The Indian rupee has not only been one of the biggest underperformers among emerging market currencies this year, but it has also been among the most volatile. Its volatility has revived a familiar narrative: that India’s currency is hostage to its current account deficit.
With the country importing the bulk of its crude oil and running a persistent trade gap, it is tempting to attribute every bout of weakness to the same structural flaw. While comfortable, that explanation does not tell the whole story.
The capital account angle
The rupee’s sharp depreciation appears to be driven more by the capital account. More precisely, it seems to reflect how the financing of India’s external deficit has quietly become more fragile. India remains a structurally current account-deficit economy. Imports of oil, gold and electronics consistently exceed exports, ensuring a steady dollar demand. This produces a large and persistent merchandise trade deficit, which widened to over $300bn in the latest fiscal year.
Yet, this headline number can be misleading if taken in isolation. India is not simply an importer; it is also a major exporter of services.
That clearly matters.
Services have emerged as the main buffer
India’s services sector has emerged as the country’s primary external buffer, albeit risks stemming from AI disruption are key to watch. In FY26, 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. We think this is important. The rupee’s recent instability cannot be explained we think by the current account alone.
Weakening FDI flows
However, the broader balance of payments is coming under pressure. What has changed instead is the nature of capital inflows. For much of the past few years, India’s external position benefited from relatively stable funding. Foreign direct investment (FDI) helped to finance the residual gap left after services exports. As long as those flows were strong and predictable, the system functioned smoothly. The rupee weakened gradually over time, but without bouts of disorderly volatility. This source of inflow has weakened. 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. In such a system, volatility is increasingly driven by the behaviour of global investors.
Emphasis on flows
This helps explain the apparent paradox that has emerged in recent months: India has delivered strong economic growth, maintained relatively stable inflation, and kept its current account deficit within manageable bounds. Yet, the rupee has weakened sharply. This suggests currency markets are not pricing growth; but rather flows.
All that being said, the current account still matters given how it determines the scale of the financing requirement. Even after accounting for the services surplus, India is left with a sizeable external gap that must be financed annually. When capital inflows are stable, this is manageable. When they are not, the currency bears the burden of adjustment.
Recent episodes of rupee weakness have been particularly acute because both the current account and capital account have deteriorated.
Impact of the Middle East crisis
The escalation in the Middle East and subsequent rise in oil prices have only worsened this dynamic given increased dollar demand from Indian importers. However, the impact of higher oil prices goes well beyond trade. It raises inflation risks, hurts growth expectations, and unsettles financial markets. In doing so, it triggers capital outflows, amplifying pressure on the currency. This feedback loop is what lies behind the rupee its current volatility.
A rise in oil prices widens the deficit and weakens the currency. That weakness feeds into investor sentiment, prompting further outflows. Those outflows, in turn, push the rupee lower still.
RBI’s approach
The Reserve Bank of India (RBI) has responded by focusing on smoothing volatility rather than defending any specific level. Nonetheless, the RBI has tolerated more volatility than in previous years. The RBI has also implemented a variety of 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.
This does not amount to a crisis. 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. But the nature of the risk has changed.
The rupee is no longer simply a currency that drifts lower over time. It is one that moves more abruptly when flows turn. For investors and policymakers alike, the lesson appears straightforward. The rupee’s vulnerability does not lie in the size of its trade deficit, nor even in the trajectory of oil prices. It lies in the reliability of the capital flows that finance the gap.
(Mitul Kotecha, Head of FX & EM Macro Strategy – Asia-Pacific, Barclays.)
Views are personal and do not represent the stand of this publication.