Vishleshan for Regulatory Exams 25th May 2026 | RBI’s “Undervalued Rupee” Signal vs BoP Optimism

India’s exchange rate story has entered a critical phase — the rupee’s steepest fall in 14 years, forex reserves sliding by $38 billion in just nine weeks, and a widening CAD that already breaches RBI’s comfort zone. Yet Governor Malhotra frames the rupee as “undervalued,” recasting depreciation as competitiveness rather than vulnerability. In this Vishleshan, we decode how REER undervaluation is being used as a policy signal, why net FDI divergence challenges the BoP optimism, and what risks crude prices, inflation transmission, and reserve drawdowns pose to India’s macro stability.

RBI governor feels rupee may be undervalued after recent depreciation

Context:  In an exclusive Mint interview on 25 May 2026, RBI Governor Sanjay Malhotra made an unusually candid remark — that the rupee is not overvalued and may actually be undervalued in both nominal and REER terms. This is not just a currency comment. It is a policy signal with layered consequences for monetary policy, the BoP management debate, and the ongoing question of how far India should let the rupee fall before defending it. This analysis unpacks what the statement actually means, what it leaves deliberately unsaid, and why the gap between the Governor’s optimism and the structural data demands careful reading.

Link to the Article: Mint

India’s Exchange Rate Position — The Numbers Behind the Statement

• The rupee fell ~9.88% in FY26 — its steepest annual decline in 14 years — and has depreciated a further ~6% in FY27 so far (calendar year 2026), hitting a record low of ₹96.90 against the dollar.
• India’s forex reserves fell from an all-time high of $ 725.7 billion (week ended February 13, 2026) to $690.7 billion (May 1, 2026) — a drawdown of ~$38 billion in roughly 9 weeks, with the steepest single-week fall being $11.68 billion in the week of March 6.
• The Real Effective Exchange Rate (REER) — the trade-weighted, inflation-adjusted value of the rupee — is the metric the Governor specifically cited. When the RBI says REER has moved into undervalued territory, it means Indian exports have become more price-competitive in real terms relative to trading partners. This is economically significant, but it is also a two-edged signal.
• Governor Malhotra’s statement that BoP is “not an undue concern yet” sits alongside data showing Q3 FY26 CAD widening to $13.2 billion (1.3% of GDP), up from $11.3 billion in Q3 FY25, driven primarily by a merchandise trade deficit that expanded from $79.3 billion to $93.6 billion YoY.
• The CAD trajectory across FY26 is more alarming than the Q3 point-in-time figure:
  • Q1 FY26: $2.7 billion (0.3% of GDP)
  • Q2 FY26: $12.3 billion (1.3% of GDP)
  • Q3 FY26: $13.2 billion (1.3% of GDP)

a consistent quarter-on-quarter widening that, if continued into Q4 FY26 under elevated crude prices, points toward a full-year CAD of $50 billion+ (1.5-1.7% of GDP), comfortably above the RBI’s comfort threshold of ~1.5%.

• On the positive side: gross FDI hit a historical peak of $94.5 billion in FY26 (+17% YoY); services exports remain resilient; and net FDI improved to $7.7 billion in FY26 vs. $1.0 billion in FY25 — though the Governor explicitly flagged that repatriations and ODI have held net numbers back.
• India’s forex reserves of ~$690 billion cover 10-11 months of imports in gross terms — a comfortable cushion by conventional measures. However, the RBI’s net short forward position means the net usable reserve position is significantly lower. The Governor’s comfort framing rests on the gross number; the structurally relevant metric is the net forward-adjusted figure.

