Capital Flight and Pressure on the Rupee

Why in News?

The Indian rupee has depreciated significantly over 2025-26, breaching ₹90 and touching record lows near ₹95.65 per US dollar. The depreciation is driven by persistent capital outflows, a widening current account deficit, geopolitical tensions affecting global energy markets, and structural vulnerabilities in India’s external account.

Capital Flight and Pressure on the Rupee: 

India’s economy is once again facing the twin pressures of capital outflow and currency depreciation, a combination that has periodically tested the resilience of its external sector. 

• Despite robust GDP growth of 6.6% in 2025 and inflation averaging just 1.7% in April-December 2025, the rupee has faced persistent weakness, indicating that the problem lies not in domestic fundamentals but in capital account dynamics. 
• India has a long-standing structural issue: it has recorded a current account surplus only four times in the last 25+ years (2001-02, 2002-03, 2003-04, and 2020-21). In every other year, India imported more than it exported, resulting in a current account deficit. 

This structural deficit creates a chronic dependence on capital inflows to finance the gap. Capital outflows directly weaken the exchange rate, and the rupee comes under pressure. 

What is Capital Flight?

• Capital flight refers to the large-scale exit of financial assets and capital out of a country due to economic uncertainty, political instability, inflation fears, expectations of currency depreciation, rising foreign interest rates, or declining investor confidence. 
• It generally occurs when:
  • Foreign investors sell domestic assets and move funds abroad.
  • Domestic investors shift wealth to safer foreign assets.
  • Investors anticipate lower returns or higher risks in the domestic economy.

In India’s case, recent capital outflows have largely come through Foreign Portfolio Investors (FPIs) withdrawing investments from equity and debt markets.

Interest Rate Differentials and Capital Flows: 

• Emerging market economies like India offer higher nominal returns on assets than advanced economies. However, this higher return must compensate investors for two additional risks: (i) currency depreciation risk and (ii) inflation risk. The net attractiveness of holding Indian assets, therefore, depends critically on the interest rate differential (the gap between Indian and foreign interest rates).
• When foreign interest rates rise (particularly those in the United States), global capital finds US assets relatively more attractive, triggering outflows from emerging markets. The single most influential factor behind the 2025 INR/USD trend has been the US Federal Reserve’s higher-for-longer interest rate stance. 

With the US yields remaining elevated, capital outflows from India have created a structural disadvantage for the rupee. 

The simultaneous occurrence of deficits in both current and capital accounts created significant pressure on the rupee in both periods (2013 & 2026). The rupee has depreciated by about 9.6% in FY2025-26, almost identical to the 9.5% fall recorded in FY2013-14.

Why is the Rupee under Pressure?

• Rising Crude Oil Prices: India imports nearly 85% of its crude oil requirements. When global oil prices rise, India’s import bill increases, and demand for U.S. dollars rises to pay for imports. As a result, the rupee weakens against the dollar. Disruptions near the Strait of Hormuz have pushed Brent crude above $100 per barrel, sharply increasing pressure on the rupee.
• Foreign Capital Outflows: Foreign Portfolio Investors have been net sellers of Indian equities, with net sales of nearly $19 billion in 2025, partly driven by concerns over US tariffs and to invest in safer assets such as U.S. Treasury bonds. The U.S. 10-year bond yield recently climbed above 4.5%, increasing pressure on emerging market currencies, including the rupee.
• Collapse of Net FDI: The combined effect of high repatriations and outward investment has compressed net FDI inflows for FY2025-26 to just under $4 billion, despite gross inflows rising 16% to $73.31 billion. This is a sharp deterioration from a peak of $43.9 billion in FY21.
• Widening Current Account Deficit (CAD): The Current Account Deficit occurs when a country’s imports exceed exports. India’s CAD has widened primarily due to higher crude oil imports, rising gold imports, and weak global trade conditions. RBI data show that India’s CAD widened to 1.3% of GDP in Q3 FY26 due to a larger merchandise trade deficit. 

The RBI has aggressively sold foreign exchange reserves (which dropped to $688.9 billion on August 1, 2025) to defend the rupee against volatility. India’s economic stability faces continued pressure as the government has raised gold import duties to 15% to curb consumption and reduce the rising import bill. 

If the U.S. Federal Reserve raises interest rates from their current 3.75% level, it could further trigger significant capital outflows from India.

UPSC PYQ 2019

Q. Which one of the following is not the most likely measure the Government/ RBI takes to stop the slide of the Indian rupee?
(a) Curbing imports of non-essential goods and promoting exports
(b) Encouraging Indian borrowers to issue rupee-denominated Masala Bonds
(c) Easing conditions relating to external commercial borrowing
(d) Following an expansionary monetary policy

Answer: (d)

UPSC PYQ 2022

Q. With reference to the Indian economy, consider the following statements:

1.     If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities.

2.     If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.

3.    If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.

Which of the statements given above are correct?

(a)     1 and 2 only

(b)     2 and 3 only

(c)     1 and 3 only

(d)     1, 2 and 3

Answer: (b)