RBI’s FX Strategy Shifts as Oil Shock Tests External Stability

The West Asia crisis appears to be at a turning point, with early signs of de-escalation easing some pressure on crude oil prices. Even so, uncertainty around the extent of damage to oil and gas infrastructure suggests that supply normalisation may take time. The episode combines elements of both a price shock and a quantity shock, affecting not only energy imports but also chemicals and metals.

In such a setting, the central question is not the immediate adequacy of India’s external buffers, but how they evolve if disruptions persist. A sustained period of elevated crude prices, with the Indian basket averaging around $90 per barrel, would alter both the current account trajectory and the balance of payments dynamics.

India enters this phase with relatively comfortable macro fundamentals. The FY27 current account deficit was tracking at around 1.6% of GDP before the crisis, supported by a strong invisibles surplus. However, higher oil prices could push the deficit to around 2.6% of GDP. While this level remains manageable in isolation, the challenge lies in its financing.

Recent experience suggests that even smaller current account deficits have proven difficult to fund. The rupee had already been under pressure prior to the crisis, with depreciation of around 6% year-on-year till January 2026, reflecting capital outflows led by foreign portfolio investment outflows and slowdown in foreign direct investment, and external commercial borrowings. The balance of payments deficit in 2025-26 has been tracking at around $35 billion, despite a relatively modest current account gap.

If the crisis persists into 2026-27, the balance of payments deficit could widen further, potentially reaching $40 billion. This reflects both a higher current account deficit and continued weakness in capital inflows. In such a scenario, the burden on foreign exchange reserves is likely to increase.

At present, reserve adequacy metrics remain within comfortable ranges. Import cover, including the forward book, is estimated at around 9.1 months as of March-end 2026. Even under a stress scenario, this could moderate to around 7.2 months by March 2027, still above levels seen during the taper tantrum period. Other indicators, including the ratio of reserves to short-term debt and volatile capital flows, also suggest a stronger position relative to taper tantrum low.

 Source:  IDFC FIRST Bank Economics Research

The constraint, however, lies not only in the level of reserves but also in how they are deployed. A key factor shaping the RBI’s intervention strategy is the size and structure of its forward book. The forward book, which had already been elevated, has limited the central bank’s ability to undertake aggressive sterilised intervention through buy-sell swaps.

This has had two implications. 

First, gross dollar selling has been more moderate compared to previous periods, resulting in a faster pace of currency depreciation. Second, the RBI has relied more on alternative tools, including liquidity infusion through government bond purchases, to offset the domestic liquidity impact of foreign exchange intervention.

As pressures on the external account builds, the trade-off between defending the currency and preserving reserves becomes more binding. In a prolonged crisis, the RBI is likely to allow a controlled depreciation of the rupee rather than expend reserves aggressively. Such an approach helps conserve external buffers and reduces the liquidity impact of sustained dollar sales.

The evolving policy response also reflects broader constraints in attracting capital inflows. Net foreign direct investment has been weighed down by elevated repatriation and overseas investment by Indian firms. External commercial borrowing flows remain subdued, given the higher cost of borrowing amid elevated US yields. Portfolio flows have also been volatile, with recent outflows reflecting global risk aversion.

These trends suggest that the challenge is going to be more on attracting capital inflows in an even more volatile external environment. In this context, measures to liberalise inflow channels may offer some support, although their impact is likely to be gradual.

Past episodes have seen the deployment of targeted tools such as special deposit schemes or swap windows for oil companies. For now, the relatively moderate level of the current account deficit and the still-comfortable reserve metrics suggest that such measures may not be immediately necessary.

Instead, the policy response appears to be anchored in a recalibration of priorities. With capital flows uncertain and external pressures rising, preserving reserve adequacy becomes central to maintaining macro stability. This, in turn, implies a greater tolerance for currency adjustment.

The underlying constraint reflects the well-known trade-off between exchange rate management, capital mobility, and monetary policy autonomy. In the current episode, allowing the exchange rate to absorb part of the shock provides space to maintain supportive domestic financial conditions.

In effect, the policy response reflects the constraints of the impossible trinity. With capital flows volatile and the economy requiring supportive financial conditions, the RBI’s ability to simultaneously stabilise the exchange rate and retain monetary flexibility is limited. Allowing the rupee to adjust in a controlled manner reduces the need for large-scale reserve drawdown while preserving space for domestic policy support.

The RBI’s challenge, therefore, is not simply to respond to external pressures but to ensure that the adjustment process remains orderly. A calibrated approach to currency movement, combined with prudent reserve management and liquidity support, may help prevent a temporary external shock from translating into a more persistent macroeconomic imbalance.