Decoding Article: Analysis

“Undervalued” Is a Policy Signal Disguised as an Economic Observation

• When a sitting RBI Governor publicly states that the rupee is “undervalued,” it is not a neutral academic observation — it is a managed communication that performs specific policy work.
• It signals to markets that the RBI will not aggressively intervene to strengthen the rupee from current levels. It gives the government cover to avoid politically difficult fuel price hikes by framing depreciation as a competitive feature rather than a vulnerability.
• It also pre-empts the criticism that the RBI is fighting a losing battle by spending reserves to defend an overvalued currency. By reframing the rupee as undervalued, the Governor repositions RBI’s intervention posture: “We were not defending an overvalued currency; we were smoothing volatility around a fair or below-fair value.”
• This is important because it is the first time the RBI has explicitly invoked REER undervaluation as a frame. Previous communications only said “no specific level is targeted.” The upgrade to “undervalued” raises the bar for future intervention — and markets have registered this: the rupee appreciated slightly after the statement, confirming that the signal was read correctly.

The Net FDI vs. Gross FDI Distinction Is the Most Analytically Important Line in the Interview

• The Governor cited gross FDI of $94.5 billion as a sign of India’s attractiveness. But he then immediately — and unusually — flagged that net FDI of $7.7 billion is the BoP-relevant number.
• The gap between $94.5 billion gross and $7.7 billion net is $86.8 billion — the difference being repatriations (foreign companies taking profits and capital back home) and Overseas Direct Investment (Indian companies investing abroad). This is the highest gross-net divergence India has recorded.
• What this actually tells us: foreign investors have been entering India in record numbers, but they have simultaneously been exiting in near-equal measure. For BoP purposes, India’s net capital inflow from FDI is thin — barely enough to cover one quarter of the current account deficit at current CAD run rates.
• The Governor expects repatriations to moderate because equity valuations have “largely corrected.” This is a forecast premised on Indian equity markets not correcting further. If markets fall, repatriation flows — which tend to be exit-driven — may accelerate, not moderate.

The BoP Optimism Rests on Four Simultaneous Assumptions That Must All Hold

• Governor Malhotra’s “manageable BoP” prognosis is built on a compound assumption: (1) crude prices remain ~$100 and do not escalate further; (2) gold import growth moderates as gold prices plateau; (3) services exports stay resilient despite global slowdown; and (4) repatriation outflows moderate as equity valuations stabilise.
• Each of these is individually plausible. All four holding simultaneously in a sustained war environment is a different probability calculation.
• The Strait of Hormuz remains blockaded. If the conflict escalates — Iranian escalation, US retaliation, Saudi involvement — crude could move to $130-140/barrel, breaking assumption (1). At $130 crude for a full year, India’s import bill increases by an additional $40-50 billion relative to the Governor’s base case, widening CAD from a manageable 1.5% to a potentially alarming 2.5-3% of GDP.
• The statement “I’m quite optimistic about having a manageable BoP” is not backed by published stress test scenarios — it is the Governor’s read of the current trajectory, extrapolated forward. The honest read is that the BoP is manageable under current war conditions, not necessarily under an escalated war.
• Rupee depreciation at 11% in FY26 feeds directly into import price inflation → WPI is already at 8.3% (42-month high as of April 2026) → if the government implements the anticipated fuel price hike, CPI receives a direct upward shock across transport, logistics, agriculture (diesel for irrigation), and manufacturing input costs → if CPI crosses 5.5% (or approaches the 6% upper tolerance band), the MPC is forced to pause or reverse the rate-cut cycle it began in February 2026 → a rate reversal raises EMI burdens for retail and MSME borrowers already under working capital stress → MSME NPA ratios, currently stabilised by ECLGS 5.0, face renewed pressure → the very banking system resilience the Governor is projecting depends on rate cuts continuing, which depends on inflation staying contained, which depends on the rupee not depreciating further — a circular dependency that the “undervalued” framing puts under strain.
• This is not a hypothetical chain. CPI is at 3.48% in April 2026 — currently benign. But WPI leading CPI by 2-3 months is the standard transmission lag in India’s price data. A WPI at 8.3% in April 2026 points toward CPI pressure arriving in July-August 2026 — precisely when Q1 FY27 bank results will also be reflecting the first impact of ECLGS 5.0 disbursement data. The convergence of CPI pressure and banking stress data in the same reporting window is a risk the Governor’s optimism does not visibly account for.

