Rupee: Precipitous fall
| Photo Credit:
Rasi Bhadramani
According to official data, India’s gross domestic product grew by about 8.2 per cent year-on-year in the September quarter of 2025. In contrast, the rupee has continued to slip to new lows, and the USD/INR has crossed the oft-quoted psychological barrier of ₹90 to a dollar for the first time.
The well-known Exchange Rate Disconnect Puzzle (Meese & Rogoff, 1983) shows that exchange rates often diverge from fundamentals such as growth, inflation or interest rates, and a recent 2023 study by Fukui, Nakamura and Steinsson finds that in many emerging markets, depreciation can occur alongside strong output and investment— demonstrating that “boom with depreciation” is a well-documented phenomenon rather than a contradiction.
The data underpin a simple but oft-ignored fact — growth and currency strength are determined by disparate forces. Growth amplifies import demand for raw materials, intermediate goods, and energy, increasing the need for foreign currency. The dollar, however, remains the global anchor-stable, widely demanded, and buoyed by the outlook of global investors. The disconnect becomes especially sharp when global capital flows reverse: growth continues, but the currency suffers.
Cyclical concerns
However, the current rupee weakness is a cause for concern as it is not a short-term noise but cyclical, driven by structural factors. For most of 2025, foreign investors have pulled money out of Indian markets, particularly equities, on the grounds of global uncertainty, rising US yields, and concerns about tariff wars. A nuanced look at yield and currency dynamics can explain why FPIs are moving out of India. While valuation concerns, sectoral reallocations, and geopolitical uncertainties do play their part, the deeper drivers lie in yield dynamics, currency expectations, and the global risk environment which frames how investors view emerging markets relative to the US.
Compared to the US 10-year Treasury yield, which is near 4 per cent, India’s 10-year government bond yield of around 6.5 per cent seems considerably more attractive at first glance. This creates a yield spread of roughly 250 basis points.
Conventionally, this spread should invite yield-seeking global investors into Indian debt and support equity inflows by lowering the cost of capital. However, yield alone does not capture all risk. The higher nominal yield in India reflects a risk premium that compensates investors for multiple exposures: currency volatility, inflation unpredictability, and broader emerging-market macroeconomic vulnerability. But this underestimates the dynamics of the currency.
FPI pullout
For a dollar-based investor, even modest depreciation of the rupee can wipe out the incremental return earned from India’s higher yields. If the rupee weakens by 3-4 per cent over the year, the effective return earned by FPIs diminishes sharply or even turns negative. Thus, it becomes important to appreciate that a static yield spread does not guarantee inflows. India may offer a 6.5 per cent yield, but if global risk sentiment deteriorates and concerns around the rupee’s stability override the attractiveness of higher nominal yields, FPIs may still prefer to exit.
Despite sustained capital outflows, the stock market hasn’t cracked because a silent structural shift: according to the latest NSE Market Pulse (Nov 2025), FPI ownership in Indian equities has fallen to a 15-month low of 16.9 per cent — while domestic mutual funds continue to hit record highs, powered by unprecedented SIP inflows. Individual investors, through direct holdings and MFs, now own nearly 19 per cent of the market, the highest in over two decades.
As a way forward, therefore, RBI should allow this structural adjustment to take place but continue to prevent sharp, disorderly volatility swings. It should avoid defending any fixed psychological level like ₹90, focusing instead on maintaining liquidity and anchoring expectations through steady, confidence-building communication. Monetary policy must remain guided by inflation and growth and avoid aggressive interventions, while structural reforms should address the root causes of rupee weakness.
The writer is Professor, Madras School of Economics
Published on December 5, 2025
