Currencies Under Siege as Fiscal Dominance Takes Hold

In economic debate, fiscal dominance is often viewed as a problem of inflation. Rising debt and deficits push central banks into a corner where raising interest rates feeds rather than restrains inflation, and political pressure erodes credibility. Yet the channel that deserves equal attention, especially in today’s interconnected markets, is the external value of money. Exchange rates reflect both the strength of a country’s macroeconomic framework and the trust of investors in its ability to manage shocks. 

When fiscal dominance takes root, currencies are frequently the first line of adjustment.

The rupee, caught in a period of global volatility, offers a contemporary example. Despite benign domestic inflation and a cautious Reserve Bank of India, the currency has shown a depreciating bias.

This mirrors the experience of the yen and yuan, economies with long stretches of low inflation but weak external performance. Fiscal imbalances in these economies have translated less into domestic price spirals and more into sustained pressure on their currencies. 

The rupee appears to be following this Asian track.

Inflation to FX
The conventional lens of fiscal dominance has been inward-looking. High debt leads to rising interest costs, which central banks are compelled to accommodate through easier liquidity or bond purchases. Inflation follows, and monetary authorities lose credibility.

But in a globalised setting where capital is mobile, the pressure also shows up in exchange rates. Even when inflation is subdued, persistent deficits and high public debt cast doubt on policy discipline. Investors demand higher risk premia or shift to safer currencies, causing depreciation.

This is not a purely theoretical concern. In the United States, where fiscal dominance is debated openly, longer-term Treasury yields have hardened despite a dovish Federal Reserve stance. Markets price the risk that fiscal stress, rather than inflation alone, will dictate the course of monetary policy. For emerging markets, the effect is amplified: currency depreciation arrives quickly, capital flows reverse, and the scope for independent policy narrows.

The rupee’s recent behaviour reflects this tension. While consumer inflation has stayed within the RBI’s tolerance band, the currency has steadily lost ground against the dollar. In view of the recent history of depreciation, markets are positioning for further weakness in the currency, not because inflation is out of control but because the fiscal trajectory leaves little room for policy independence.

Asian Parallel
Japan and China offer striking parallels. For more than two decades, Japan lived with low inflation, even deflationary tendencies. Yet the yen’s long-term path was downward, as fiscal deficits and debt levels convinced investors that currency weakness was the natural adjustment valve. The Bank of Japan’s yield curve control and persistent bond purchases reinforced the perception of fiscal dominance. 

China’s yuan has faced similar pressures. Despite a controlled inflation environment, the currency has weakened steadily in recent years. Large fiscal expansions to support growth, compounded by concerns over property-sector bailouts, have created an expectation of soft money policy. Capital outflows, trade surpluses notwithstanding, have kept the yuan under pressure.

For India, these experiences hold cautionary lessons. A growing public debt burden and expectations of populist spending ahead of elections raise questions about fiscal discipline.

The RBI’s credibility in controlling inflation is intact, but markets see the larger picture of fiscal pressure. In such a setting, the rupee risks taking on the characteristics of the yen and yuan: not a runaway inflation story but a slow erosion of currency strength.

Central Bank Independence
Currencies are also the barometer of institutional credibility. When central banks are perceived as independent, currencies tend to display resilience even in periods of fiscal stress. The European Central Bank’s insistence on inflation control, despite pressures from member states, helped anchor the euro during the eurozone debt crisis.

In contrast, when markets sense that central banks are accommodating fiscal needs, currencies wobble. The debate over quantitative easing in advanced economies highlighted this risk. By purchasing government bonds on an unprecedented scale, central banks blurred the line between monetary and fiscal policy. While inflation remained subdued for years, investor confidence in fiat currencies was periodically shaken, with gold rallying as a hedge.

India’s context is subtler. The RBI has not been forced into outright monetisation of deficits, but liquidity operations, special bond purchases, and pressures around managing government borrowing have created an impression of fiscal influence. As foreign investors weigh these factors, the rupee becomes the natural release valve for uncertainty.

Dollar Anchor
Investor trust is the final determinant of exchange rate stability. When fiscal dominance raises doubts about policy sustainability, currencies weaken not only against the dollar but also against other emerging-market peers. This is compounded by the structural strength of the dollar, which remains the anchor currency. In periods of stress, capital flight to the dollar intensifies.

Recent moves in gold highlight this dynamic. Unlike the rally of 2011, driven by fears of money printing, today’s surge is rooted in scepticism about fiscal sustainability across major economies. Investors increasingly see gold as insurance against fiat currencies exposed to fiscal dominance. This sentiment weighs heavily on emerging market currencies like the rupee, which lack the global reserve status of the dollar or the euro.

For India, the balance of payments has provided some cushion, with remittances and services exports offsetting a wide goods trade deficit. But these flows are not immune to global downturns or shifts in policy. A sudden tightening of US trade policy or visa restrictions could dent inflows, leaving the rupee more vulnerable. In such a scenario, fiscal dominance would magnify external shocks.

Policy Implications
What does this mean for policy makers? First, the FX channel should be treated as central to the debate on fiscal dominance, not a side effect. A weak currency erodes purchasing power, fuels imported inflation, and raises the cost of servicing external debt. It also undermines investor confidence, making it harder for governments to finance deficits on favourable terms.

Second, credibility matters as much as numbers. Even with a debt-to-GDP ratio that appears manageable, if markets perceive that the central bank is constrained by fiscal needs, the currency will bear the brunt. India’s experience shows that communication and transparency from the RBI are critical. Clear signals that inflation control remains the priority can anchor expectations, even when fiscal stress is visible.

Third, fiscal discipline cannot be postponed indefinitely. Investors may tolerate short bursts of expansionary policy, but over time, persistent deficits erode confidence. The risk is not only higher borrowing costs but also a steady drift of the currency into weaker territory. The yen’s long-term decline and the yuan’s recent slide illustrate the consequence of ignoring the FX dimension.

Looking Ahead
The rupee’s trajectory will depend on a delicate balance of domestic and global factors. Domestically, fiscal consolidation and credible monetary signals can slow the depreciating bias. Globally, the dollar’s strength, US bond yields, and geopolitical risks will remain dominant drivers.

What is clear, however, is that fiscal dominance shifts the burden of adjustment onto currencies. Inflation may be subdued, growth may be steady, but the rupee can still weaken if markets believe that fiscal pressures have compromised policy independence. In such an environment, exchange rate management becomes as important as inflation targeting.

Fiscal dominance is often described in terms of inflationary risk, but in today’s world, its most visible expression is in currencies. The yen, the yuan, and increasingly the rupee demonstrate how external value suffers even when domestic prices appear stable. Investor confidence, central bank credibility, and fiscal discipline all converge in the FX market.

For India, the lesson is unambiguous. To preserve currency stability, fiscal and monetary authorities must signal that discipline is not negotiable. The rupee may not escape global pressures, but with credible policies, it can avoid sliding into the persistent weakness that characterises economies where fiscal dominance has become entrenched. In the end, currencies tell the clearest story: when fiscal dominance rises, exchange rates fall.

BasisPoint Briefing — Explainers from seasoned practitioners for readers who want more than the basics.