What would have been the value of the rupee if India had its own oil reserves?
The counterfactual is worth contemplating, because it illuminates a structural reality that lies at the heart of India’s economic story. Unlike many commodity exporters, India must continuously earn dollars to sustain growth. Energy imports are not a cyclical requirement; they are a permanent feature of the country’s development model. That makes the availability of dollars as important to economic stability as the availability of capital itself.
Those dollars can arrive through exports, remittances and capital flows. Exports constitute earned income. Portfolio investments, foreign direct investment and remittances provide supplementary inflows. Together, they have helped finance India’s energy dependence and preserve macroeconomic stability over the past three decades.
India’s Structural Dollar Constraint
Yet, the global environment has become considerably less benign.
Trade frictions have intensified, and geopolitical tensions have added to uncertainty in energy markets. Capital has become increasingly concentrated around the artificial intelligence investment cycle, attracting funds toward the United States, and a handful of Asian technology hubs. The consequence is straightforward: while India’s demand for dollars remains structural, the supply of dollars has become less predictable.Whenever demand for dollars rises faster than supply, pressure on the rupee inevitably follows.
The foreign exchange reserves accumulated by the RBI constitute one of the principal instruments available to cushion such pressures. Broadly speaking, these reserves can be deployed either through intervention in the spot market or through operations in the forward market.
Persistent intervention in the spot market inevitably reduces reserves because dollars must be sold immediately. Consequently, there are limits to how long such a strategy can be sustained. The RBI has, therefore, chosen a more nuanced approach by facilitating dollar deposits and absorbing part of the associated hedging costs.
Given that Indian banks do not generate dollar earnings, their ability to offer attractive returns on dollar deposits is constrained by prevailing US interest rates. By absorbing a significant portion of the currency hedging costs, the RBI improves the economics both for banks and for overseas depositors.
As several investment banks have pointed out, such deposits can themselves serve as collateral for further dollar borrowing, allowing investors to enhance returns through leverage. Which naturally raises the question of where the ultimate collateral for these liabilities and their associated hedging costs resides.
The collateral ultimately rests upon the RBI’s existing foreign exchange reserves. However, the corresponding claims would crystallise only several years from now. In that sense, the burden on reserves remains contingent rather than immediate.
That, by itself, is not undesirable. It effectively gives the central bank time to rebuild reserves and allows present pressures to be addressed without immediately depleting its balance sheet.
How The RBI Bought Time
But what changes three years from now?
Implicit in the RBI’s strategy seems to be the expectation that several favourable developments would have materialised by then. Geopolitical tensions in West Asia may have eased, allowing energy markets to normalise. The present drift towards protectionism and trade disruptions could give way to a more stable global trading environment. Capital currently concentrated around the artificial intelligence investment cycle may once again broaden its search for opportunities across emerging markets.
Equally important, domestic reforms capable of attracting both debt and equity capital may have moved from intent to implementation. India’s gradual transition towards cleaner sources of energy could begin reducing its dependence on imported fossil fuels and, with it, its structural demand for dollars. Export markets and payment arrangements may also become more diversified, reducing excessive reliance on any single currency or geography.
Finally, Indian households may channel a larger share of their savings towards financial assets rather than traditional stores of value, thereby easing another source of external pressure.
In essence, the central bank’s approach rests on confidence in India’s long-term growth trajectory. That is neither unusual nor imprudent. Monetary authorities can smooth volatility and redistribute pressures across time, but they cannot by themselves alter the structural conditions that ultimately determine the economy’s external position. Those outcomes ultimately lie beyond Mint Street.
The Assumptions Behind Stability
However, like all exercises in inter-temporal risk transfer, the strategy carries assumptions whose probability and consequences merit closer scrutiny.
Perhaps the most consequential assumption is that the current phase of American economic nationalism represents an aberration rather than the beginning of a more enduring shift. While the post-war American-led order remains intact, it is increasingly being reshaped. The growing tendency among major powers to ask allies and partners to absorb a larger share of the costs associated with sustaining that order may prove more durable than many expect. India, unlike China, possesses relatively limited economic and geopolitical counterweights against such a world.
