In this episode of How India's Economy Works, host Puja Mehra speaks with economist Renu Kohli, formerly at the Reserve Bank of India and the IMF and currently senior fellow at the Centre for Social and Economic Progress (CSEP). They talk about the recent depreciation of the rupee and why this episode may be different from previous currency shocks. Despite India's large foreign exchange reserves, the rupee has faced sustained pressure. Why?

Renu Kohli argues that the deeper issue lies not in India's trade balance but in the drying up of foreign capital inflows. She explains the difference between reserves earned through exports and what she calls "borrowed reserves", examines the decline in foreign direct investment, and discusses whether policymakers underestimated the structural nature of these pressures.

The conversation also explores the RBI's exchange-rate management strategy, the limits of using reserves to defend a currency, the impact of global capital flows, and why short-term measures can only buy time. Looking ahead, she outlines the reforms India may need if it wants to attract and retain long-term foreign investment in an increasingly competitive global environment.

What does the rupee's recent weakness tell us about India's place in the global economy? And what must change to ensure that external vulnerabilities do not become a lasting feature of India's growth story?

Tune in for insights on the rupee, foreign capital, forex reserves, and the structural challenges shaping India's economic future.

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TRANSCRIPT

NOTE: This transcript is done by a machine. Human eyes have gone through the script but there might still be errors in some of the text, so please refer to the audio in case you need to clarify any part. If you want to get in touch regarding any feedback, you can drop us a message on feedback@thecore.in.

Puja Mehra: Dr. Renu Kohli, thank you so much for coming to the show.

Renu Kohli: Thank you very much. Pleasure to be here.

Puja Mehra: Dr. Kohli, I want to speak to you today about how India has gone about dealing with the rupees depreciation. Although now there are some signs that the Iran conflict that sort of precipitated the rupees decline, maybe reaching some sort of durable peace deal between the US and Iran with Israel also being asked to maintain its positions of peace. That may have settled down.

But we have seen in several past episodes that the rupee begins to depreciate. And this time the difference was that we had very comfortable levels of forex reserves. And yet this has happened.

So I want to ask you, how was this time different from past episodes?

Renu Kohli: Okay. A lot of questions in there, how the rupees we manage, despite so much of reserves and difference with past episodes. So let me take it in the reverse order about reserves, but having abundant reserves.

I think one thing that stands out very clearly from this episode is that no amount of reserves is enough. And in particular, India's reserves are accumulated, they're high cost reserves, they're essentially borrowed reserves. They're not accumulated from current account surpluses.

And so, you know, borrowed reserves are even less adequate than otherwise.

Puja Mehra: You may want to explain for our listeners what you mean when you say borrowed.

Renu Kohli: Yes. Borrowed reserves, look at it in terms of the external accounts. So one side of it is the trade balance, which is basically trade in goods and services.

And if the exports exceed imports of goods and services, then a country accumulates foreign exchange reserves, which is earned. These are earnings from having sold goods or services. On the other side of the external accounts is the capital account, which is to do with inflows and outflows of finances or financial flows.

So, you know, you can break these up further into foreign direct investments, which tends to be more long term in nature and more productive because it generates future earnings in terms of profits, dividends and sales earnings and exports. And then there is the short term flows which come into our stock markets or into the bond market. So that is the essential difference.

The thing is that India has traditionally run a current account deficit in the sense that it imports more than it exports and therefore it doesn't have current account surpluses. And whatever is accumulated or absorbed into reserves, it's called reserves accretion, comes off its capital flows or excess of capital that flows into the country. Now that will be short term in nature.

In the last few years, what has happened is that the short term flows have tended to exceed the long term, which is a foreign direct investment. So that's what we mean by reserves being borrowed. So to return to your question, Puja, despite having so much of reserves and things have been much better than in the past, so we can look at, you know, two or three episodes.

We can look at 2013, which is the most recent one. We can also go back even further to the 2008-09 when the Lehman Brothers collapsed in September 2008 and then it sort of triggered the global financial meltdown and the crisis. So those are the two most recent crises in the past.

