Since September 2024, the rupee has been under pressure from what started as a sell-off by foreign portfolio investors on the back of an earnings slowdown and then turned into what seems like a persistent headwind. In other words, whatever could have gone wrong went wrong, justifying bearish sentiment on the currency.

Alongside FPI outflows, net foreign direct investment inflows also moderated, driven by outward flows when the artificial intelligence theme picked up pace, clouding the outlook for services exports. Oil prices also moved up this year when the higher US tariffs on India were dropped.

While higher oil prices are a negative, the impact on the external sector has been limited because of resilient diesel exports. The same goes for services exports, which have held up.

All in all, sentiment remained negative even as the underlying economy started to pick up pace after the government’s reduction in the goods and services tax, with monetary easing by the Reserve Bank of India also bearing fruit.

In order to change the sentiment and attract dollar inflows, RBI announced a series of measures starting with a swap window for incentivising dollar inflows on 5 June 2026, which was an overwhelming success to the extent that the scheme was withdrawn a month earlier than scheduled.

Still, the pressure on the currency started to build up as oil prices rose with the escalation of the conflict in the Middle East. In the midst of all of this, growth and earnings momentum improved meaningfully. Still, given relative growth and valuations along with concern on impact of high energy prices, FPI outflows continued.

While markets have been fretting over the external sector, the actual balance of payments deficit is only $26 billion over 2024–25 and 2025–26. Hence, the outflows aren’t that large given that the current account deficit has been well behaved over the last three years at around 0.7% of GDP.

Even this year, given elevated oil prices and domestic demand, it is likely, at worst, to double from the average seen over the last few years. Yet, as against a moderate BoP deficit, the spot and forward intervention by the RBI has been $188 billion over the last two years.

What explains the gap?

It is the hedging behaviour of importers. Over the last two years, while actual imports increased by $128 billion, hedging demand for dollars increased by $189 billion. At the same time, dollar sales by exporters in the forward market increased by only $52 billion when exports increased by $85 billion.

This widening gap is, in turn, explained by the fact that realised depreciation is much higher than the forward premia paid by importers. As against realised depreciation of 4.4% between 2022–23 and 2025–26, forward premia are only 2.2%.

Hence, importers are better off paying the premia and protecting themselves against greater depreciation. For exporters, it is the other way around, with no incentive to receive premia and sell dollars since realised depreciation is higher.

This has distorted the demand for and supply of dollars when the actual BoP deficit isn’t that large.

Hence, the RBI introduced measures on 10 October 2026 to rebalance the forward market by restricting cancellation and rebooking of forward contracts and imposing a 20% foreign exchange risk reserve on importers.

Notably, as much as a third of contracts were being cancelled and rebooked the same day. With these measures, the demand from importers in the forward market has dropped by around half, while in the case of exporters, the volume has gone down by a third.

Hence, the forward market is in much better balance now than it was over the last few years, which has implications for RBI’s forex reserves and forward position as well. Between March 2019 and March 2021, RBI’s forward book rose from a short position to a long position of $73 billion.

This was when forward premia were much higher than realised depreciation, and forex reserves increased to $577 billion. During this period, importers had no incentive to hedge, with realised depreciation being lower than forward premia.

This started to change with the long forward position turning neutral by March 2024 and then into a short position of $103 billion by March 2026. Forex reserves rose during this period because of the revaluation of gold.

Foreign currency assets between March 2024 and March 2026 fell by $19 billion to $552 billion. This was when forward premia were far lower than realised depreciation, and the RBI had to provide the dollars to balance the market.

Within the forward market, one more trend that is visible is the increase in the tenor of contracts. As much as a fifth of contracts are now being written with maturities of more than six months, with a visible rise in contracts with tenors of more than 12 months.

This implies that importers are locking in the low premia for longer maturities or that some of the capital outflows too are being hedged, thus raising the demand for dollars.

How do the measures help?

By bringing down demand for dollars in the forward market, the measures help restore balance. With forward premia rising and now aligned with realised depreciation over the last few years, importers have less incentive to hedge.

History shows that the forward book and reserves can rise, as was the case between 2019 and 2021. This was when capital inflows into India were abundant and hedging demand was low.

Lower oil prices would help improve the external backdrop, while trade deals could sustain the momentum in goods exports. Continued domestic economic momentum and more attractive valuations could also help attract foreign inflows.

The current measures have helped rebalance dollar demand in the forward market, but a lasting improvement in rupee sentiment will depend on stronger foreign inflows.

In the interim, what could also help is the RBI continuing to raise the repo rate to bring inflation back to target, with the government’s supply measures ensuring that food inflation starts to ease in the coming months. This should also ensure that domestic and foreign interest rates converge closer to forward premia and thus discourage hedging demand for capital outflows.