The RBI’s new regulation on ECBs (external commercial borrowings) can be read along with the message given in the Economic Survey on the rupee being under pressure in the year. This is notwithstanding an otherwise remarkable performance of the economy.
The current account deficit is very much in control even though the exporters have faced challenging times. It is the capital account that has been transformed, putting pressure on the currency. The measures announced by the RBI on the amount and tenure of borrowing will surely help companies raise more money in this market and support the capital account.
Historically the capital account was kept steady by FPI and FDI which have become more fragile. While often it is argued that we need to be more open to such investment, polices have been comprehensive; and it does look like that nothing substantive can really be done. FDI can flow into almost all sectors with limits being increased over time. The challenge is to have investors interested in the India story. It is the pull factor rather than push which matters here.
The pull factors
There are two main issues here. The first is that there needs to be a growing global corpus of investible funds to be deployed in overseas markets. With quantitative easing of central banks giving way to tightening, there is less easy money available. The other factor is that the avenues for investment have widened over time. What was earlier ‘mainly emerging markets’ has now broadened to cover developed countries too which are working hard to push up growth. Therefore, European countries and the US are also active destinations for FDI. It will always be a challenge to get a higher slice of funds at this end.
Data on FDI show some interesting trends. The first is that gross FDI has been high in the last five years ending FY25 and averaged $78 billion per annum which is impressive. However, the repatriation of equity has been rising quite prodigiously from $27 billion in FY21 to $51 billion in FY25. This has lowered the net inflows substantially. Clearly, companies are using these funds to pay dividend to their investors or deploying the same elsewhere.
Second, the net FDI by Indian companies overseas has increased from around $11 billion in FY21 to $27 billion in FY25, which is often interpreted as a phenomenon of internationalisation of Indian firms. This is what has brought the net FDI number to less than $10 billion, which is what affects the capital account in the balance of payments. Interestingly, during the first eight months of the current year, net FDI was just $5.6 billion with gross FDI flows being $27.7 billion and net FDI outflows $22.1 billion.
The FPI picture
The picture on FPI is also interesting. There was a time when it was assumed that there could be $30-40 billion flowing in every year with the inclusion of Indian bonds in the global indices providing a booster. However, this has not played out all the time. In FY24 $41 billion came in after two years of negative flows. Covid was a good time for FPI which was high at $36 billion. In FY25 net inflows were just $1.6 billion and in FY26 a negative $7.5 billion for the first 10 months of the year.
Now, equity flows have tended to be negative for two reasons. The first is that Indian stocks are seemingly overvalued. While this argument is debatable, the high P-E ratios in some sectors have buttressed this argument that the upside remains limited unless earnings grow at sharp rates, which is not happening. Growth in earnings (denoted by net profits) has been quite subdued post Covid which probably does not justify high valuations in some sectors where the P-E ratio was in range of 30-40 like say FMCG, consumer durables, healthcare, realty, etc.
The other is that the stocks in developed countries, including the US, UK, Japan, France and Germany, are doing very well making other markets attractive. Hence portfolio reallocation has been favouring other markets where the P-E ratios are relatively lower, at less than 15, thus promising a better upside.
There is hence a lot of ambiguity when it comes to the capital account; the direction of net inflows would be hard to conjecture. These are decisions taken by overseas players, and policy reforms within the country have only a limited bearing on these outcomes. FDI was assumed to increase exponentially and numbers of $100 billion on an annual basis were taken for as granted. However, investors have been taking back their profits which has affected the net inflows. Further, Indian companies are looking to diversify their businesses outside the country which has made FDI fragile.
FPIs were always considered to be ‘hot money flows’ given their nature. While this has not quite affected the stock market significantly as domestic institutional investors like mutual funds have been more than active in this market given the growing retail interest, the currency market has been under pressure. All this makes the capital account uncertain, given their volatile nature. New emerging geographies will offer scope for foreign direct investment while stock markets across the globe will provide opportunity for portfolio investors. This will be the new normal.
Hence, it will be important to keep the current account balance under control; and the big hope for us is the IT sector that has potential to counter the deficit on the trade account. The focus on domestic production will help to an extent to lower demand for imports. However, all the FTAs signed would mean extending the perimeter for imports as our exports make deeper inroads into other countries. This means that a stable path for the rupee cannot be taken as a given.
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