And even earlier than that, we could go back to 1991. Now these episodes, definitely having a larger amount of reserves definitely helps. It helps in stabilising market sentiment and confidence, which is extremely important.

It's all about expectations. You don't really need the reserves as much to sell or buy, but the fact that the central bank can intervene and can support the exchange rate does impart confidence to investors and stabilise market sentiment. Having said that, now we can come to the shock.

The shock is the trigger is the West Asia war. Within that, it is the price of oil, which has skyrocketed, coupled with a lot of choke points arising from the closure of street performance. And a lot of India's critical imports like fertilisers, petro products and LPG, LNG gases, a lot of them, more than 50% of the fertilisers, for example, come from there.

So the choke supplies and having to arrange alternate supplies at higher prices. So both the aspects, the higher oil prices and higher supplies of certain necessary items have pushed up the import bill. And that's what is the current account side.

So again, and at the same time, some bit of exports have been impacted simply because it's also a trade route. So the same channel which is closed through which India imports, it also exports through that as do many other countries. So that's what has happened.

So what is unusual in this instance is that actually in the past crisis, for example, if I were to take 2013, India had a very, very wide gap on its current deficit. It was like historically the highest, if I'm not mistaken, it was in December 2012, six months before or five months before Ben Bernanke made his famous statement that, you know, they might have to taper off their patent QE. It was as much as 6.7% of GDP. And, you know, we can compare that it's like more than three times what is considered a comfortable or a sustainable threshold for India, which is in the region of 2% of GDP. So the current account has been actually very, very well behaved. It has been under 1% of GDP and not just before the West Asian crisis started, but also in the last two, three years, it's been very, very moderate.

So the pressure hasn't come from that side. What happened is that this expanded the current account gap precisely at a time when foreign capital, the financial capital inflows have been drying out and they haven't been drying out very recently. Of course, there is an acceleration of outflow of portfolio short-term capital.

That is, there is no doubt about that. At the same time, the exit of foreign capital, both short-term and long-term, FDI and portfolio was negative last year, which is financial year 25. And before that, FDI has been dry for almost close to three years on a trend basis, since 2022, actually.

And in three of the four years, last four years, India has recorded a deficit on its balance of payments, which is the sum of the current and the capital account. And whatever is the excess or the deficit reflects in our balance of payments. And that's what we mean by the balance of payments deficit.

So if you look at the balance of payments pressures, then it is more akin to what happened in 1991. So 2013 wasn't really, there was no oil shock, for example. It was a current account to excess, a huge current account blew up.

And at the same time, it was an erosion of investor confidence because they said, OK, all this liquidity is going to dry out, financial conditions are going to tighten. And so investors started withdrawing from countries. And India happened to be vulnerable simply because its stock of reserves was under $300 billion, whereas its financing gap was very, very large.

In this instance, it's been different, it's been different because there's a dearth of foreign capital and it's unable to finance it. In 1991, actually, the situation was similar in the sense there was the Iraq war blew up oil prices blew up and pressurised India's balance of payments. And there was a financing gap.

That's just the same term coinciding with the blowing up of the current account. The third aspect that you said, Puja, which you actually started with, but I felt that contextually, perhaps it's better to explain this about rupee management. I can see where the pressures are coming from.

And in real time, it's very difficult or hard for a central bank to assess exactly what the equilibrium value or the fair value of the exchange rate ought to be. But they're also aware of how much of speculation the pressure is there, whether it is speculation or not, it's the market expectations and market's own assessment of what the value of the rupee might be. In this instance, the management one is there is certainly an acceleration in the rate of depreciation starting from the end of February.

But if you go back, rewind that before for like at least last two or three years, the rupee has been drifting down. It's been a more modest rate of depreciation, but the Reserve Bank has been actively supporting it and managing it. I do not, in my view, I do not think that that was such a good idea, because if you look at the fundamentals, the exchange rate is determined both in the goods market, which is your current account, which is export versus imports, but it's also determined on the financial side, which is the assets market.

