Floating: A Double-Edged Sword

The history of exchange rate regimes originated in fixed standards that prevailed for more than three centuries. Since the repudiation of the US dollar’s convertibility into gold in 1971, which was, actually, a sovereign default of the US, and the advent of floating exchange rates, economists and their textbooks have extolled their balance of payments equilibrating and shock-absorbing properties. They have even urged emerging and developing economies to overcome the ‘fear of floating’ and let go. The reality, as we have come to experience rather painfully since the 1970s, has been very different. 

The early generations of currency crises were related to the straightforward structuralist constraint on the sheer availability of foreign exchange. Limited export capability, both in volume and in composition, meant that desirable levels of imports, investment, and growth remained unattainable without encountering a debt-servicing stone wall.

With the spate of emerging market crises in the 1980s and 1990s, the narrative shifted to surges of capital flows, sudden stops, and reversals. Another generation of currency crises had arrived that amplified economic cycles, accentuated financial system vulnerabilities, and spread contagion. Exchange rate instability was primarily driven by global factors such as global growth and policy uncertainty, interest rate volatility, trade and financial linkages, and crude oil and key commodity prices, or the so-called push factors.

Globally-induced risk aversion drove down emerging market currencies again during the COVID pandemic and the Ukraine war. In 2025, the Indian rupee has been affected by the rotation of portfolio flows towards East Asia, chasing the AI theme. There are already indications that those AI allocations have become overweighted, and soon there will be a rotation in favour of India. Unless AI is a bubble that bursts and takes down all markets. Even so, India is likely to suffer relatively less because of the absence of the AI flavour in our markets. All in all, 2026 may well be a year of a stronger rupee.

The Fickleness of Capital Flows
Increasingly, in the case of emerging markets like India that opened up with varying degrees of caution, it is the tail that wags the dog. It is capital flows that dominate exchange rate dynamics.

These globally mobile flows have come to be dominated by passive investors who are guided by fund managers graduating out of Ivy League business schools and are greatly influenced by stentorian flagship sentiments on Wall Street, Main Street, and multilateral organisations into risk-on, risk-off allocations.

Mark Carney, in his earlier avatar as a central bank governor and member of the Group of Thirty, compiled evidence to show that a fifth of all surges in capital flows to emerging markets have ended in financial crises.

These countries are three times more likely to experience a financial crisis after these capital flow surges than in normal times. And the reality is that these cascades and retrenchments in the face of which exchange rates rise and fall like flotsam and jetsam on welling and ebbing tides are driven by global factors over which national authorities have no control or power to resist.

Newer-generation currency crises are driven not so much by a country’s capacity to pay for imports or to service its debt but by on-off sentiments stirred by global developments that herd passive investors into stampeding for safe haven. Fundamentals just do not matter.

In fact, the motivation of trying to understand what drives capital flow volatility, in order to quantify the tail risks and fashion appropriate responses, has driven economists, including Carney, to profile the entire distribution of capital flows conditional upon various push and pull factors.

The objective is to try to assign probabilities to capital outflows in response to specific shocks. Work done in this vein on India in the RBI indicates that there is a 5% chance of portfolio outflows of 3.2% of GDP or a little over $125 billion in response to a COVID-type contraction in real GDP growth or a global financial crisis (GFC)-type decline in interest rate differentials vis-à-vis the US or a GFC-type surge in the VIX. In a black swan event in which all these shocks hit together in a perfect storm, there is a 5% chance of portfolio outflows of 7.7% of GDP and a short-term credit cutback of 3.9% of GDP.

Quite naturally, these tail risks shape the view of the central bank on the exchange rate, but may not worry the other viewpoints involved in market making or playing referee. They will, however, join the chorus of cries like Cassandra and make moves in the market that accentuate the downward movement, making much of a depreciation as if it were an inexorable slide into a bottomless pit, and reflecting on the helplessness of the central bank.

Oftentimes, money is to be made. It is the central bank that steps in to lean against the wind, pitting its balance sheet against centrifugal forces, putting its credibility on the line, knowing fully well that the combined international reserves held by all central banks are probably less than the turnover in global foreign exchange markets in a single day. In the process, it takes on huge exchange rate risk — the price of stability.

History has noted instances when these exchange rate risks crystallise and mutate into solvency risks. In the case of India, this almost happened in the case of the foreign currency non-resident accounts scheme during the 1991 balance of payments crisis. In the case of the Philippines, the central bank had to be closed down in 1993. A currency crisis claimed the Banco Central del Ecuador in 2000. The Central Bank of Venezuela’s policies, and in some cases assets, have been rendered ineffective or severely compromised due to currency devaluation and international sanctions during 2016 to the present. Forced restructuring/replacements after currency crises have also occurred in countries like Argentina, Libya and others. 

This column is Part II of a six-part weekly series on exchange-rate policy and financial stability by Dr Michael Debabrata Patra.

Part I set out the competing narratives on the rupee and the case for exchange-rate stability. Click here.
Part III will examine how volatile capital flows, not trade fundamentals, now dominate currency movements and shape central bank behaviour.
Part IV will set out a detailed proposal for strengthening the RBI’s foreign exchange intervention toolkit and reserve strategy.
Part V will assess why the IMF’s evolving surveillance and labelling practices risk undermining exchange-rate stability rather than preserving it.
Part VI will bring the argument full circle, asking what India’s fundamentals imply for the rupee, stability, and policy credibility in an uncertain world.