What the Article Does Not Say Loudly Enough

• REER undervaluation is not inherently good for India. An undervalued currency makes exports cheaper— but India is a net importer of crude, electronics, capital goods, and fertilisers. Every percentage point of REER undervaluation that makes IT services exports more competitive simultaneously raises the rupee cost of the oil import bill. For a country where oil is 30%+ of the merchandise import basket, the net REER effect is not obviously positive. The Governor frames REER undervaluation as a feature; for the import-dependent economy, it is simultaneously a bug.
• The Governor’s BoP optimism does not account for the RBI’s net short forward book. India’s gross reserves of ~$690 billion include the RBI’s outstanding forward dollar sales — a net short position that has reportedly swelled to ~$100 billion since the war began. The net usable reserve position is therefore lower than the headline number. The Governor cited gross reserves as comfort; the structurally relevant figure is the net forward-adjusted position, which is not publicly quoted in real-time.
• The 100/$ benchmark carries asymmetric psychological weight that the Governor downplays. Both former Governor Subbarao and Finance Commission Chairman Panagariya have argued that ₹100/$ is “just a number.” Technically, they are correct. Currency milestones have outsized impact on import price expectations, consumer confidence, and NRI remittance behaviour. If the rupee crosses 100 and the RBI is seen standing aside on the logic that it is “undervalued,” the second-round effects on inflation expectations may be harder to contain than the first-round depreciation itself.
• Remittance resilience is assumed but not stress-tested. India received $137 billion in remittances in 2024 (World Migration Report 2026), primarily from the US, UAE, Saudi Arabia, and Kuwait. The Gulf states are at the epicentre of the West Asia conflict. If war disruption reduces Gulf employment for Indian workers — or if the US imposes a 1% remittance tax on outward flows (discussed in ESCAP 2026 report) — remittance inflows could see meaningful decline. The Governor’s “minimal impact” assessment on remittances is not supported by a disclosed stress scenario.

What to Watch

• Weekly RBI forex reserve data (every Friday release) — the real-time confidence signal: the Governor has effectively signalled that the RBI will not intervene aggressively to strengthen the rupee. The reserves data will tell whether the market believes him. If reserves stabilise or recover toward $700 billion, it confirms that the market has absorbed the depreciation as the new equilibrium. If reserves continue falling past $670 billion despite the undervaluation framing, it means the market is testing the RBI’s resolve — and a policy reversal becomes likely. This is the single leading indicator of whether the Governor’s communication strategy is working.
• REER data (monthly, RBI release ~3-4 week lag) — the lagging structural confirmation: the Governor’s “undervalued in REER terms” claim needs the monthly REER index to validate it. If the next REER print confirms that India has moved below the 100 benchmark (indicating undervaluation relative to the base year), it gives the RBI’s position technical credibility and reduces pressure to intervene. If REER remains above 100 — meaning the rupee is still overvalued in trade-weighted, inflation-adjusted terms despite the nominal fall — the Governor’s framing will face analytical challenge from markets and economists.
• Net FDI and FII flow data (monthly, DIPP + SEBI/NSDL) — the medium-term BoP signal: the Governor’s optimism rests on capital flows compensating for CAD pressure. Net FDI at $7.7 billion is thin cover for a CAD running at $13+ billion per quarter. If FII flows remain positive or neutral in May–July 2026, the capital account arithmetic holds. If FIIs start exiting Indian equity and debt in response to rupee volatility, capital control signals, or global risk-off — the BoP picture deteriorates faster than the Governor’s base case anticipates. The FII flow data, released daily by SEBI/NSDL, is the highest-frequency leading indicator for the BoP trajectory.

The Governor’s interview is doing three things simultaneously: it is managing market expectations about RBI intervention thresholds, it is framing the rupee’s fall as an economic adjustment rather than a crisis, and it is signalling confidence in India’s structural resilience. All three may be correct. The question is whether they remain correct at $110 crude, ₹102/$, and a widening CAD — or whether this interview will be looked back on as the moment the RBI inadvertently gave the market permission to test the next level of depreciation.