The rupee’s depreciation is often seen as an opportunity – but this narrative overlooks its impact on borrowers of foreign-currency debt
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A weaker rupee may boost exports, but it also raises hidden risks for firms with foreign debt—exposing fragile hedges and testing financial stability.
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The recent real depreciation of the Indian rupee has been widely welcomed by commentators. The dominant narrative is comforting: A weaker real exchange rate improves export competitiveness, supports manufacturing, and provides a growth impulse amid global uncertainty. It is also argued that depreciation helps offset higher external tariffs faced by Indian exporters. In this view, the depreciation is not a problem but an opportunity. This narrative, however, overlooks an important aspect: The impact on borrowers of foreign currency debt. Ignoring it risks an overly comfortable macroeconomic interpretation and an underappreciation of key policy challenges.
India’s total external debt exceeds $700 billion, with close to two-thirds owed by private financial institutions and non-financial corporations. A depreciation of the rupee raises debt-servicing burdens in domestic-currency terms. Assessments of vulnerability typically emphasise three mitigating factors: Borrower hedging, the adequacy of foreign exchange reserves, and the fact that external debt, at roughly 18-19 per cent of gross domestic product (GDP), is low by international standards.
These assumptions warrant closer scrutiny. Hedging is often treated as full insurance against currency movements. When borrowers claim to be largely hedged, it is commonly assumed that the rupee cost of servicing foreign currency debt will not rise with depreciation. In practice, plain vanilla hedges are expensive. Borrowers, therefore, adopt cost-reducing strategies that provide protection only up to a point while assuming risk beyond that point. Premiums earned from selling protection offset the cost of buying protection, and in some cases the notional amount of protection sold exceeds that purchased, creating non-linear exposures.
A simple example illustrates the risk. A borrower buys options that cap rupee depreciation at 2 per cent, at a cost of 2 per cent of the loan amount. To reduce this cost, the borrower sells insurance on twice the loan amount against depreciation beyond 3 per cent, earning a premium of 1 per cent. The net hedging cost falls to 1 per cent, and the borrower remains protected as long as depreciation stays below 3 per cent. If the rupee depreciates by, say, 7 per cent, however, the insurance sold is triggered as well. Because the notional value of protection sold exceeds that purchased, losses on the sold positions dominate, and the borrower incurs net losses despite being classified as hedged. The risk is amplified further when borrowers sell multiple contracts for every one purchased.
These strategies rely on an implicit assumption about central bank behaviour — that the Reserve Bank of India (RBI) will prevent sudden exchange rate moves while allowing gradual adjustment. When the rupee depreciates sharply over a short period, this assumption can fail. A move of more than 5 per cent raises concerns that embedded thresholds have been breached, leaving borrowers exposed precisely when currency risk is most severe. The problem is compounded by the fact that many external liabilities are hedged through the dollar rather than directly against the rupee, exposing borrowers to cross-currency basis risk when global dollar conditions tighten.
The broader implication is clear. Without detailed information on the structure, scale, and trigger points of hedging strategies, it is difficult to assess borrowers’ true exposure to exchange rate movements. Current disclosures lack the required granularity. As a result, even borrowers reported as hedged may incur significant losses when the rupee depreciates sharply.
What, then, of the comfort drawn from India’s large foreign exchange reserves and external debt-to-GDP ratio? Reserves help prevent a balance-of-payments crisis by ensuring access to foreign currency at the aggregate level. They cannot prevent borrower losses or distress if depreciation is sudden and large. Access to forex does not eliminate balance-sheet stress.
This matters because roughly one-third of external borrowers are financial institutions. India’s experience with the IL&FS default in 2018 and the subsequent non-banking financial company crisis is instructive. A localised default triggered a sharp loss of confidence, widespread rollover failures, and a contraction in credit supply, pushing GDP growth below 4 per cent in 2019. The global financial crisis of 2008 offers an even starker reminder of how distress in financial institutions can propagate into a broader macroeconomic crisis.
These dynamics are directly relevant in the context of external borrowing. A rapid depreciation that undermines hedges can impair balance sheets and trigger funding stress even without balance-of-payments pressure. It is, therefore, important that the central bank assess these risks carefully, including through internal stress tests of sharp currency depreciation over short horizons.
This analysis does not argue for maintaining an artificially high exchange rate. The appropriate role of the RBI is to smooth excessive volatility and prevent disorderly movements, using reserves to buy time for exporters, importers, and borrowers to adjust. At the same time, a deeper assessment is required to understand why the rupee is depreciating in real terms. If the movement reflects structural weaknesses in the tradable sector, monetary policy cannot address them. Exchange rate management can create space and reduce short-term risks, but restoring competitiveness lies elsewhere.
The authors are from the Indian School of Business. Tantri is also an independent director with Power Finance Corporation
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