Does India's dependency on US dollars make the economy vulnerable?

India’s reserves remain among the world’s largest. But a stronger dollar, costlier oil and volatile capital flows are testing the resilience of those buffers. Greater export sophistication, a stronger international role for the rupee and lower energy import dependence could all reduce vulnerability.

India's foreign exchange reserves remain among the largest in the world – at nearly $689 billion. By conventional metrics, India's external position appears considerably stronger than during previous episodes of economic stress. This is supported by the 2025-26 Economic Survey, which describes India’s external sector (the part of the economy that ‘interacts’ with other countries) as resilient, while the Reserve Bank of India (RBI), the country’s central bank, has repeatedly highlighted the economy's stronger macroeconomic fundamentals compared with previous crises.

Yet within ten weeks of the closure of the Strait of Hormuz in February 2026, India’s reserves fell by nearly $40 billion. The rupee touched a record low of ₹96.8 per dollar, and policy-makers began discussing measures to contain demand for imports.

This apparent contradiction raises a broader question: does India suffer from a structural form of dollar dependence that leaves it vulnerable even when reserve levels appear comfortable?

The answer is not that India faces an imminent balance of payments crisis. Rather, the country remains exposed to a structural liquidity vulnerability embedded within a dollar-centred global financial system. The Iran-US war shock has exposed how commodity price spikes, capital flow volatility and exchange rate pressures can interact to consume external buffers much faster than headline reserve numbers suggest.

The detail behind the headlines tells a more complicated story. India carries approximately $766 billion in external debt, more than half of which is dollar-denominated. Effective usable reserves, once the RBI's forward commitments are netted out, are closer to $588 billion than the headline figure implies (RBI, 2026c; Department of Economic Affairs, Ministry of Finance, 2026).

The trend is equally telling: reserves covered 115% of external debt in 2021, but that ratio had fallen below 100% by 2025 and stayed there for 13 consecutive quarters – a sign that external liabilities have grown faster than reserve accumulation (Ministry of Finance, Government of India, 2026; RBI, 2026c).

Figure 1. Monthly average of the US dollar against the Indian rupee, January 2022 to May 2026.

Source: Federal Reserve H.10

Why does the dollar structure make India vulnerable?

India's external position remains fundamentally stronger than during previous balance of payments crises. Although the country has recorded a merchandise trade deficit every year since 1980, these deficits have been substantially offset by services exports and remittance inflows.

Global economic stress can create simultaneous demand for dollars through trade payments, debt servicing and capital outflows. This leads to liquidity vulnerability from the way in which India's external sector remains embedded within a dollar-centred international monetary system, which operates through three reinforcing mechanisms.

The first is what economists Barry Eichengreen and Ricardo Hausmann call ‘original sin’ – the inability of most emerging economies to borrow internationally in their own currency. India's $420 billion of dollar-denominated external debt means that every rupee depreciation raises domestic debt servicing costs.

The second mechanism operates through trade pricing. What’s known as the dominant currency paradigm means that the dollar accounts for almost five times the US share of global imports (Gopinath et al, 2020). India's import prices are set in dollars regardless of the bilateral rupee exchange rate. This means that when the rupee weakens, depreciation compounds the import bill rather than correcting the trade balance. This is exactly what we are seeing in the current crisis.

The third mechanism arises through global financial markets. The Bank for International Settlements (BIS) Triennial Survey shows that the dollar was involved in almost 90% of all foreign exchange transactions in 2025, its highest recorded share (BIS, 2025a).

At the same time, approximately 60% of global foreign exchange reserves continue to be held in dollars despite gradual diversification efforts (International Monetary Fund currency composition of official foreign exchange reserves, IMF COFER, 2025). The RBI's Financial Stability Report had also forewarned in December 2025 that India's financial system remained exposed to external spillovers arising from geopolitical tensions and global financial volatility (RBI, 2025).

The global financial cycle and India's three transmission channels

Interpreting the crude oil shock, capital outflows and rupee depreciation through the lens of a global financial cycle helps to provide better perspective. Research from 2015 shows that international financial conditions are increasingly shaped by global dollar funding conditions. Commodity prices, capital flows and exchange rates often move together as manifestations of a common underlying cycle.

The closure of the Strait of Hormuz illustrates this dynamic clearly. Higher oil prices increased India's demand for dollars. Simultaneously, global investors reduced exposure to emerging markets, generating portfolio outflows. The resulting depreciation of the rupee increased balance sheet pressures associated with dollar liabilities.

Rather than three separate shocks, these developments represent three transmission channels through which a tightening global dollar environment affects a net dollar deficit economy.

