The Wrong Culprit for a Falling Rupee: Policy Misdiagnosis and Betrayed Market Confidence
In July 2026, the Indian rupee levels near its record low, closing at approximately 96,57 against the US dollar after it has reached 96,83 in May this year. This depreciation of nearly 2% during the month of July occurred alongside escalating tensions in the Middle East and resulting increases in Brent crude oil prices.
However, despite maintaining foreign exchange reserves of more than $675 billion and a record net short forward position of approximately $106.6 billion as of 31 May 2026, the Reserve Bank of India (RBI) has relied on a combination of primarily invisible market interventions and only selective support for the currency. This approach has made the scale of the rupee defence difficult for investors to assess, contributing to market confusion.
Policymakers have publicly characterised this volatility as a temporary phenomenon and have decided to focus instead on a strategy centred on attracting even more foreign financing than enforcing policy changes to stabilise the exchange rate. But even after the recent announcement of newly attracted $20 billion in dollar deposits the rupee has continued to underperform, which speaks of a policy inefficiency and a deeper problem with possibly other underlying causes.
Contrary to the belief also backed up by the RBI that the sole driver of the decline of the rupee is the surge in global oil prices and the rising uncertainties regarding the fossil fuel supplies, investor statements and policy trends, as well as academic research regarding markets behaviour, show that there is a misdiagnosis of the situation by the central bank. The rising geopolitical tensions transform investment patterns and alienate capital from emerging markets towards US-dollar funds, the negative effect on the rupee is strengthened further by the unpredictability of the RBI’s actions that emerges as a result from the same underappreciation of the crisis. Therefore, the observed volatility is not a mere symptom of the energy shock, but a reflection of eroding market confidence in India’s internal economic stability and institutional predictability, as well as a logical consequence of the changed US borrowing strategies.
of the Problem
A look into the central bank’s current policy framework based on actual interventions and statements from those in charge shows a strategy built upon the diagnosis that the depreciation of the rupee is a temporary response to the energy-shock of the US-Iran conflict. It is undeniable that fossil fuel prices play a crucial role. India’s dependency is extremely high with net imports accounting for around 85% - 90% of its crude oil needs. The expected inflation and the resulting depreciation are claimed as mainly related to the foreign exchange shifts and not requiring RBI's constant intervention. The main argument behind that statement is that at least on prima vista India’s macroeconomy remains stable and therefore a focus on attracting more financing seemed more beneficial than making aggressive structural policy changes.
However, market data suggests that the problem may be deeper, with the oil price volatility being just the trigger and not the source of the matter. First, a comparative analysis with other oil-dependent countries in the region seems necessary to appraise the influence the war has had on the currency. In the last month, the Indian rupee has lagged behind its other Asian counterparts like the Indonesian rupiah and the Thai baht. And that trend is observed not only in the short term - over a period of one year the INR has fallen notably more than comparative currencies. And if oil prices and expected inflation surges that follow were the primary driver, the other energy-importing nations in the region would experience proportional depreciations.
A symptom showing that the crisis lies on a deeper level is the state of internal investments. Over the last decade corporate investment in India has steadily shrunk and is now at just over half its peak, reached during the boom during the 2000s (Subramanian, 2026). It may be argued that this erosion is driven by both short-term loss of confidence among investors and by long-term structural changes in the labour-intensive manufacturing sector as new technologies including AI increasingly substitute for human labour that once drove the economic growth.
Additionally, the argument that the RBI’s evaluation of the situation is inadequate is further supported by the evident failure of the decision to use mainly capital inflows to stabilise the currency. Despite the successful mobilization of more than $20 billion in dollar deposits only during June and July 2026, these inflows were used primarily to unwind forward positions rather than to support the rupee efficiently. As a result, official foreign exchange reserves increased by around $3 billion in the last months, while the rupee continued to depreciate. This suggests that a simple dollar shortage in the economy is not the issue. Instead, there is a fundamental “turn away” by global investors.
