DAW 23rd April 2026, Mains Answer Writting 2027

DAW 23rd April 2026, Mains Answer Writting 2027

Question

Q. Despite being in a ‘Goldilocks phase,’ Indian rupee depreciates. Analyse the underlying causes. (10 marks 150 Words)

Model Answer

Approach:

  • Introduction

  • Begin by briefly explaining the concept of the Goldilocks phase and establish that India currently exhibits strong macroeconomic fundamentals. Highlight the paradox of rupee depreciation despite favourable domestic conditions.

  • Body

  • First, briefly establish India’s Goldilocks conditions, then analyse the underlying causes of depreciation, focusing on capital outflows, global monetary conditions, oil price shocks, and structural external imbalances.

  • Incorporate conceptual insights (BoP pressures, investor sentiment, global financial integration) and conclude the body with a way forward focusing on export strength, energy security, stable capital flows, forex buffers, and rupee internationalisation.

  • Conclusion

  • Conclude by emphasising that exchange rates are driven more by external sector dynamics and global financial flows than domestic fundamentals alone.

  • Provide a forward-looking remark on strengthening external resilience and sustaining investor confidence for long-term currency stability.

Introduction A ‘Goldilocks phase’ refers to an economic condition marked by strong growth, low inflation, and overall macroeconomic stability. India is presently experiencing such a phase with steady GDP growth, manageable inflation (within RBI’s tolerance band), and improving fiscal consolidation. Yet, despite these favourable conditions, the rupee depreciated sharply, breaching ₹95 per US dollar in March 2026 and settling around ₹94.8, indicating that currency movements are not solely determined by domestic economic performance. Body Goldilocks Phase in India

  • India is witnessing robust economic growth, with GDP expanding at over 8% and supported by strong domestic demand, services exports, and public capex.

  • Inflation has declined sharply from 4.26% (Jan 2025) to ~0.7% by late 2025 and ~1.9% in FY 2025–26, indicating sustained price stability.

  • Labour market conditions have improved significantly:

  • Unemployment ~4.7%

  • Labour Force Participation Rate ~55.8%

  • External sector indicators show relative resilience:

  • CAD moderated to ~1.3% of GDP

  • Forex reserves ~$686 billion, providing over 11 months of import cover

  • Monetary policy has turned accommodative, with ~125 bps repo rate cuts in 2025, reflecting strong policy space.

Underlying Causes of Rupee Depreciation

  • Persistent Capital Outflows and Weak Investor Sentiment

  • The most critical driver of rupee depreciation is the persistent outflow of capital, particularly in the form of Foreign Portfolio Investment (FPI).

  • During 2025–26 and early 2026, India experienced net FII outflows from equity markets, which increased demand for dollars and exerted downward pressure on the rupee.

  • These outflows are influenced by concerns regarding India’s medium-term growth prospects and global competitiveness.

  • The absence of globally dominant firms in high-technology sectors such as artificial intelligence and advanced manufacturing has reduced India’s attractiveness relative to other economies.

  • At the same time, there has been a growing trend of domestic capital moving abroad in search of higher returns, further contributing to dollar demand.

  • FII Selling and Weak Financial Markets

  • Continued selling by Foreign Institutional Investors in equity markets, especially in early 2026, has led to significant dollar outflows.

  • Weak performance in stock markets reduces investor confidence and discourages fresh inflows of foreign capital.

  • This creates a self-reinforcing cycle in which falling markets lead to further capital outflows and additional pressure on the rupee.

  • As a result, such dynamics contributed to the rupee breaching the ₹95 per US dollar mark in March 2026.

  • Global Monetary Conditions and Dollar Strength

  • Tight monetary policy by the US Federal Reserve has led to higher interest rates in advanced economies, particularly the United States.

  • This has strengthened the US dollar and made investments in US assets more attractive for global investors.

  • Consequently, capital has shifted away from emerging markets like India, weakening their currencies.

  • Additionally, global uncertainties have increased risk aversion, leading to a flight to safe-haven assets such as the US dollar.

  • Surge in Crude Oil Prices due to the West Asian Crisis

  • The escalation of the West Asian crisis in 2026, including tensions involving the United States and Iran, has led to a sharp increase in crude oil prices, exceeding $100 per barrel.

  • India, which imports over 85% of its crude oil requirements, is highly vulnerable to such price shocks.

  • Rising oil prices have significantly increased the import bill and the demand for foreign currency.