And while the current account was very well behaved, and as I said earlier, that it was much lower and very reasonable around in the region of one to one and a half percent of GDP, the capital account wasn't, the capital account was in deficit. So there would be a revaluation or an understanding as to how it is being determined by the fundamentals. These pressures were fundamental.

They weren't speculative because they were persisting for the last three years. In particular, we had a very strong episode in the last quarter of 2024, October to December. There was a huge, enormous amount of pressure and the Reserve Bank actually intervened massively, close to, I think, a hundred billion dollars, if we count both forward as well as the spot market intervention.

That was supportive. The situation changed in the first quarter of 2025 and the rupee was allowed to strengthen back to, I think, 83 or something like that to the dollar. In hindsight, or even at that time, actually, in my view, it ought to have been allowed to remain weak because that was a fundamental adjustment.

And if the adjustment had happened towards the end of 2024, then it was OK. It should have been allowed to be kept weak. So we wouldn't have this kind of persistent pressures because it's very important to flag the point that these pressures have been there upon the rupee, notwithstanding the fact that the current account is not being very wide.

And that is the critical difference from the past, from 2013, from 2008, 2009 and from 1991 as well. So there is a fundamental difference. We don't know about the short term capital because there is no doubt pressure which is coming from Britain of recreating capital and all of it shifting globally towards investment in artificial intelligence and tech related stocks.

So, you know, a few pool of countries, just about three or four markets, essentially Korea, Taiwan, China, and of course, at the apex is the United States. So these are the countries which are attracting a lot of capital. So India is suffering and we cannot expect anything of that.

So there is, you know, a coincidence of structural and fundamental and cyclical factors both. So in the last three months, I think the exchange rate management, the Reserve Bank has been doing what it has been doing. It has been selling a lot.

Its forward position did come down, unwind a bit, but it's again started building up. At last market reports say the data has yet to come out, but it's again in the region of 110 to 115 billion dollars. Now, if the central bank is committed ahead by that much of an amount, we have to subtract that straight away and the market knows it.

If the market knows it, everybody knows it. You and I know it too.

Puja Mehra: Can we come to this point about how the central bank is actually speculating on the rupee appreciating in the future? Let's come to this in a bit. But the rest of what you said, I had a few questions.

You said that in many ways, the current shock is more like the 1991 shock. What was the situation, the current account and the capital account in 1991? Were the trends similar and that was a structural change, is it?

And is this also, you're saying this is a conference on structural and cyclical issues, but are we seeing also some medium to long term changes in the capital account? Would you say that?

Renu Kohli: I would not say that this is akin to the 91 shock. It's only regarding the external accounts. In that case, in 1991, it was very much a fiscal crisis which spilled over to the external dynamics.

It was very much driven by the public debt dynamics as well. So there's a difference. My only comparison with 91 was confined to the coincidence of both current account and capital account in India at that time had only external borrowings of the debt creation kind.

And it borrowed from the IMF. Its capital markets were not open. In fact, that triggered the liberalisation of the stock market as well.

So, you know, there's very limited comparison to be made with 91 in that sense, because the economic structure and integration of the markets was very varied, of the economy as a whole was very different. So my comparison would be only confined to the capital and the current account thing. And as in the case of 2013 as well, or for that matter, 2008 and nine, the differences made in reserves and the amount of reserves handling exchange rate management and what stands out in this since 91 or maybe in the last, let's just say, eight, nine, twenty, thirty, what stands out is that the cause or the principal cause is one, it's not precipitated just by the West Asian war.

The precipitation, the trigger is that it has opened up and exacerbated or exaggerated the current account deficit. What was there was already a pre-existing conditions, which was a dearth of foreign capital coming into the country, both foreign direct investment as well as short-term capital. That's what is the difference, I think, from any such in the past and particularly ever since India liberalised and it's integrated both on the trade side and on the financial market side.