This changing behaviour of foreign investors is also reflected in the Indian National Securities Depository Limited (NSDL) monthly FPI data. Between January and July 2026, foreign portfolio investors remained persistent net sellers of Indian equities, while their allocations to debt markets strengthened following some selective cases of RBI and government measures aimed at improving the attractiveness of their bonds. Although the first half of July recorded net inflows of approximately $2.5 billion across equity and debt markets, these recovered only a small fraction of the capital withdrawn during the previous months.
An important contribution to the Misdiagnosis thesis is that of Arvind Subramanian (2026), who similarly argues that the rupee’s weakness has been misdiagnosed. He also rejects the argument that the depreciation is merely a temporary foreign-exchange problem. However, his explanation lies on a slightly different mechanism. While Subramanian emphasises long-term structural weaknesses like growing AI-reliance and slowed labour- intensive manufacturing, the argument developed here is that the immediate acceleration of the rupee’s depreciation is primarily driven by a collapse in market confidence caused by inconsistent RBI intervention, combined with the global portfolio reallocation towards higher-yielding US-dollar assets.
The investors aversion can be linked to a massive loss of market trust and increased institutional unpredictability. Those are driven by the inconsistency in the support the Reserve Bank of India has offered to the stabilisation of the currency. Reuters (July 21, 2026) reports that traders are finding it difficult to understand how much weakness policymakers can tolerate.
This unpredictability and indecisiveness is rooted in a sharp internal dispute within the central bank. The current leadership, including the Governor Sanjay Malhotra and his Deputy Poonam Gupta, favours an approach that allows more freedom and expects the markets to regulate the currency’s level on their own. They argue that reserves must be used only to adjust to macroeconomic shifts, rather than for aggressive rupee defence policies, with the RBI having to step in only in cases of excessive volatility. Here emerges the problem of the missing definition of that “excessive volatility” - there is no clear framework that defines their understanding of a situation that requires intervention, so the investors don’t know at which point they can trust the central bank to save the rupee and therefore prefer to leave the market than to take the risk no intervention poses. In contrast, bank veterans, simultaneously involved in the market, fight for more intervention to reinforce confidence and discourage those considering moving their capital away from India.
The consequences of this divided strategy are observable in the bank’s recent actions. The rupee support policy is inconsistent and difficult to understand. For example, while the RBI implemented a $100 million cap for commercial banks’ net open forex positions in April to deter speculations, it has also highly refrained from deploying its dollar reserves to their full potential with limited support only in some of the most critical times, but without any signs beforehand.
Apart from investors' confidence loss, there are additionally some broader implications of the selective interventions, supported by academic research. In their work Siddharth et al. (2024) argue that in a managed floating regime like the one India has, irregular or selective interventions disrupt long-term equilibriums, which causes the exchange rate to deviate from its market-clearing level and leads to increased overall currency volatility. Those uncertainties not only cause investors to expand their portfolios more carefully but often urge them to exit the market in favour of other more predictable and sometimes more profitable alternatives.
The other driver of the depreciation is the dollarisation of Indian economy due to the structural hierarchy of the global financial system, where the United States serves as the “core” and emerging countries like India belong to a “periphery”. This structure results in severe restriction of financial freedom for peripheral economies and a loss of effective control over the domestic interest rate and money supply.
One of the cases when this dependency becomes visible is in time of interest rate hikes initiated by the US Fed. When that happens, usually to combat domestic inflation, new bonds are issued, which drives prices falls and consequently yields spikes to attract new buyers. Currently there is still no actual spike of the rate, but such is expected among investors by the end of the year (CBS News, July 24, 2026). But not only the increased rates can play a role, also the elevated due to the war overall US borrowing that is used to cover the budget deficits surging from the spendings on military costs stays relevant and is already happening.
