Quo Vadis Indian Rupee!

As the Indian rupee depreciates against the US dollar, some economists argue that a flexible exchange rate that allows the rupee to depreciate in response to external shocks acts as a natural adjustment mechanism. In this view, a weaker rupee makes imports more expensive, encourages domestic buyers to shift toward domestic commodities, and enhances exports by making them cheaper for foreign buyers. These arguments are not logically watertight even in theory. Moreover, in the specific structural context of India, such arguments rest on assumptions that do not hold in practice and, therefore, produce outcomes that are often contractionary rather than stabilising.

India’s import structure is heavily concentrated in price inelastic commodities, such as crude oil, natural gas, and fertilisers. Oil, in particular, is not a discretionary commodity but a necessary input, directly or indirectly, for every sector of the economy. There are no immediate or adequate domestic substitutes. As a result, when the Indian rupee depreciates relative to the US dollar, import volumes do not fall significantly, but the domestic currency cost of these imports rises sharply. The economy, therefore, does not “adjust” by reducing imports; instead, it pays more for (by and large) the same quantity of essential goods, effectively transferring real income abroad and tightening demand for domestically produced output. This expenditure switching from domestically produced commodities to imported ones leads to a decline in output, employment and investment.

At the same time, the idea that domestic buyers will shift from imported to domestic goods is also limited by structural realities. In several key sectors such as electronics, machinery, and high-quality intermediate inputs, domestic alternatives are at best highly imperfect substitutes for imported ones in terms of quality or availability.

Exchange rate depreciation also operates through inflationary channels that disproportionately affect ordinary households. As fuel (or other imported input) prices rise, transport costs increase, which then feeds into food prices and other essential commodities. Since wages in India do not adjust immediately or fully in line with inflation, real incomes decline, reducing purchasing power. Firms facing higher imported input costs may attempt to preserve profit margins by passing costs onto buyers (poorer households and smaller firms), further reinforcing inflationary pressures.

In a demand-constrained economy like India, this dynamic of persistent exchange rate depreciation can suppress mass consumption, which is the primary driver of demand (especially when exports are income elastic, imports are price inelastic and government expenditure is constrained by the Fiscal Responsibility and Budget Management legislation). Thus, rather than acting as a neutral price adjustment, exchange rate depreciation often redistributes income away from workers and petty producers toward profit earners.

Another important dimension of exchange rate changes is financial vulnerability. While it is often suggested that India’s financial system is resilient because banks have limited direct foreign exchange exposure, a significant part of corporate borrowing, particularly in infrastructure, real estate and energy, is linked to external debt denominated in foreign currencies, such as the US dollar. A depreciation of the Indian rupee increases the domestic currency burden of servicing this debt, weakening balance sheets and discouraging investment.

At the same time, India’s dependence on volatile foreign portfolio flows means that exchange rate movements are tightly linked to global financial conditions. In periods of uncertainty (involving the ratio of trade deficit to output exceeding a threshold level) or rising US interest rates or depreciation of the Indian rupee, foreign portfolio capital can flow out rapidly.

A depreciating currency, rather than reassuring investors, may intensify expectations of further decline, triggering capital outflows and reinforcing downward pressure on the rupee. This creates a self-reinforcing cycle of depreciation and financial tightening that will undermine macroeconomic stability. It needs to be emphasised here that India's stockpile of foreign exchange reserves is based on borrowing and not current account surpluses. Therefore, there is no guarantee that this vicious cycle of adverse expectations-driven foreign portfolio capital outflow will self-correct.

Beyond these economic mechanisms, the exchange rate debate cannot be separated from realities of international political economy. India’s external vulnerability is not merely economic but also strategic. As long as the global monetary system remains heavily US dollar-oriented, particularly in oil and commodity trade, India must constantly earn or borrow US dollars to secure essential imports. This effectively constrains the ability of India’s broader foreign policy to traverse a trajectory of authentic strategic autonomy, with detrimental consequences for the Indian economy.

Recent developments in West Asia, including escalating conflict involving US military intervention against Iran and its aftermath, highlight this constraint of international political economy. The Indian government has been reluctant to express any discernible strategic position on the unfolding conflict in spite of the fact that the Indian economy is dependent on energy, fertiliser, remittances, etc. from West Asia. Likewise, Indian import of Russian energy is effectively operating within the ambit of US government waivers on unilateral sanctions.

Such a foreign policy posture sharply limits India’s ability to challenge the structural conditions that shape its vulnerability, particularly the unilateral sanctions regimes, US dollar dominance, and political and economic instability in oil-producing regions. In this sense, economic policy and foreign policy are deeply intertwined: India’s vulnerability to external price shocks is reinforced not only by its limited economic heft but also by its consequently constrained agency in international political economy.

This intricate interdependence between strategic agency and economic policy becomes crucial in understanding why exchange rate flexibility alone cannot be treated as a sufficient policy tool when dealing with crises such as the current one.

A more relevant policy framework to deal with the current crisis must instead focus on demand management that requires capital controls on foreign capital flows, structural transformation that involves a calibrated integration with regional production networks, and greater strategic autonomy that is inseparable from diversification of the composition of foreign currency reserves.

Trishna Sarkar is Faculty in the Department of Economics, Dr Bhim Rao Ambedkar College, University of Delhi. C Saratchand is Professor, Department of Economics, Satyawati College, University of Delhi. The views are personal.