RBI’s Exchange Rate Management Policy: Defending The Rupee Amid The West Asia Oil Shock

Policy Update
Akshat Jangid

Background

On February 28, 2026, war broke out in West Asia after the United States and Israel launched a coordinated large-scale air campaign across Iran, reigniting long-standing regional tensions. The conflict quickly escalated, with Iran closing the Strait of Hormuz, a strategic maritime channel connecting the oil-rich Persian Gulf to the Gulf of Oman and the Arabian Sea. More than 20 percent of global oil and liquefied natural gas exports pass through the strait, making it one of the world’s most critical energy corridors and particularly important for Asian economies such as India.

Figure 1: Strait of Hormuz

Source: Strait of Hormuz | Map, Importance, Conflict and Closure, Control, Oil, & Facts | Britannica

For India, the conflict represents not only a geopolitical and energy-security challenge but also a significant macroeconomic risk. India imports nearly 90% of its crude oil requirements, making its trade balance, inflation, and currency highly sensitive to movements in global oil prices. When crude prices rise, Indian refiners require additional US dollars to pay for the same quantity of oil. This results in increased demand for dollars in the domestic foreign-exchange market, placing pressure on the rupee and potentially widening India’s trade deficit. A weaker rupee can further increase the domestic cost of imported oil, contributing to higher transportation, production, and energy costs and potentially feeding into broader inflation.

These pressures have placed renewed attention on India’s exchange-rate management framework. The rupee operates under a market-determined exchange-rate regime, with the Reserve Bank of India (RBI) generally allowing market forces to determine its value while intervening in the foreign-exchange market to contain periods of excessive volatility rather than defend a formally announced exchange-rate target. Although this framework has faced previous shocks from changes in US monetary policy, capital outflows, and commodity price movements, the West Asia conflict presents a particularly difficult challenge because it combines global uncertainty with an oil price shock and heightened demand for foreign currency.

The central policy challenge is therefore whether the RBI can contain excessive depreciation and financial-market volatility without attempting to artificially maintain a particular value of the rupee or excessively drawing down India’s foreign-exchange buffers.

Functioning

The RBI does not peg the Indian national rupee to any foreign currency. Instead, allows the currency to move within the market-determined exchange rate system and intervenes only when currency movements are volatile or disruptive. By allowing free-market forces to determine the exchange rate, the RBI can maintain an independent monetary policy and a free-floating exchange rate. Still, it can be susceptible to imported inflation (a major macroeconomic phenomenon known as the Trilemma).

One of its most direct instruments is intervention in the spot foreign-exchange market. When the rupee comes under heavy depreciation pressure, the RBI can sell US dollars and purchase rupees. By increasing the supply of dollars in the domestic market, such intervention can reduce sudden exchange-rate movements.

Another way is through forward and derivative markets. These are the type of transactions that basically allow central banks to influence future dollar availability without being solely dependent on spot transactions. State banks can act as intermediaries in such markets. At the beginning of August, it was reported that public banks made several dollar sales on behalf of the RBI.

India’s exchange-rate management has also extended beyond simple direct intervention. In 2026, the RBI introduced new measures, like the forex swap facility for FCNR(B) deposits, to strengthen India’s balance of payments and attract additional foreign-currency inflows. These measures generated tens of billions of dollars in overseas deposits and helped push India’s foreign-exchange reserves back above $700 billion. The RBI then decided to end one discounted foreign-exchange swap facility earlier than originally planned after inflows proved significantly stronger than anticipated.

This framework works by combining several elements, such as market intervention, reserve management, and the continuous strengthening of foreign inflows, and does not rely on a single economic instrument.

Performance

One way to analyze its efficacy is through monitoring the rupee’s market movement. Despite substantial pressure from rising crude oil prices and high corporate demand for dollars, INR traded in a narrow band during July and August. On August 21, it closed at Rs. 95.69 per dollar after the RBI intervened to prevent an even sharper depreciation.

In terms of currency volatility, the rupee’s two-week realized volatility had fallen below 2%, while one-month implied volatility stood at roughly 4%, below its year-to-date average. This suggests that intervention has been effective in reducing short-term fluctuations even though it has not reversed the broader depreciation of the rupee.

Even though the rupee experienced a rapid, sharp decline at the onset of the conflict, it has remained largely stable over the past two months, while continued uncertainty surrounding Iran and Middle Eastern oil supplies remained an important market risk.

At the same time, India has attracted foreign currency inflows, which have strengthened its external buffer, with an estimated $57 billion cash injection raising foreign reserves past $700 billion.

Figure 2: India’s Foreign Reserves (as of August 2026)

Source: DBIE

This provides the RBI with considerable capacity to intervene. However, intervention is not costless. By the end of June 2026, the RBI reportedly had net forward-dollar liabilities of approximately $103.3 billion. It is important to assess India’s reserve adequacy by considering not only headline foreign-exchange reserves but also forward commitments and other external economic liabilities.

Impact

The RBI’s strategy has so far been more successful at stabilizing the pace of depreciation than strengthening the rupee itself. This is a critical economic distinction, as a national currency can weaken while remaining consistent. From a macroeconomic perspective, preventing sudden and disorderly movements can be more important than protecting any specific exchange rate target.

The benefits of intervention are especially relevant for India because depreciation during an oil price shock can produce a vicious cycle. Higher crude prices increase India’s demand for dollars. A weaker rupee then makes each dollar of imported oil more expensive in domestic-currency terms, adding additional pressure to inflation and the trade balance.

RBI intervention can help interrupt this process by slowing exchange-rate movements and discouraging speculative positions. Recent market behavior suggests that traders are reluctant to aggressively bet against the rupee, given expectations that the RBI may intervene in the market.

