Rupee Faces Continued Volatility in 2026 Despite Potential US Trade Pact

The Indian rupee is grappling with multiple challenges, including global trade disruptions and significant foreign fund outflows. Despite strong domestic economic conditions, the currency's decline is expected to continue until tariff impacts are resolved. The Reserve Bank of India (RBI) views the rupee's depreciation as a temporary measure to counteract tariff shocks, anticipating stability once a trade agreement with the US is achieved.

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Since January, the rupee has fallen nearly 5% from 85 per dollar, even reaching a historic low of 91 against the US dollar. Throughout the year, it weakened by over 19% against the euro, around 14% versus the British pound, and over 5% against the Japanese yen. Among Asian currencies, it performed poorly despite a more than 10% drop in the US dollar index and weak international crude oil prices.

Impact of Foreign Investment and Trade Deficit

The rupee's decline accelerated after US President Donald Trump announced reciprocal tariffs in April, prompting foreign investors to seek better returns elsewhere. This trend is evident in foreign direct investment (FDI) flows, which turned negative between January and October. Anindya Banerjee from Kotak Securities explains that FDI acts as an anchor for balance of payments; when it weakens, reliance on portfolio flows increases.

The government attributes the rupee's slide to a widening trade gap and stalled negotiations on a US trade pact amid a weak capital account. "The depreciation of the INR has been influenced by the increase in trade deficit and likely prospects arising from ongoing developments in India's trade agreement with the US," said Minister of State for Finance Pankaj Chaudhary in the Rajya Sabha on December 16.

Capital Account Crisis and Central Bank Policies

Dilip Parmar from HDFC Securities identifies a capital account crisis as the main reason for the rupee's fall. Unlike previous crises driven by trade issues, this decline results from shrinking capital inflows. The RBI's rate cuts to support domestic growth have made the rupee less attractive. The central bank has adopted a more flexible exchange rate policy, described by the IMF as a crawl-like arrangement.

Uncertainty over an India-US trade deal and US tariffs on Indian exports have negatively impacted the rupee by widening the trade deficit. Anuj Choudhary from Mirae Asset ShareKhan predicts further declines towards 91 and 92.50 levels soon. The challenges intensified with reduced net foreign investment inflows—total inflows minus outflows—leading to increased reliance on volatile portfolio flows.

Future Outlook for the Rupee

Jateen Trivedi from LKP Securities notes that higher commodity prices and risks related to US trade deals have deterred FDI, impacting the rupee due to lack of inflows. Between January and October this year, total investment inflows turned negative at USD -0.010 billion compared to USD 23 billion during January-December 2024. Net FDI stood at USD 6.567 billion while net portfolio investment was negative at USD -6.575 billion.

Dilip Parmar highlights that a record USD 17.5-billion exit by FIIs in 2025 created high demand for dollars, pushing down the rupee. The current account deficit is expected to widen to over 2% in 2026 as US tariffs fully impact Indian exports, increasing structural dollar demand. A US trade pact would help but isn't a complete solution according to Banerjee of Kotak Securities.

Despite these challenges, strong macroeconomic fundamentals are expected to support the rupee through volatility. With steady growth and moderate inflation, India's economic factors provide long-term stability for its currency. Banerjee projects that due to global volatility and risk-off phases, the rupee may test levels of 92–93 in coming months but could appreciate to 83–84 by FY27 end as global capital shifts towards stable economies.

With inputs from PTI