This year has been marked by exceptional dollar weakness, as the world grapples with the uncertainty created by the Trump tariffs. The policy unpredictability from the US has prompted countries to seek alternatives to the dollar. Central banks have been diversifying their FX reserves into gold and other developed market currencies such as the euro. However, the negative sentiment toward the dollar has not benefited the rupee, which has faced the strongest depreciation pressures among key Asian currencies.

Capital Flows: The Main Driver of INR Weakness

The pressure on the INR is primarily driven by weak capital flows and tariff tensions. In the first seven months of FY26, net FPI inflows have been nearly zero, compared to US$10bn inflows during the same period last year. Unlike other emerging markets, India is experiencing a divergent trend in capital inflows, which is also reflected in currency performance. EMs have seen a 22% YoY increase in FPI inflows, totalling US$188bn in FYTD26 (till September). This divergence suggests that investors view Indian equities as overvalued.

Debt inflows have also moderated, largely due to normalisation following India’s inclusion in the JP Morgan EM bond index, which was completed in March 2025. On a positive note, FDI inflows have picked up, supported by reduced repatriation pressures. Net FDI inflows in FYTD26 (till August) stood at US$10.1bn, compared to US$3.3bn in FYTD25.

Overall capital inflows—including FDI, FPI, external commercial borrowings, and banking capital—have likely turned negative in Q2–Q3FY26, contributing to increased depreciation pressure on the rupee and prompting more active RBI intervention.

Current Account: A Milder Drag

The drag from the current account remains relatively moderate. The trade deficit widened to US$155bn in H1FY26 from US$145bn in H1FY25, driven by a surge in gold imports. Gold imports rose 16% YoY to US$26.5bn, reflecting higher global prices.

The impact of bilateral tariffs on exports is becoming evident, with India’s exports to the US declining 12% YoY in September 2025—the month when the 50% bilateral tariff came into effect. There was significant frontloading of exports during the pause period when only a 10% tariff was applicable, which helped cushion some of the negative impact.

The trade deficit is expected to widen to US$327bn in FY26, compared to US$287bn in FY25. Despite this, the overall current account deficit remains low, supported by a strong services surplus and robust remittance inflows. Trade tensions are largely confined to merchandise trade, while services exports remain relatively unaffected.

Risks to services exports could rise if the proposed outsourcing tax under the HIRE Act is implemented. Additionally, higher H1-B visa costs could negatively impact remittances over time. The US is the largest source of remittances to India, accounting for 28% of gross inflows. However, the impact in FY26 will be limited, as the higher visa cost applies only to new applicants. On the positive side, outsourcing demand could increase.

The overall current account deficit in FY26 is estimated at 1.3% of GDP, up from 0.6% last year. Thus, despite a challenging global environment, the current account deficit remains contained. The pressure on the INR is mainly due to capital outflows.

RBI Intervention: A Changing Strategy

The most critical factor affecting the rupee is the RBI’s intervention in the FX market. Compared to last year, RBI intervention has been lower, resulting in greater two-way volatility in USDINR. To illustrate this shift, consider net dollar selling in the spot and forward markets: in FY26 (till October), RBI’s net dollar selling is estimated at US$34bn, compared to US$55.8bn over just four months (October 2024 to January 2025) last year.

This change in intervention strategy stems from the build-up of net dollar short positions in RBI’s forward book. Last year, RBI used buy-sell swaps to reduce the liquidity drain from spot market intervention, causing the forward book to rise from US$14.6bn in September 2024 to US$88.8bn in February 2025. These short positions imply that RBI must sell dollars when contracts mature.

This year, the focus has been on reducing the forward book, which reached a near-term low of US$53.4bn in August. Consequently, the RBI’s ability to defend the INR through additional spot market intervention has been limited.

Since September 2025, persistent depreciation pressure has forced the RBI to become more proactive in the FX market, increasing intervention in the spot, forward, and NDF markets. This is reflected in the forward book rising again to US$59.4bn in September, as the RBI added buy-sell swaps. October 2025 alone saw US$17bn in net dollar selling. This increased intervention has helped reduce USDINR volatility, but the associated liquidity drains limit how long such measures can be sustained.

(Gaura Sengupta is the Chief Economist at IDFC FIRST Bank.)

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