India's Rupee Experiences Sharp Decline: Separating Temporary and Structural Factors

Indian Economy Faces Uncertain Future Amidst West Asia Conflict

The Indian economy, which had been in a "sweet spot" at the beginning of 2026, is now facing significant challenges due to the ongoing West Asia conflict. According to estimates, the country's GDP for the fiscal year 2026 (FY26) was expected to grow by 7.6%, while Consumer Price Index (CPI) inflation was running at 2.75%. The fiscal deficit and current account deficits were also within targets, standing at 4.4% and 1%, respectively. Additionally, India's foreign exchange reserves were ample, totaling around $720 billion, and Brent Crude was trading at approximately $62.

However, the situation has taken a turn for the worse. The conflict has led to a sharp spike in Brent Crude prices, from around $70 just before the war to over $110 currently. This will have a significant impact on the country's macroeconomic indicators, including GDP growth, fiscal deficit, current account deficit, the rupee, and corporate earnings.

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The energy crisis triggered by the war has impacted the Indian economy, not just as a price shock, but also as a supply shock. The closure of the Hormuz Strait has affected the supply of Liquefied Petroleum Gas (LPG) and Liquefied Natural Gas (LNG), impacting various businesses such as hotels, restaurants, travel, and LNG users. This, in turn, will widen the trade deficit and put pressure on the country's current account deficit.

The sustained selling by Foreign Portfolio Investors (FPIs) in the stock market has also made the rupee one of the worst-performing emerging market currencies. The rupee's weakness is partly a temporary trend, triggered by the oil shock and the consequent impact on trade and current account deficits, and partly structural, as India has been dependent on FPI inflows to finance current account deficits.

The Reserve Bank of India's (RBI) directive to banks to cap their open rupee positions in the onshore market at $100 million and barring banks from offering rupee non-deliverable derivatives has led to a short squeeze, pushing the rupee up to around the 93 level. However, this relief is likely to be temporary, as the underlying fundamental issues relating to rising trade and current account deficits and sustained FPI selling are not addressed.

In the near-term, the rupee weakness is likely to continue. Stability can emerge from two sources: an end to the war and a sharp decline in crude prices, or a significant decline in FPI selling. The first can happen at any time, while the second will require clarity on India's growth, inflation, and corporate earnings, which will emerge only when there is a de-escalation in the West Asia conflict and the opening of the Hormuz Strait.

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