So 91 is a long time ago, many, you know, more than three decades. So it would be unfair and unreasonable to compare it very significantly or more appropriate would be 2030 than 2008-09.

Puja Mehra: And I also want to talk a bit about you said that the RBI did, if I understood you correctly, seems to have erred in assessing the fundamental shift is leading to the dollar shortage on the capital side. So do you feel that the RBI's assessment of what caused the dollar shortage and therefore how that should have required them to adjust their rupee policy has something to do with what is happening now?

Renu Kohli: It may not be a mistake, actually, or an error, because in real time, as I said, any central bank would not know. And what we are also looking at the rate of depreciation before the vestation shock is exposed. Right.

So we don't know how much the pressure was and it's the realised rate of depreciation. To go back to the question whether the RBI erred on the capital account side, it's hard to give an unequivocal answer to that. But definitely there is a misreading because there might have been an expectation that the short term capital flows will resume because it hasn't really happened in India for a long time.

And portfolio capital flows have remained very healthy in equity markets, particularly, which is entirely justifiable in the short run, you know, like a period of three to four months. Maybe, you know, these flows will resume. There's always an exit in December, for example, you know, as portfolio investors square their positions and go off on holiday.

We had some kind of a similar play in August as well. So it may have been that. But the assistance was actually on the foreign direct investment side.

So definitely some steps ought to have been taken. It is not a policy variable under the control of the central bank, the capital account, honestly. The decline in FDI has been persistent for about three years, since 2022.

That was one aspect that ought to have been incorporated. And the capital flows, probably the expectation might have been that these might resume. But in the last one year, that exit has been accelerated.

So here we are. Now, a fundamental assessment, if we see any kind of assessments, there are many assessments of the, you know, particularly the IMF always comes out with one, for example, each year in its country report. So the assessments are typically made on the basis of, you know, both on balance and on the capital side and so on.

Perhaps it is hard to disentangle the cyclical or, you know, one-off factors from structural factors. But at least it's hard for me to put a time period on it. But yes, for something, a situation that has been continuing, that ought to have been reckoned with.

And perhaps an adjustment of the rupee could have been bigger or even before starting from this point.

Puja Mehra: What I'm saying is, or at least the RBI could have impressed upon the government, given that they are in constant policy dialogue with government. They give inputs all the time.

Renu Kohli: I'm quite sure they must have.

Puja Mehra: Regarding, you know, steps being required for making FDI an attractive proposition to investors. And if they do not see their suggestions and their inputs resulting in significant changes, then they probably should have revised their policy. So when you say that, you know, in real time, it's difficult for them to make these calls, but perhaps they were optimistic because they tend to be very optimistic, no?

Renu Kohli: We don't know. I mean, it's hard for us to sit outside and know whether FDI was discussed or not. So that's not an issue.

So my response has been to your question on the management of the exchange rate, because that is more in the domain and real time decisions taken by the central bank. And in terms of management of the exchange rate, you know, when you're seeing that there is a dearth of capital is flying out for like three or four successive years, would it be a wise policy or forward looking policy or looking perspective to continuously prop up the exchange rate by increasing exposure and intervention and increasing exposure in the forward market as well as in the spot market and then combining that with the forex swaps? These are, you know, essentially just purchase and sales of forex. These are not really another guise of liquidity support and so on.

So that's something very much that the central bank has been doing increasingly from 24.3 onwards. And that is the aspect of exchange rate management, because it has led to a situation wherein actually measures became ineffective. How could we say that it became ineffective?

Because in April, the central bank was forced to limit the net open positions of the banks in a very, very hard hitting way, 200 million daily basis. And that is unproved that the forward market in the spot intervention was not being able to stabilise the exchange rate or the market expectations. There may have been and there always is speculation.

But to think that, you know, there is no, I mean, all exchange rate management is essentially about management expectations, really. So they took that measure and they hurt them very hard, all the markets. So that is one measure I would say, at least in my analysis, I would say that that is something that ought to have been averted and should have been reckoned with much earlier.