However, the policy cannot eliminate India’s underlying terms-of-trade shock. If global crude remains expensive for an extended period, India’s import bill will remain high regardless of the amount of short-term intervention undertaken by the RBI.

There is a fundamental difference between managing volatility and preventing economic adjustment. The first can improve financial stability. The second could require increasingly large interventions and may ultimately become unsustainable if the external shock persists for an extended period.

Emerging Issues

Imported Inflation: As mentioned before, the adopted framework is susceptible to imported inflation, meaning that attempts to control the situation could raise domestic fuel, transportation, and production costs due to a combination of expensive crude and a weaker rupee.

Figure 3: Inflation Rate

Source: India’s inflation accelerates to 4.45%, but unlikely to shift RBI rate outlook | Reuters

Sustainability of Foreign-Exchange Intervention: India possesses substantial foreign-exchange reserves, but continued intervention can gradually reduce the liquid buffer available for future external shocks. Headline reserves also need to be interpreted alongside the RBI’s sizeable forward-market positions.

Should the RBI Defend Specific Exchange-Rate Levels? Repeated intervention as the rupee approaches psychologically important levels, such as ₹96 per dollar, could lead market participants to assume that the RBI is informally defending particular thresholds. This could distort price discovery and encourage traders to test the central bank’s willingness to intervene.

Oil Dependence Remains the Structural Vulnerability: India is in dire need of a long-term solution to its oil dependence. Exchange-rate intervention addresses the financial-market consequence of the oil shock rather than its underlying cause. India’s dependence on imported crude means that geopolitical instability in West Asia will continue to affect the rupee through the trade balance, inflation expectations, and dollar demand.

Forward-Market Exposure: The growing use of forward intervention allows the RBI to conserve immediate spot reserves, but it shifts part of the obligation to a later date. The large stock of forward-dollar liabilities, therefore, deserves attention when evaluating the true cost and sustainability of exchange-rate management.

Reduced Value of the Rupee: Very heavy intervention can suppress short-term currency volatility. While this creates stability, excessively tight management may also prevent the exchange rate from fully reflecting underlying changes in India’s external position. Over the last decade, the rupee has experienced a massive 35.4% decline in its value relative to the dollar. Even though this promotes exports and has indeed improved India’s global competitiveness, sharp external shocks can damage the economy and raise inflation.

Way Forward

The RBI should continue to distinguish between preventing sudden disorderly market movements and defending a predetermined rupee value. Intervention is most defensible when it smooths excess volatility, prevents speculative overshooting, and allows businesses essential time to adjust to external shocks.

India should also continue rebuilding foreign-exchange buffers during periods of strong capital inflows. The success of the 2026 measures in generating substantial foreign-currency inflows showcases the value of maintaining multiple sources of external financing rather than relying solely on reserve drawdowns during periods of stress.

Promoting a stronger currency hedging culture among major oil companies and other large importers could further reduce concentrated demand for dollars during periods of market volatility. Firms with large foreign-currency exposure should be encouraged, or even instructed, to manage their risks proactively rather than be indirectly dependent on RBI intervention.

Over the longer term, however, the strongest protection for the rupee will come from reducing India’s structural exposure to imported energy. Expansion of renewable energy, diversification of crude oil suppliers, strategic petroleum reserves, increased domestic energy production, and improved energy efficiency can reduce the extent to which geopolitical disruptions in West Asia pressure India’s balance of payments.

India’s proactive measures during the ongoing West Asia conflict demonstrate both the strengths and the key weaknesses of India’s exchange-rate management framework. RBI intervention has been effective in containing short-term volatility even as the rupee has depreciated under persistent oil and dollar pressures. The objective of policy should not necessarily be to restore an earlier exchange rate, but to ensure that adjustment occurs gradually by allowing market forces to naturally run their course rather than creating financial conditions or destabilizing inflation expectations.

Ultimately, the sustainability of India’s rupee defense will depend less on how many dollars the RBI is willing to sell and more on the resilience of India’s external economy to future energy and geopolitical shocks.

References

Dbie. (n.d.). Data.Rbi.Org.In. Retrieved August 25, 2026, from https://data.rbi.org.in/DBIE/#/dbie/home

Kalra, J. (2026a, August 17). Oil pangs, FX swap window closure drags Indian rupee to two-week low. Reuters.

Kalra, J. (2026b, August 21). Rupee dips on week as oil pangs linger, intervention prevents fall past 96/USD. Reuters. https://www.reuters.com/world/india/rupee-battles-oil-hedging-drag-rbi-shield-weak-dollar-cushion-fall-2026-08-21/

Reserve Bank of India – weekly statistical supplement. (2025). Rbi.Org.In. https://www.rbi.org.in/Scripts/BS_ViewWss.aspx

Reuters. (2026, August 24). Interventions hold rupee on narrow leash, traders await US sanctions on Iran. Economic Times. The Economic Times. https://economictimes.indiatimes.com/markets/forex/forex-news/interventions-hold-rupee-on-narrow-leash-traders-await-us-sanctions-on-iran/articleshow/133461311.cms

Reuters Staff. (2026, August 18). India’s central bank intervenes across markets to steady rupee as oil, US yields climb. Reuters. https://www.reuters.com/world/india/indian-central-bank-keeps-up-interventions-cushion-rupee-oil-strain-traders-say-2026-08-18/

About the Author

Akshat Jangid is an undergraduate Economics student from Rutgers University with an interest in public policy, rural development, governance, and evidence-based policy analysis. He is currently a Research & Editorial intern at IMPRI.

Acknowledgements

The author gratefully acknowledges the reviewers (Gargi Bisht & Rishika Soni) and IMPRI for providing their guidance, comments, and suggestions during the review and writing process.