The hostilities in the Middle East have triggered a prolonged and even bigger selloff in US government bonds. This additional supply shock pushes yield even higher - that on the benchmark 10-year US Treasury note hit an 18-month high of over 4,7%. This environment has stimulated a rebalancing of global portfolios, alleviating capital from emerging markets like India towards a safer and now also more profitable US treasury bonds.
And the financial market indicators confirm the benefits of the US yields since the one-year USD/INR forward premium fluctuated around 3%. In the case of India, the combination of loss of trust in the domestic currency and the surging more appealing alternative the dollar presents enforces the depreciation beyond the RBI’s expectations.
Academic research (Akram & Mamun, 2024) into the Indian rupee swap yields provides an explanation why India struggles to stop this capital flight. While the RBI theoretically can influence borrowing and lending rates, the Indian swap market is still not fully developed and reacts slowly to policy corrections. Shocks to the relationship between interest rates and swap yields in India take up to 4 months to disperse, in that time investors usually have already left the market. Consequently, rupee funds remain permanently less profitable than US-dollar funds in volatility periods.
Adding to the short-term pressure the Fed’s policy puts on the rupee, the de facto dollarisation of the Indian economy, specifically regarding debt and energy imports also plays a role. This dependency creates a transmission route for inflationary waves and an increased amount of the supply of US government bonds results in financial volatility in the peripheral emerging economy. To try and limit capital flight and rebalance global capital back to the rupee the central bank may be forced to increase domestic interest rates. Such a move risks further sifting of the already slowed down economy that can later pose more problems when it comes to attracting foreign capital to benefit the currency.
In response to the vulnerabilities, India has already initiated a de-dollarisation strategy to shift from a multilateral system dependent on the US towards bilateral trade agreements. As the US remains a crucial partner, the new approach focuses on expansion and diversification of financial alternatives and hasn’t been aggressive toward dollar dependencies yet. Important steps in that direction include a Memorandum of Understanding with the UAE for the establishment of a Local Currency Settlement System and a CEPA agreement between the two countries. Furthermore, in 2025, the number of countries hosting authorised banks to open Special Vostro Rupee Accounts in INR has increased up to 30, now including Germany and the UK. India also utilises more currency swap agreements with other countries in the region to reduce USD exposure. Additionally, the free trade agreement concluded in January this year with the EU has established the world’s biggest free trade zone. The reduced tariffs are expected to boost EU exports to India by more than 100% over the next 6 years.
However, these structural shifts are still in progress and are insufficient to prevent the nearing currency crisis. As long as the global financial system remains centred on the US dollar and investors continue to find incentives to favour the US assents especially during periods of uncertainty, the rupee will remain exposed to external shocks Therefore, a natural market stabilisation of the rupee is unlikely and the approach to only focus on attracting major FDI-related foreign incomes seems inefficient.
The oil shock explanation should not be dismissed entirely. Given India’s dependence on imported energy, the recent surges of the prices, as well as the concerns of the overall fossil fuel supply chains following the escalation of the war and the talks about an involvement of the Houthis in the Red See, have put a logical pressure on the rupee, that didn’t come as unexpected. The comparison with other local currencies, despite being convincing, can be attributed also to the higher vulnerability the massive net import of energy presents for the country. From this perspective the central bank’s position that the oil shock may be the only responsible for the rupee depreciation appears justified.
Yet the structural issues that are already discussed suggest that the oil explanation is just one part of the story, it acts as a trigger to the currency crisis, but the effects are multiplied by other mechanisms as well. First, the promise of intervention in cases of an estimated “excessive volatility” combined with arbitrary interventions leave traders to gauge the RBI’s tolerance towards depreciation and therefore the lack of transparency becomes the cause for ineffective hedging strategies that alienate capital holders. For instance, Reuters (Gopakumar et al., 2026) cites Singapore-based hedge fund managers that have decided to reinstate bearish rupee positions specifically because the rupee fell beyond the levels they expected the central bank to intervene. And second, as the previous section proves, external shocks have massive influence over the Indian assets. The role of the dollar drives investors away from emerging markets and leaves their currencies in need of stabilisation policies.
