's intervention in the currency markets has far exceeded the balance of payments deficit, with significant smoothening operations having been done. This shows the extent of positioning against the rupee.

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The underlying current account deficit (CAD) is anticipated to be around 1% of GDP. However, the outlook on the capital account becomes critical, with both net FDI and net portfolio flows remaining muted. Net FDI, which was around $36 billion on an average over FY15 to FY22, has remained less than a billion over the last two years. Similarly, net FPI flows continue to remain negative. NRI deposit growth at around $11.04 billion for the current FY till February has declined by around 24% as compared to the growth rate over the last FY.

The prospect of an elongated conflict in the Middle East would lead to spillover of CAD beyond 1%. The financing of even a moderate CAD under 1% has been challenging over the last two years. Capital flow visibility on the portfolio route remains muted currently, with equity flows hostage to relative valuation metrics as well as global risk appetite. Narrowing rate differentials continue to cloud the outlook on debt flows, even as the currency view provides a further negative feedback loop into prospects of incremental flows.

While recent administrative actions may have had some short-term impact on speculative positioning in the INR, they are unlikely to fully deter such activity. Positioning costs may have increased marginally, as domestic players now face somewhat tighter limits. At the same time, the emerging fundamentals possibly warrant caution with respect to the near-term trajectory of the currency.

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A material improvement in capital flow dynamics is quite essential to provide a basis for a near-term structural appreciation trend. Even as services surplus continues to remain strong, a resolution of the Middle East crisis could provide a more favorable backdrop to the current account outlook.