Oil shock

India imports approximately 88% of its crude oil requirements – almost entirely priced in dollars. Oil and gas together account for nearly a quarter of the country's merchandise import bill (RBI, 2026b). Brent crude oil surged from around $75 per barrel before the Strait of Hormuz closure to a peak of $138 in April 2026. Because oil is invoiced in dollars, a weaker rupee magnified the impact of higher global oil prices.

According to RBI estimates, every sustained $10 increase in crude oil prices raises India's import bill by roughly $14-15 billion annually and widens the current account deficit by approximately 0.3-0.4 percentage points of GDP (RBI, 2026a).

The vulnerability is amplified by geography. Nearly a third of India's crude oil imports go through the Strait of Hormuz, one of the world's most strategically important maritime chokepoints (US Energy Information Administration, EIA, 2025).

Capital flow reversal

Foreign portfolio investors withdrew approximately $21 billion during the two months following the Strait of Hormuz closure, adding to the $18 billion withdrawn during 2025. Calvo (1998) identified sudden stops as among the most destructive forces affecting emerging economies because they simultaneously tighten financing conditions and expose balance sheet vulnerabilities.

Exchange rate pressure

The rupee's decline to ₹96.82 per dollar (on 20 May 2026) intensified balance sheet pressures associated with dollar liabilities. Depreciation does not increase the stock of debt measured in dollars. What it does do is increase substantially the domestic currency value of existing dollar liabilities and raises debt servicing costs in rupee terms.

Research from 2002 presents this phenomenon as a key reason why emerging market central banks frequently intervene in foreign exchange markets despite formally flexible exchange rate regimes. Each pressure reinforces the others. Higher oil prices increased dollar demand; capital outflows reduced dollar supply; and exchange rate depreciation intensified balance sheet effects. What appeared to be three shocks was ultimately one structural vulnerability operating through three transmission channels.

Figure 2. Three pressure dashboard, January-May 2026

Source: EIA, NSDL, Federal Reserve H.10

How does India compare with its emerging market peers?

So, India’s economy is vulnerable. To get a better understanding of the extent to which this vulnerability is structural, it helps to look at how other major emerging economies have navigated similar dollar dependence and what the path out of it actually requires.

China offers a useful case study. Its renminbi internationalisation is the most instructive benchmark. Around half of China's cross-border transactions are now denominated in the country’s domestic currency, and analysis by the BIS confirms that the currency's foreign exchange transaction share was 8.8% in 2025, compared with 1.9% for the rupee (BIS, 2025b).

The structural reason for this gap is more than just institutional effort: China runs a current account surplus and is a net exporter of currency to its trading partners. India runs a structural goods deficit and is a net importer of dollars.

South Korea offers a more relevant comparison, in terms of structural changes. Starting from dollar-denominated external debt and current account deficits in the 1990s, the country systematically upgraded its export basket from textiles into semiconductors and consumer electronics until it became a persistent surplus country. The Harvard Growth Lab now ranks South Korea third on its economic complexity index, compared with India's ranking of 43^rd.

Even so, the experiences of China and South Korea, as well as Singapore and Taiwan, demonstrate that export sophistication alone does not eliminate dependence on the dollar-centred international monetary system.

How could policy-makers in India address the country’s structural vulnerability?

There are three policy areas on which decision-makers in India could focus to reduce the economy’s structural vulnerability.

Rupee internationalisation

This is the most discussed but furthest from scale. The RBI's Special Rupee Vostro Account framework has now expanded to over 20 countries, yet rupee settlement remains only a small fraction of India's overall external trade, compared with more than 28% of China's cross-border trade in goods alone now settled in renminbi (People’s Bank of China, 2025).

Research from 2018 identifies three pre-conditions for currency internationalisation: macroeconomic credibility; prudential policies that discourage excessive foreign currency intermediation; and deep local currency capital markets. India has made genuine progress on the first and the second conditions, but it is still far away from the optimum when it comes to the third.

Export basket sophistication

This can reduce external financing needs over time. Research by Ricardo Hausmann and colleagues from 2007 shows that sophisticated exports generate capability spillovers that compound over time. India's challenge is not merely to increase manufacturing output, but also to move up the complexity ladder in tradable sectors.

Energy transition

The shift towards clean energy may represent the most direct reform available. India spent approximately $174 billion on energy imports during 2025-26. Renewable energy deployment is more than just good climate policy – it can also act as good balance of payments policy. Put differently, reducing hydrocarbon dependence directly lowers structural demand for dollars.

Ultimately, reducing vulnerability requires shrinking the Indian economy's structural demand for US currency. Greater export sophistication, a stronger international role for the rupee, deeper domestic capital markets and lower energy import dependence all move the country in that direction.