A further argument in support of the RBI’s restrained approach is that part of the rupee’s depreciation represented a necessary correction and should be regarded as beneficial. The RBI’s 40-currency Real Effective Exchange Rate (REER) index stood at 108.14 in November 2024, indicating that the rupee had become relatively expensive in inflation-adjusted, trade-weighted terms. From this perspective, allowing some depreciation would help restore external competitiveness.
However, this explanation becomes less convincing over time. RBI data show that the REER values continued to fall, reaching 89.08 in May before recovering only slightly to 91.26 in June 2026. Since a decline in the REER reflects a real depreciation of the currency, the initial valuation adjustment had already been already completed. The continued weakening of the rupee therefore cannot be attributed solely to an overdue correction. Instead, growing uncertainty surrounding the RBI’s intervention strategy and the broader deterioration in investor confidence became increasingly important drivers of the currency’s decline.
Now let’s investigate the implications this deeper understanding of the rupee crisis shows. If the current policy trends persist and the RBI doesn’t adopt a working strategy to save the currency, the market instability may continue even after the current conflict and become structural due to a fundamental loss of trust. The consequences will be durable and acute regarding the overall state of the economy, a further drawback of foreign capital will slow down the growth and put India in a very unfavourable position in the global markets. Therefore, immediate and trustworthy commitments toward a support for the rupee are needed in the short-term.
The gradual shift away from the dollar-dependency and towards bilateral trade agreements and a diversification of trading partners appears to be a pragmatic measure in the long-term. It would reduce India’s exposure to changes in US monetary policy and provide flexibility in international trade for the country. Still, internationalization without a solid underlying investment climate is likely to fail to attract solid quality foreign non-dollar capital.
Another important step for lowering the market risks and keeping trades even in times of similar crises is a focus on the developing swap market, which has the potential to reassure investors, but is still way too slow when it comes to closing the yield gaps. A bettered swap market would allow businesses and investors to hedge exchange-rate risks more efficiently, reducing the uncertainties during higher currency volatility periods.
The argument presented in this article depends on whether the current weakness of the rupee reflects a deeper loss of confidence or merely a temporary response to the oil shock. If the currency stabilises without a change in the RBI’s intervention strategy and if foreign capital returns despite the current policy uncertainty the central bank’s interpretation would gain considerably more credibility. The key indicators to watch over the coming months are the foreign portfolio investment flows into India and the level of US Treasury yields, as both directly influence investors’ allocation decisions between Indian and US assets. Also, a sustained recovery in investment and portfolio inflows without broader policy adjustments would weaken the argument that institutional unpredictability has become the main driver of the depreciation. In that scenario, the evidence would point much more strongly towards the external shock itself, driven by the war, than to a broader crisis of market confidence.
Not of Crude
The depreciation of the Indian rupee, which approached a new record low against the USD this month, cannot be brushed off as a product only of the Middle East conflict and the energy shock it has triggered. While the RBI treats the slide as a temporary reaction, the reality is that the rupee’s struggles are rooted in eroding market confidence. When the currency defence is conducted through forward positions and limited direct support rather than visible market interventions, investors often cannot understand the central bank’s commitment rightly, what leads to the loss of market confidence, that is crucial for the stability of the currency. External factors and the US dollar hegemony continue to accelerate the problem. The rising US government bonds yields attract indecisive investors from emerging markets and make the safe US dollar assets even more appealing by increasing their profitability.
To effectively combat the currency crisis the RBI needs to reassess its approach to reestablish market trust. The country’s intent for de-dollarisation is also very pragmatic but needs the support of a stable investment environment to show positive results. The situation is still manageable, but the central bank needs to reassess its stance on time to keep capital from flying the country.