India's Currency Plunge: A Case for Capital Mismanagement

India's Rupee Volatility: Beyond the Current Account Deficit

The Indian rupee has been one of the biggest underperformers among emerging market currencies this year, and its volatility has revived a familiar narrative: that India's currency is hostage to its current account deficit. However, this explanation does not tell the whole story.

While India remains a structurally current account-deficit economy, with imports of oil, gold, and electronics consistently exceeding exports, the country is not simply an importer. It is also a major exporter of services. This is a crucial aspect to consider, as services have emerged as the main buffer in India's external position.

In the latest fiscal year, services exports generated a surplus of roughly $210bn, offsetting about 60-65% of the merchandise deficit. When remittances are included, so-called "invisibles" have nearly fully offset the goods deficit at times, keeping the current account deficit modest by emerging-market standards. This is why India, despite its large goods deficit, typically runs a current account deficit of only around 1-2% of GDP.

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However, the broader balance of payments is coming under pressure. The nature of capital inflows has changed, with foreign direct investment (FDI) weakening. India has become more reliant on more volatile portfolio flows to finance its external gap. Consequently, the rupee has become more sensitive to marginal shifts in capital flows, evolving from a currency primarily anchored by its current account dynamics.

As shown in the table, India's current account deficit has been offset by its services surplus and remittances. This suggests that the rupee's recent instability cannot be explained by the current account alone.

The capital account angle is driving the rupee's sharp depreciation. The financing of India's external deficit has quietly become more fragile, and the country is more reliant on volatile portfolio flows to finance its external gap. This has made the rupee more sensitive to marginal shifts in capital flows, and its volatility is increasingly driven by the behavior of global investors.

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Recent episodes of rupee weakness have been particularly acute because both the current account and capital account have deteriorated. The escalation in the Middle East and subsequent rise in oil prices have worsened this dynamic, given increased dollar demand from Indian importers. However, the impact of higher oil prices goes well beyond trade, raising inflation risks, hurting growth expectations, and unsettling financial markets.

The Reserve Bank of India (RBI) has responded to the volatility by focusing on smoothing volatility rather than defending any specific level. The RBI has tolerated more volatility than in previous years and has implemented regulatory measures to avoid depleting FX reserves. Intervention has been calibrated to prevent disorderly moves while allowing the currency to adjust gradually to underlying pressures.

This approach reflects a recognition that while reserves can dampen volatility, they cannot fully offset sustained capital flow pressures. India's macroeconomic fundamentals are stronger than those of many of its peers, and its services sector provides a powerful offset to its structural trade imbalance. However, the nature of the risk has changed, and the rupee is no longer simply a currency that drifts lower over time. It is one that moves more abruptly when flows turn.