RBI Faces Policy Choice Between Capital Controls and Rupee Defense

The Reserve Bank of India finds itself caught between managing inflationary pressures and a sharp depreciation of the rupee, a tension that has narrowed its immediate policy options to regulatory tweaks on capital inflows. The central bank is formally committed to maintaining price stability, yet the exchange rate matters acutely because 45.8 per cent of India’s GDP is attributable to trade in goods and services, meaning shocks from the external account percolate directly into domestic growth (Indian Express).

The Indian rupee is not an outlier; the dollar has broadly appreciated against a range of currencies, with the Indonesian rupiah, Japanese yen, and Korean won also depreciating since the beginning of the war. Movements in the exchange rate are driven by net capital flows, specifically portfolio flows sensitive to relative rates of return in India and the United States. The benchmark risk-free return of government yields in India exceeded those in the US for a long time but has converged swiftly since 2025. Even though India’s financial reputation improved after S&P upgraded its sovereign rating, global investors became more risk-averse and preferred the United States as a safer destination, compounding shocks from trade frictions and making it difficult for the RBI to stand still as foreign exchange reserves depleted in May and June (Indian Express).

The RBI’s intervention in the rupee market has been strategic. It has refrained from committing to a specific price level and has stepped in to manage volatility. Despite being more volatile than the yen, won, and baht over the 2021-25 period, the rupee has remained relatively stable in 2026. The closest comparable event remains the taper tantrum of 2013, when the RBI adopted a more proactive stance, including liberalising rules around foreign currency non-resident (FCNR) deposits. This time, the central bank has gone further by bearing almost all hedging costs for these deposits, as interest and principal are payable in foreign currency. The scheme has reportedly drawn inflows of $17.4 billion in its early months, compared with $26 billion over the entire duration in 2013 (Indian Express).

The question now is whether this is enough to offset outflows from portfolio investment and what happens when these deposits mature over two or three years. In 2016, there was a sizable retreat of FCNR deposits, and similar reversals in three years could impact the rupee. The RBI has also opened up further foreign investment in government securities by including more long-term debt under the fully accessible route, with fiscal relief such as capital gains and withholding tax exemptions adding to the appeal. Foreign portfolio investors purchased debt worth Rs 21,652 crore under this route in June, though that dissipated in July (Indian Express).

A more fundamental question confronts the RBI: whether it should pursue permanent capital account openness akin to countries like Korea or guard the rupee through controls. The editorial argues the central bank needs to look beyond defending the currency to address this structural choice (Indian Express).