There are also reasons to be cautious about the pace at which India’s dependence on imported fossil fuels can be reduced. The transition to green energy, while inevitable, is itself intertwined with supply chains in which China enjoys overwhelming dominance, whether in solar modules, batteries, electric vehicles or critical minerals. Strategic concerns have naturally limited India’s appetite for excessive dependence in these areas, making a rapid rewiring of the economy unlikely.
To be sure, geopolitical tensions in West Asia may well ease, and alternative payment arrangements may gradually gain acceptance. Yet India’s historical preference has been to remain anchored to the established dollar-based financial architecture. Consequently, even if energy exporters increasingly experiment with non-dollar settlement mechanisms, India’s transition away from the prevailing order is likely to be gradual rather than abrupt.
Capital flows into emerging markets have historically moved in long cycles. Yet, the present episode is not a broad retreat from the asset class. It is, instead, a reallocation of capital towards those economies and sectors perceived to be the principal beneficiaries of the artificial intelligence investment wave.
The assumption embedded within the RBI’s strategy is that this divergence is cyclical rather than permanent. As the current phase matures and productivity gains from AI begin to diffuse more widely, India too could unlock earnings growth strong enough to restore the momentum of dollar inflows.
That is a reasonable expectation. But it remains an expectation nonetheless. Today’s interventions are, in the end, underwritten by confidence that future productivity gains will validate present optimism.
Where Risks Begin Emerging
There is, however, one complication. The remarkable rise of domestic savings flowing through systematic investment plans has helped sustain valuations even amidst the recent withdrawal of foreign capital. While this has imparted resilience to Indian markets, it has also raised the bar for future returns. Strong earnings growth may prove insufficient if valuations themselves become a constraint on the re-entry of global capital.
That leaves regulatory reform as perhaps the most reliable assumption embedded within the RBI’s strategy, for it remains one variable over which policymakers retain meaningful control.
Yet, even this assumption is not without constraints. The political economy has a rhythm of its own. As electoral cycles approach, governments everywhere become more cautious. The appetite for difficult reforms often yields to the imperatives of redistribution and political stability. Administrative energies shift from structural change towards managing immediate electoral outcomes.
Which is why the next twelve months may represent a particularly consequential window. Beyond that, the scope for ambitious reform could narrow considerably.
There is also little reason to believe that Indian households will meaningfully reduce their affinity for gold. Gold has long served as a hedge against uncertainty and a store of value that commands deep cultural and economic trust. Recent experience with Sovereign Gold Bonds has done little to weaken that preference. If anything, it has reinforced the belief that financial substitutes cannot easily replicate the certainty associated with physical ownership.
The Window Cannot Last
Which brings us to the nature of the RBI’s intervention.
The collateral underpinning these dollar liabilities and their associated hedging costs ultimately rests on confidence in the future adequacy of India’s foreign exchange reserves. Those contingent claims would remain largely theoretical if energy prices moderate, the global trading environment stabilises, India’s dependence on imported fossil fuels diminishes, export markets diversify, alternative settlement mechanisms gain acceptance and domestic reforms succeed in attracting fresh capital flows.
The difficulty, however, lies in the sheer number of assumptions involved. Even if most of these outcomes are directionally correct, their pace and magnitude may prove insufficient. The issue is not that every assumption must fail. It is that several of them need only prove partially true for today’s contingent liabilities to acquire greater economic significance.
Which is why the claim on reserves is best viewed not as hypothetical, but as deferred.
The RBI has succeeded in buying time and in preventing immediate pressures from becoming destabilising. But time, by itself, cannot substitute for structural adjustment. The burden now shifts from monetary policy to economic policy.
The centre of gravity has therefore shifted from Mint Street to North Block. What happens from here will depend less on monetary ingenuity and more on the quality and urgency of economic policy.
India’s central bank has purchased time.
That might be just one reason for the government to fully unveil the reform bazooka now.
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