And perhaps the intervention could have been, the rupee could have been allowed an adjustment much before, even then the shock. Because we are in a world of shocks, particularly that has been very, very evident from 2022 onwards after Russia's invasion of Ukraine. And increasingly, these shocks are only geoeconomic in nature.

They are to do with trade sanctions, they are to do with other kinds of sanctions, tariffs, other kinds of sanctions, supply pressures, supply chain choke points and so on. So a policymaker does factor that in.

Puja Mehra: So what does this tell us? In fact, first, I want to say to listeners that we did an episode actually on what the RBI did with the banks positions a couple of weeks ago. We discussed exactly what you're saying.

But after that, the steps that are being taken, like you're saying, these are all essentially about short-term measures on supply and demand of dollars. So does that tell us that the RBI still thinks that the dollar shortage in the capital account is short-term in nature because they're taking such large positions on the forward side? In future, the rupee will appreciate, things will not be like how they are.

Capital inflows will recover. Are they disconnected from some of the global changes that we are seeing?

Renu Kohli: I don't think so. I don't think that they would be disconnected. I haven't touched upon the capital flow measures that they took on the last monetary policy review on June 5, for example.

Those are very much short-term measures, definitely. And as many people would have said or have commented on, it's a little band-aid solution, etc., but they were necessary. I would say that the situation came to that much, right?

So they've had to be taken. And unlike past episodes, this is basically a dearth of savings. India is having to import foreign savings at a very high price, much, much costlier.

Right. So what the FCA now deposit rates that the banks have put out and all and the absorption of all these, the hedging risks or currency risks onto the central bank's balance sheet is something unavoidable. And I think these measures could have actually been taken even earlier than this.

So I do not know quite why they took so long. They had to be done and they were done. They could have been done earlier, perhaps.

So one of the things that could have been done much earlier, and it still puzzles me as to why the government waited for so long, is the raising of the import duties on precious metals, particularly gold and silver, because that was contributing to the current account expansion and the value of imports, gold imports was going up. In 2013, we found that it was actually very effective. The duties were raised in about six steps.

But the compression in the current account was enormous. The swing was as much as 50 percent. It halved from 6.7 percent of GDP in December 2012 to something like 3.6 percent of GDP by March itself, very dirty. And eventually it shrank to, I think, 1.2 or something by the September quarter. So that is something that ought to have been done much earlier, particularly, especially when the war triggered and the depreciation pressures exacerbated. And the duty increases have occurred only, came about only in, I think, the first week of May, perhaps sixth or seventh of May or so.

It could have been done as early as the first week of March because the pressures were very evident immediately and it compounded severely by then. This only again points out that no amount of reserves is enough. And they've been done despite, you know, some like last round, I think 585 or 82 billion of reserves.

And if you take away 100, 100 billion of the forward position, then it's about 480. Healthy amount. But the point is, the number could be 1 trillion as well.

And it would buy you some time. Just as these measures, the common expectation is that the band is that it could fetch them or anything between 30 to 60 billion of NR deposits and all. It does buy you time, but it doesn't give you immunity.

So these are very short term measures. And ideally, in an ideal world, the policymaker should be combining the short term measures with long term stabilisation measures. The stabilisation package should be a comprehensive one and coming all together.

They might be examining the whole thing internally. We do not know. It's hard to say that these are wrong.

I think that sometimes you have to do these things. So it has been done.

Puja Mehra: I'm not saying they're wrong. I'm saying that they're essentially short term in nature. And like you're saying, they buy time.

Although we must add here that the finance minister has said that some more measures are coming. Just yesterday, she made an announcement. And I think the long term attracting capital, foreign capital measures can only come from government, which you also said.

But if the AI bubble bursts, are you in a position to say how that will change some of these things that the RBI is looking at for the capital account and for the rupee?

