The Indian rupee has been hitting new lows against the US dollar every other day, drawing public attention and concern in recent weeks. The attention seems unwarranted as there is nothing novel about the rupee’s depreciation against the dollar. The Indian Rupee has been losing value against the US dollar for a long time; since 2007, it has lost more than half its value. The reason it has become worrisome now is because of its rapid, volatile decline. Previously, the rupee enjoyed a period of stability between November 2022 and November 2024. The current phase of increased volatility began in December 2024, when it was trading at ₹84.65 per dollar. It has lost nearly 10 per cent in value against the dollar since then.
Capital withdrawal by foreign investors, who have withdrawn ₹1 trillion from Indian equity markets so far this year, is touted as a major cause for the depreciation. But this cause-and-effect relationship is somewhat misleading. A decline in the rupee’s value against the US dollar adversely affects foreign investors’ dollar-denominated returns from Indian markets. So, a rupee decline, or even the possibility of one, might persuade foreign investors to shield themselves by withdrawing capital from Indian financial markets. This implies that the rupee’s decline might have triggered the withdrawal of foreign capital, not the other way round, as is generally assumed.
There is no dependable long-term correlation between foreign capital flow and the rupee exchange rate. The rupee has lost more than 50% of its value over the past 18 years, while foreign investors have invested close to ₹11 trillion in the Indian stock market during the period. This wouldn’t have happened had foreign investors found a declining currency as repulsive. The ₹1 trillion withdrawal this year constitutes less than 10% of their cumulative investments over the past 18 years. Perhaps, in the short term, (the possibility of) a fall in the rupee may persuade foreign investors to become risk-averse and withdraw funds for the time being; however, once the currency finds its footing and stabilises at a lower level, foreign investors will bring back more money than they had withdrawn.
Currency volatility is a form of renegotiation of existing understanding between foreign investors and Indian markets due to changed economic conditions. It is akin to foreign investors saying, “Things have changed. If you want us to keep our money here, you’d better give us a better deal.” The current economic condition that has triggered the need for renegotiation is probably the 45% spike in Brent crude oil prices to above $100 per barrel, consequent to Iran’s blockage of the Strait of Hormuz. India imports 88% of its crude oil, which it pays for in US dollars, so a rise in crude oil prices leads to higher dollar outflows. The blockage has also significantly constrained India’s access to its largest trading partner, the United Arab Emirates, reducing dollar inflows. A significant downward pressure on the rupee is the cumulative effect of these two developments. Anticipating this outcome, foreign investors might be calibrating their risk exposure by withdrawing capital from India.
However, it seems that the geopolitical risk ignited by the American-Israel attack on Iran and its consequent impact on oil prices aren’t the only factors influencing rupee volatility. Typically, global capital flows towards assets and countries that offer the best risk-reward ratio. A straightforward way to assess a country’s risk-reward competency is the difference between its risk-free rate (typically the 10-year government bond yield) and that of its global counterparts, especially the 10-year US Treasury yield. In 2021, with the Indian 10-year yield at 6.02% and the US 10-year yield at 1.47%, the difference was 4.55 percentage points. In 2023, the respective yields rose to 7.32% and 3.84%, with the difference narrowing to 3.48 percentage points. As time progressed, the gap narrowed further. By mid-2025, the Indian 10-year yield was 6.20%, and the US 10-year yield was 4.42%, a difference of 1.78 percentage points, the lowest in several decades. Today, the difference is 2.47 percentage points. I presume the natural yield differential between India and US 10-year bonds should be around 3.00-3.50 percentage points. A value higher than that places India in a position to attract foreign capital flows, whereas a value lower than that suggests India is more likely to be overvalued, with a greater risk of foreign capital outflows. Given the yield gap of 2.47 percentage points today, we have a lot more catching up to do before our markets become attractive again.
If crude oil prices don’t retreat to their previous levels, they will percolate into our economy through higher food and fuel prices, resuscitating higher inflation. The benchmark bond yield, which has been increasing since the war began, likely reflects the higher inflation expectations. However, as signs of de-escalation and talks surface, will everything now return to its earlier stages: crude oil prices at $65-70 per barrel, the rupee stabilising around current levels, and stock prices that have fallen around 15% since the war began recouping all losses? Or will capital continue to leave the country, the rupee continue to fall against the US dollar, and stock prices remain volatile until the difference between India’s and the US’s 10-year bond yields reaches its natural level?
The Israel-America-Iran war, the resultant blockage of the Hormuz Strait, and a sharp spike in crude oil prices were exogenous shocks. Nearly a year ago, on April 2, 2025, another exogenous shock arrived in the form of Trump’s punitively high trade tariffs on US trading partners, which ignited extreme uncertainty and asset price volatility for a few weeks. Indian stocks fell more than 5% in the week following the tariff announcement, but sharply recovered the entire fall the next week itself and then went on to make new all-time highs. Will it be the same this time, or will the current situation escalate towards larger distress and panic?
The Indian stock market has been booming for more than two decades now, with two short-term disruptions: first in 2008, with the onset of the global financial crisis, and then in 2020, with the Covid-19 crisis. The sharp decline in US interest rates to near-zero during 2001-2003 was a key enabler of this boom, as extremely low rates in advanced economies led capital to flow into assets and into countries that offered better returns. India was a significant beneficiary of this capital flight from advanced countries. Attempts to raise US interest rates to normal levels in 2005 and 2018 had to be abandoned early because of apparent economic weakness. Moreover, with inflation and inflation expectations remaining low, there was no urgency to raise interest rates either.
However, the dynamics that allowed global capital to flow towards India and enabled a boom here no longer exist. US policy interest rates increased sharply from 0.25% to 5.50% during 2022-2023 in response to an inflation spike during 2021-2022. Although the rates were later brought down to 3.75% during 2024-2025, they remain much higher than they were for most of the last two decades. This poses a significant risk for India and other emerging economies because, with interest rates in the US and other advanced economies near normal today, a principal enabler of the Indian stock market boom since 2003 – extremely low global interest rates – has disappeared. It has not only made it much more challenging for India to attract global capital but has also made a reversal of capital flows (capital flight out of India) more likely. The faster decline in the Indian rupee since late 2024 suggests it might already be happening. The currency decline and capital outflows will cease and stabilise once yields (both bond and equity) in India increase and reach their equilibrium in the new normal. That is not good news for Indian investors, at least in the short term, because higher bond and earnings yield mean lower bond and stock prices.
Subscribe
Subscribe to receive our latest content in your Inbox.
AMN CAPITAL 