Attempts by the central bank to hold back the rupee risk doing more harm than good
The Indian rupee has been under intense scrutiny in recent weeks, with its depreciation against the US dollar attracting widespread attention. Much of the commentary has framed this decline as a sign of weakness, often applauding the central bank’s efforts to resist it. But this view overlooks a basic point: The exchange rate is a price. And like any price, it must adjust to shifts in demand and supply. Trying to hold it at an artificial level does not fix underlying imbalances — it only postpones the adjustment and risks making the eventual correction more disruptive.
Consider a familiar example. When the monsoon fails, the supply of vegetables falls short of demand. Prices rise, and this serves a purpose: Households cut back consumption, and farmers are encouraged to bring as much produce as possible to the market. The imbalance begins to correct itself.
Now imagine the government steps in to prevent prices from rising. The gap between demand and supply does not disappear—it simply persists. To manage it, the government would then have to impose restrictions, such as rationing or limits on sales. In the end, consumers would face shortages and reduced access, defeating the very purpose of the intervention. This is precisely why governments typically allow such prices to adjust rather than trying to control them.
The same logic applies to the foreign exchange market. When demand for dollars exceeds supply, the price of the dollar rises — and the rupee falls. What we are seeing today is simply this basic market adjustment at work.
So why is demand for dollars rising faster than supply? There are two main reasons.
First, India has been running a current account deficit, which was around $40 billion in 2025-26, but foreign capital inflows were insufficient to finance it. This imbalance helps explain why the rupee was already under pressure last year.
Second, the war in West Asia has made matters worse. By pushing up the prices of key imports, it is likely to widen the current account deficit further—potentially to around $80 billion this year.
As a result, India faces a difficult challenge: It needs to attract around $80 billion in foreign capital at a time when global investors are becoming more risk-averse and pulling money out of emerging markets into safer developed economies. In such a situation, the most practical way to restore balance is to allow the rupee to depreciate.
How does depreciation help? In much the same way that higher vegetable prices restore balance — by reducing demand and encouraging supply. The exchange rate works through two key channels.
First, a weaker rupee helps restore balance through trade. As it depreciates, Indian goods become cheaper for foreign buyers, boosting exports and bringing in more dollars. At the same time, imports become more expensive, which reduces domestic demand for foreign goods. Together, these effects help narrow the current account deficit.
Second, a weaker rupee makes Indian financial assets cheaper for foreign investors. In dollar terms, Indian stocks and bonds now cost less, which can make them more attractive. This can encourage foreign investment into Indian markets, bringing in dollars and helping to finance the current account deficit.
In contrast, if policymakers try to hold the exchange rate at an artificial level, the underlying imbalance does not disappear — it lingers, and can even intensify over time.
The main reason is that the market is aware of the $80 billion funding gap — and that the central bank cannot finance it indefinitely by selling dollars, since it will eventually run out of reserves. Unless this gap is expected to close on its own, some depreciation of the rupee becomes inevitable. Faced with this prospect, firms and households will naturally look for ways to safeguard their wealth, including shifting part of it abroad.
There is another concern. When the central bank tries to manage the exchange rate, the private sector shifts its focus from market signals to guessing the central bank’s next move. This uncertainty can itself be destabilising. If the currency is supported through restrictions — such as the recent curbs on gold and silver imports — it can unsettle the private sector and raise fears of further controls. Such fears can trigger precautionary behaviour, with firms and households pre-emptively moving money out of the country, adding to the pressure on the rupee.
In other words, attempts by the central bank to hold back the rupee risk doing more harm than good — by eroding confidence, fuelling uncertainty, and distorting market signals. This can widen the gap between dollar demand and supply, discourage investment, and complicate economic recovery. The exchange rate is not the problem; it is the mechanism through which the problem is corrected. Holding it back only delays the adjustment and makes the eventual cost higher. In these circumstances, the most effective policy is also the simplest: Allow the rupee to move freely and do its job as the economy’s primary shock absorber.
The author is associate professor of economics, IGIDR, Mumbai. The views are personal
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