Examine the relationship between capital account volatility (FPI flows) and exchange rate management by the RBI.

Q. Examine the relationship between capital account volatility (FPI flows) and exchange rate management by the RBI. (15 marks, 250-350 words)

The Balance of Payments comprises the current account and the capital account; while the former is structurally slow-moving, the latter — dominated by footloose Foreign Portfolio Investment (FPI) — can reverse within weeks. India's FY 2025-26 experience, where FPIs turned net sellers even as the current account deficit stayed moderate at 0.6% of GDP [2], shows how capital account volatility, not trade alone, now drives rupee pressure and forces RBI intervention.

How FPI volatility transmits to the exchange rate - FPI is "hot money" — driven by global risk sentiment and US Fed rate cycles rather than domestic fundamentals; India recorded a net FPI outflow of about $4.3 billion in FY26 against net inflows the previous year [3]. - Outflows mean portfolio investors sell rupee assets and buy dollars, raising dollar demand and depreciating the rupee. - The capital account thus stopped financing the current account, tipping the overall BoP into a deficit of $30.8 billion in FY26, over six times the previous year's [1].

RBI's exchange rate management response - India follows a managed float: RBI does not target a level but smoothens excessive volatility through spot and forward dollar sales. - This intervention is financed by reserves, which depleted substantially on a BoP basis during FY26 [1][3] — reserves act as the shock absorber for capital account swings. - Complementary tools include easing External Commercial Borrowing norms, incentivising NRI deposits, and supporting banks' overseas dollar fund-raising [1]. - Stable invisibles — services exports and remittances — cushion the impact, helping the current account even post a quarterly surplus [2].

Limits of the relationship - Reserve drawdown is finite; excessive defence of the rupee can be self-defeating. - Intervention treats symptoms, not the structural crude-and-gold import dependence underlying the trade deficit.

Capital account volatility and exchange rate management are therefore two sides of one coin: reserves buy time, but durable stability requires shifting the financing mix from volatile FPI toward stable FDI, deepening forex markets, and export diversification. A resilient external sector, anchored in adequate reserves and structural import substitution, is essential to sustaining India's growth momentum without recurrent currency stress.

(~330 words)

Sources: 1. RBI Annual Report 2025-26, Reserve Bank of India — FY26 BoP deficit of $30.8 billion, reserve drawdown, and measures to attract foreign currency inflows 2. Developments in India's Balance of Payments, RBI Press Release (Q4:2025-26) — full-year CAD of 0.6% of GDP and the Q4 current account surplus 3. Reserve Bank informs decline in India's current account deficit, Akashvani News (Prasar Bharati) — net FPI outflow of $4.3 billion and depletion of foreign exchange reserves