Renu Kohli: Oh, yeah, yes, but you know, hope is not a strategy and the least of it is it's not for a central bank. We could still see that, you know, politicians could be taking such bets, but no central banks, they don't do that. And just as I don't think that the central bank is betting on the rupee appreciating or whatever, at least they will never say so.

And it would not be appropriate. The central bank doesn't really engage in this kind of bets on its balance sheet.

Puja Mehra: They are perhaps betting on the government coming out with some long term measures. Maybe that is what they're betting.

Renu Kohli: Yeah. So these may be to do with the investment side. Notably, what has been pointed out is that, you know, to have more investment friendly climate, there are taxation issues.

There are these arbitration or to do with the investment treaty, the nature of treaties that have been signed. I think in the FY25 budget, it was promised that they would be re-examined and re-looked. So these are the kind of issues.

It's a difficult, very difficult external environment that we are facing. The worldwide, you know, there is growth is hard to come by. And therefore, there are structural fundamental forces at work, apart from the ageing populations, demography and huge amount of public debt.

And now there is this huge, big buildup of AI technology and expectations. No one knows where the productivity and if at all it would come from because it doesn't come in a lump productivity against a crew over a long period of time, as we saw the most recently in the Internet case. So I don't think that any central bank would be betting on the popping of the AI bubble because that's not a strategy.

They should be taking measures. The good thing is that the war, there's been some kind of ceasefire and the signature and agreement. And at least for some time, we could ask ourselves whether the trouble, the clouds have blown over again.

The answer is, you know, yes and no. For some time, yes. The big bill of fertiliser subsidy and petrol and diesel subsidy and even otherwise rising inflation, et cetera, may have been warded off.

But the longer term problem on the external side will continue. It does not go away just because the ball has been resolved. Right.

So we can have good growth numbers, we can have good inflation numbers, but if you still are not able to attract foreign capital, then we have to think that, you know, yes, there are other ways or other measures that might have to be taken.

Puja Mehra: Yeah, you know, one, capital isn't essentially going to flow to the best destination because now there are whole strategic and other considerations. It's no longer like it was until a few years ago. But two, also, we have to look at our own competitiveness and what is it that we are offering to investors?

Even Indian investors are not investing. Why would foreign investors invest? In fact, in some of the shows that we've done on these subjects, people who are in Singapore, for instance, come here and say that India doesn't look as attractive from the outside as it does from the inside.

So there are two completely separate set of things to think about here. But what measures would you like to see for more durable foreign capital inflows?

Renu Kohli: It has to be definitely on the long term direction. It's paramount that the government examines that side. I don't think that I know keenly enough what the issues are, not being a subject expert on what is ailing FDI, but certainly there should be a very, very keen examination of what are the factors which are deterring FDI.

Why is it going to small countries like Vietnam? Why has India not been able to take advantage of the China plus one? I mean, it was just like not even three or four years ago.

We were so upbeat, but were we just very overoptimistic that it would naturally come to India? It hasn't. And if it hasn't, why?

Those are elements that have to be examined. If we look at the gross inflows, so the kind of capital that is coming into India appears to be more medium term horizon, like say five to seven years, a lot of VC and PE capital, which is all par for the course. There's no argument or, you know, there's no dislike or anything about it.

But the point is that this kind of capital seeks to cash out when they take a view. Their typical horizon is five to seven years. And then they would just cash out when the valuations in their view, in their judgement have peaked, which is what has been happening.

We've been seeing a lot of exits in the last three, four years. And that is something that tells you that India is finding it increasingly hard to not just attract capital, but also retain capital within the country because it's also outward flows. So what is its repatriation dividends, profits?

It's not being reinvested into the country. So these are things that are to be examined very seriously because, you know, it can turn the situation is grave in the sense that it can become a lasting if it's persisted for three, four years. One should be worrying about it because it can easily become an enduring feature.

And it's important to reverse it.

Puja Mehra: Dr. Kohli, thank you so much for helping us understand what the rupee policy has been and what in a more ideal world it could be.

Renu Kohli: My pleasure.