  • Consequently, the rupee depreciated by over 4.1% between February and March 2026 following the onset of the crisis.

  • Structural External Sector Imbalances

  • India’s growth model remains largely domestic demand-driven rather than export-led, which limits foreign exchange earnings.

  • Although exports have improved, they remain insufficient to offset the high level of imports.

  • India continues to depend heavily on imports of crude oil, gold, and electronics, which creates a persistent demand for dollars.

  • This structural imbalance results in continuous depreciation pressure on the rupee over the long term.

  • RBI’s Managed Float and Limited Intervention

  • The Reserve Bank of India follows a managed float exchange rate regime, where it intervenes mainly to reduce excessive volatility rather than defend a fixed exchange rate level.

  • In 2026, the RBI introduced measures such as capping banks’ net open currency positions at $100 million to curb speculative activity.

  • The exchange rate framework has become more flexible, allowing the rupee to adjust gradually to external shocks while conserving foreign exchange reserves.

  • Reform Transition and Confidence Gap

  • India is undergoing a reform glide path, including GST rationalisation, trade diversification, and financial sector reforms.

  • However, such transitions often create short-term uncertainties and adjustment challenges.

  • These uncertainties, combined with rising global competition, may reduce investor confidence and lead to temporary capital outflows.

Implications of Rupee Depreciation Positive Implications

  • Depreciation improves export competitiveness by making Indian goods cheaper in global markets.

  • It encourages import substitution and supports domestic manufacturing initiatives.

  • It can help improve the current account balance over time if export growth strengthens.

Negative Implications

  • Depreciation leads to imported inflation, particularly in fuel, fertilisers, and essential commodities.

  • It increases the burden of external debt servicing, as repayments in foreign currency become more expensive.

  • It places pressure on the fiscal deficit, especially through higher subsidy requirements.

  • Persistent depreciation may also affect investor confidence and financial stability.

Way Forward

  • Strengthening Export Competitiveness and Diversification

  • India must move from a low–medium value export basket to high-value, technology-intensive exports such as electronics, semiconductors, defence equipment, and services.

  • There is a need to diversify export markets beyond traditional partners to emerging regions like Africa, Latin America, and Southeast Asia.

  • Improving logistics efficiency, ease of doing business, and integration into global value chains (GVCs) will enhance export competitiveness.

  • Policies such as Production Linked Incentive (PLI) schemes should be strengthened to boost manufacturing exports.

  • Reducing Energy Import Dependence

  • India’s heavy reliance on imported crude oil makes the rupee vulnerable to global price shocks and geopolitical disruptions.

  • There is a need to accelerate the transition toward:

  • Renewable energy (solar, wind, green hydrogen)

  • Electric vehicles (EVs) and battery storage ecosystems

  • Enhancing domestic exploration and strategic petroleum reserves can also reduce vulnerability.

  • Enhancing Stable Capital Inflows (FDI over FPI)

  • India should prioritise Foreign Direct Investment (FDI), which is more stable and long-term, over volatile Foreign Portfolio Investment (FPI).

  • This can be achieved through:

  • Improving policy certainty and regulatory stability

  • Strengthening infrastructure and ease of doing business

  • Promoting India as a global manufacturing and innovation hub

  • Encouraging investments in sectors such as technology, manufacturing, and green energy will attract durable capital flows.

  • Building Adequate Forex Reserves for Resilience

  • Maintaining robust foreign exchange reserves is crucial to absorb external shocks and manage currency volatility.

  • Adequate reserves provide:

  • Confidence to investors

  • Ability for the Reserve Bank of India to intervene during excessive volatility

  • India should continue to:

  • Build reserves through capital inflows and current account management

  • Ensure optimal utilisation without excessive depletion

  • Promoting Rupee Internationalisation

  • India should gradually promote the use of the rupee in international trade and financial transactions.

  • Measures include:

  • Expanding bilateral trade settlements in rupees

  • Encouraging rupee-denominated bonds (Masala bonds)

  • Developing deep and liquid financial markets

  • This will reduce dependence on the US dollar and enhance monetary sovereignty.

Conclusion The depreciation of the rupee during a Goldilocks phase highlights the limits of domestic macroeconomic stability in a globalized financial system. It underscores that exchange rate movements are shaped by external vulnerabilities, capital flow dynamics, and structural constraints. Sustained currency stability will depend on strengthening the external sector, deepening structural reforms, and enhancing resilience to global volatility, thereby aligning India’s strong domestic fundamentals with external stability.