Why has the Indian rupee depreciated against the US dollar recently?

The Indian rupee has depreciated due to a combination of factors including weakening foreign capital inflows, global interest rate normalization, persistent trade and current account deficits, strengthening of the US dollar, geopolitical uncertainties, and changing investor sentiment in global financial markets.

What is rupee depreciation?

Rupee depreciation refers to a decline in the value of the Indian rupee relative to foreign currencies, especially the US dollar. It means more rupees are required to purchase one unit of foreign currency.

What is the Real Effective Exchange Rate (REER)?

The Real Effective Exchange Rate (REER) is an index that measures the value of a country's currency against a basket of major trading partner currencies after adjusting for inflation differentials. A REER below 100 generally indicates that the currency may be undervalued.

Why does the RBI consider the rupee undervalued?

The Reserve Bank of India considers the rupee undervalued because its Real Effective Exchange Rate (REER) has fallen below 100. A lower REER suggests that the rupee's market value is weaker than what economic fundamentals may justify.

What is market overshooting in exchange rates?

Market overshooting occurs when exchange rates move significantly beyond levels justified by economic fundamentals due to panic, speculation, herd behaviour, excessive risk aversion, or sudden shifts in investor sentiment.

How do foreign capital inflows affect the value of the rupee?

Foreign capital inflows through Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) increase demand for the Indian rupee. A decline in these inflows reduces foreign exchange availability and can contribute to rupee depreciation.

What role do global interest rates play in rupee depreciation?

Higher interest rates in advanced economies attract global capital away from emerging markets like India. This reduces foreign investment inflows, strengthens the US dollar, and puts downward pressure on the Indian rupee.

How does the Balance of Payments affect exchange rates?

A persistent current account deficit or reduced capital inflows can weaken a country's Balance of Payments position. This increases demand for foreign currencies and can lead to depreciation of the domestic currency.

What is the relationship between the current account deficit and rupee depreciation?

A current account deficit means a country imports more goods, services and capital than it exports. This increases demand for foreign currencies and often leads to depreciation of the domestic currency.

How does rupee depreciation affect the Indian economy?

Rupee depreciation can make exports more competitive and improve export earnings. However, it also raises the cost of imports such as crude oil, fertilizers, electronics and machinery, potentially increasing inflation and widening fiscal pressures.

What measures does the RBI use to manage rupee volatility?

The RBI manages exchange rate volatility through foreign exchange reserve interventions, dollar sales, swap operations, forex auctions, liquidity management measures and regulations to curb excessive speculative activity.

What are India's foreign exchange reserves and why are they important?

Foreign exchange reserves are external assets held by the RBI, including foreign currencies, gold and Special Drawing Rights (SDRs). They help stabilize the currency, finance imports, maintain investor confidence and absorb external economic shocks.

Can rupee depreciation be beneficial for exports?

Yes, a weaker rupee can make Indian exports cheaper and more competitive in international markets. This may boost export demand and improve trade performance, provided global demand conditions remain favorable.

Why is distinguishing between economic fundamentals and market overshooting important?

Distinguishing between structural economic changes and temporary market overshooting helps policymakers determine the appropriate response. Structural depreciation may require economic reforms, while overshooting may warrant calibrated central bank intervention.

What are the major determinants of exchange rates?

Exchange rates are influenced by factors such as inflation, interest rate differentials, trade balances, current account deficits, capital flows, foreign exchange reserves, economic growth, geopolitical developments and investor sentiment.

Why is rupee depreciation an important topic for UPSC preparation?

Rupee depreciation is important for UPSC GS 3 Economy because it covers exchange rate management, Balance of Payments, foreign investment, monetary policy, inflation, foreign exchange reserves, global economic developments and India's macroeconomic stability.

What is the difference between nominal exchange rate and REER?

The nominal exchange rate measures the value of one currency against another, while the Real Effective Exchange Rate (REER) adjusts exchange rates for inflation and trade weights, providing a broader assessment of currency competitiveness.

How does investor sentiment influence currency markets?

Investor sentiment can significantly impact exchange rates through capital inflows and outflows. During periods of uncertainty, investors often shift funds toward safe-haven assets such as the US dollar, causing emerging market currencies to weaken.

Daily Mains Question - GS 3 - 24th June 2026

Daksha Jain
2 days ago
2 min read

Test your UPSC CSE 2026-27 preparation with today’s GS 3 Daily Mains Question — covering Indian rupee depreciation, Real Effective Exchange Rate (REER), exchange rate dynamics, capital flows, foreign direct investment (FDI), foreign portfolio investment (FPI), balance of payments, global interest rate normalization, market overshooting and RBI’s exchange rate management.

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Q. To what extent can the recent depreciation of the Indian rupee be attributed to changing economic fundamentals rather than market overshooting? Discuss. (15 Marks, 250 Words)

Answer. The Indian rupee has depreciated by more than 10% against the US dollar over the past year, raising concerns about external sector stability and inflationary pressures. While the Reserve Bank of India (RBI) views the rupee as undervalued based on its Real Effective Exchange Rate (REER), economists remain divided on whether the depreciation reflects a structural shift in economic fundamentals or temporary market overshooting.

Depreciation as a Reflection of Changing Economic Fundamentals

1. Weakening Capital Inflows

Since April 2024, net inflows from Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) have been negative.
Reduced foreign capital availability has weakened demand for the rupee.

2. Global Interest Rate Normalisation

The era of near-zero interest rates in advanced economies has ended.
Higher global yields have redirected capital towards developed markets, reducing flows to emerging economies such as India.

3. Balance of Payments (BoP) Pressures

Persistent current account and trade deficits increase demand for foreign currency.
A weaker rupee may represent a new equilibrium in response to changing external balances.

4. Reduced India-Specific Investment Pull Factors

Strong FDI inflows during 2005–10 were linked to a robust private investment cycle.
Subsequent inflows were driven largely by abundant global liquidity rather than domestic growth opportunities.

Why Depreciation May Also Reflect Market Overshooting

1. REER Indicates Undervaluation

The rupee's REER fell to 90.96, its lowest level since 2013.
A REER below 100 suggests potential undervaluation relative to trading partners.

2. Investor Sentiment and Herd Behaviour

Exchange rates often react sharply to uncertainty and risk aversion.
Panic-driven capital outflows can push currencies below fundamentals.

3. Flight to Safety

Global uncertainty encourages movement of funds into US assets.
Emerging market currencies often weaken disproportionately during such periods.

4. RBI Intervention Signals

RBI has deployed:
- Forex reserve sales
- Swap windows
- Dollar auctions
- Restrictions on speculative positions
Such interventions suggest concern about excessive market-driven depreciation.

Evaluation

Economic Fundamentals	Market Overshooting
Weak capital inflows	Panic-driven selling
Higher global interest rates	Investor sentiment shocks
BoP adjustment	Herd behaviour
Structural external changes	Temporary mispricing

The rupee's depreciation appears to be driven primarily by changing economic fundamentals, especially weaker capital inflows and global monetary tightening. However, the sharp decline in REER and evidence of heightened market sentiment indicate that some degree of overshooting cannot be ruled out. Therefore, the depreciation is best viewed as a combination of structural adjustment and temporary market excesses, warranting calibrated RBI intervention rather than aggressive exchange-rate defence.

Value Addition (GS-III Concept):

Exchange Rate Determinants Framework: Capital Flows + Interest Rate Differentials + Current Account Balance + Inflation + Market Sentiment + Central Bank Intervention.

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