The rupee’s movement over the past four years has reflected a mix of fundamentals, Reserve Bank of India intervention and market sentiment, making it difficult to attribute currency moves to any single factor, according to a report titled ‘What drives the exchange rate?’ by Bank of Baroda.
Since the eruption of the Ukraine war in 2022, the rupee has moved from an average of Rs 74.44 per dollar in January 2022 to an average of Rs 95.47 per dollar in August 2026, a depreciation of around 28%.
The movement has come amid varying trends across major currencies. During the same period, the dollar appreciated 2.4% against the euro, while the yen depreciated 38%, the Indonesian rupiah 24% and the Korean won 17%. The Brazilian real and Mexican peso, however, appreciated.
The report notes that at times, the balance of payments warranted a depreciation in the rupee, while on other occasions the currency declined as the dollar strengthened. This, it said, made it difficult to gauge the movement in the rupee.
While the long-term expectation has generally been for a depreciation of 3-4%, the report says the underlying arguments have changed over the past few years.
More recently, large inflows of dollars through FCNR and external commercial borrowings have not translated into a stronger rupee because the dollars have remained with the RBI and have been added to reserves rather than being infused into the market.
“In the current situation, a range of Rs 94.5-96 looks likely in the near term,” the report said.
The report broadly divides the forces affecting the rupee into fundamentals and sentiment.
Fundamentals are reflected in changes in foreign currency assets, which in turn depend on the current account deficit and capital flows, including foreign direct investment, foreign portfolio investment, NRI deposits and external commercial borrowings, among others.
RBI intervention is another channel through which the currency can be influenced. The central bank can intervene directly through spot-market transactions or take positions in the forward market, which can send strong signals to the market about the RBI’s position.
The rupee can also be affected by changes in reserves arising from valuation effects. Such changes are beyond direct control and can occur as movements in the dollar affect the value of reserve assets.
Sentiment, meanwhile, is influenced by market expectations around the dollar, oil prices, gold imports, geopolitical developments and tariff policies.
For example, rising oil prices can cause the rupee to decline, while signs of a truce can support the currency. Market expectations about what the RBI may do can also influence sentiment.
The report cites the RBI’s FCNR scheme involving swaps as an example. The rupee strengthened following the announcement despite there being no change in fundamentals.
To assess how strongly these factors have influenced the rupee, Bank of Baroda conducted a series of regressions using monthly data from January 2022 to June 2026. Data on RBI intervention was available up to June 2026.
The analysis examined the percentage change in the rupee against variables including changes in foreign exchange reserves, the RBI’s net purchase or sale of dollars in the spot market, changes in the RBI’s forward position, monthly FPI flows and changes in the dollar-euro exchange rate.
The bank said these were “rudimentary regressions” intended to test the significance of the variables and determine the proportion of changes in the currency that could be explained by them. The analysis, it stressed, cannot be used for forecasting, which would require additional tests.
Foreign exchange reserve changes were used to encapsulate the fundamentals because they capture elements of both the capital and current accounts. FPI flows were also examined separately as an academic exercise because currency movements are often assumed to be directly linked to portfolio flows.
The regression results show that three sets of equations had the highest R-square values and involved four variables, although not all the variables in those equations were statistically significant.
The R-square, or coefficient of determination, indicates the proportion of the change in the rupee explained by the independent variables included in each equation.
RBI spot and forward operations emerge as significant
The RBI’s spot and forward positions were statistically significant in all the equations in which they were included as explanatory variables.
When the RBI’s spot and forward positions were used together, the regression had an R-square of 34%. When used independently, the explanatory power fell to 25% for spot intervention and 19% for forward positions. Both variables remained significant when considered separately.
The report says the coefficient for spot intervention was 0.56 for a $1 billion infusion, while the coefficient for the forward position was 0.34. When both operations were considered together, the coefficients were 0.49 and 0.26%, respectively.
Based on these results, the report concludes that conducting both operations together would be more effective from the point of view of currency management.
Why higher reserves may not translate into a stronger rupee
Changes in foreign exchange reserves were statistically significant in one of the regressions, but the R-square was lower at 18%.
The report says this “probably explains why a large inflow of dollars resulting in a sharp increase in the forex reserves may not lead to a major change in the foreign exchange rate.”
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This is relevant to recent dollar inflows through FCNR and external commercial borrowings. According to the report, the inflows have not pushed up the rupee to the extent that might otherwise have been expected because the dollars have remained with the RBI and have been added to reserves.
“Sharp appreciation, which theoretically should have been the case, has been checked as the dollar inflows have not been infused into the market but added to reserves,” the report said.
FPI flows do not tell the whole story
FPI flows had a significant coefficient when considered on their own, but were not significant when combined with other variables.
The report notes that currency movements are often linked directly with FPI flows. However, over a monthly period, its analysis suggests that FPI flows are “not too significant” when other variables are taken into account.
The dollar-euro exchange rate showed a similar pattern. Its coefficient was not significant when combined with other variables, but was significant when used as the sole independent variable.
Sentiment remains a missing piece
The analysis ultimately finds that the rupee is influenced through multiple channels and that no single variable emerges as a dominant driver.
The factors examined in the regressions accounted for no more than 40% of the variation in the exchange rate.
A substantial portion of the movement not captured by the equations is attributed in the report to sentiment.
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This can include the timing of purchases by importers and exporters and decisions to hold back remittances.
The report concludes that “the factors driving the exchange rate are through multiple routes and separating them statistically does not reveal any dominant variable.”
At the same time, it finds that “RBI intervention has a positive impact in terms of stabilising the currency.”
"The factors driving the exchange rate are through multiple routes, and separating them statistically does not reveal any dominant variable. Besides, all these factors account for not more than 40% of the variation in the exchange rate. But RBI intervention has a positive impact in terms of stabilising the currency. A substantial part which is not captured in the equations is sentiment, which can include actions of importers and exporters in terms of timing of purchases or holding back of remittances," concluded the report.
Disclosure: This article has been written by Kumar Gaurav, who is not a SEBI-registered Research Analyst or an Investment Adviser. Gaurav and their ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimers here
