Business Standard: Time Bought, Not Problems Solved
Time Bought, Not Problems Solved
India’s buffers can manage markets for now, but hard policy choices still lie ahead
India is navigating uncertainties arising from the US-Israel-Iran conflict. Economic and regulatory buffers are in place, and markets have priced in higher risk. However, macroeconomic vulnerabilities remain. India needs more investments and innovation. To this end, appropriate policies can help address external and fiscal imbalances, attract foreign investment, and better support balanced growth.
Markets, Flows, and Regulations
India has been managing a persistent external imbalance.
In FY25, India experienced a core external deficit of $38 billion, across its current account deficit (CAD), net foreign direct investment (FDI), and net equity foreign portfolio investment (FPI). This expanded to $40-45 billion in FY26 and could rise to $50 billion in FY27.
Against this, the Reserve Bank of India (RBI) has an estimated $585 billion in foreign currency reserves net of forward sales. This buffer provides India time for adjustment.
However, through FY25 and FY26, the RBI had to net supply around $195 billion of foreign exchange, significantly higher than the estimated $80 billion of core deficit. Around USD 115 bn of dollar demand was, therefore, driven not by core deficits, but by hedging and speculation. The offshore INR non-deliverable forward (NDF) market is key to this dynamic.
Given capital account restrictions, domestic participants cannot freely speculate in currency markets. No such constraints apply to offshore participants in NDF markets. A few years ago, the RBI permitted Indian banks to arbitrage onshore and NDF markets, aligning pricing and liquidity across both.
As accommodative monetary policy narrowed interest rate differentials between the dollar and the rupee despite India’s persistent external imbalance, participants steadily increased their hedging and speculative bets against the rupee. When the RBI moved to curb onshore-NDF arbitrage last month, an estimated $40 billion of NDF positions were being intermediated by domestic markets.
Currency markets should respond to a persistent external deficit with a weaker rupee. Indeed, in the 40-country trade-weighted real effective exchange rate (REER) terms, the rupee has weakened from 107 in early 2025 to around 92 now.
However, well beyond core deficits, when large, one-sided positioning creates a self-reinforcing spiral of depreciation, the exchange rate can begin to influence fundamentals rather than reflect them. Regulatory intervention may then become essential.
The RBI’s measures to limit arbitrage between onshore and offshore markets, for now, were justified in this context, even while one can debate the timing and manner of their execution.
It is worth emphasising that the RBI has not stopped anyone with trade or capital exposures from hedging onshore. Nor will its steps arrest speculative positions in NDF markets. However, they will limit domestic support for, and raise the cost of, such speculation.
India’s equity market valuations have also eased significantly over time, relative to global markets. The share of FPI ownership in Indian equity is at multi-decadal lows.
India’s risk premiums have adjusted upwards.
Macroeconomic Vulnerabilities
Nevertheless, macroeconomic vulnerabilities remain. Based on the oil price estimates of the Monetary Policy Committee (MPC), India’s CAD could rise to $50-60 billion in FY27. This is a concern given India’s struggle to attract capital flows.
There are significant fiscal pressures. State governments may be understating deficits by deferring expenditures. Adjusting for this, India’s true fiscal deficit could be higher by as much as 1.0-1.5 per cent of gross domestic product (GDP). The rising trend of direct cash transfers adds to the fiscal burden, as will the upcoming pay commission outcomes.
Higher energy input prices could significantly add to the pressure on India’s fiscal balance, unless retail prices are increased meaningfully. Choices must be made between expanding the fiscal deficit or risking higher inflation and slower growth.
Growth is already being affected by supply chain disruptions. El Nino and any fertiliser shortages will further increase risks to both growth and inflation. Concerns also persist around the impact of artificial intelligence (AI) on employment and the crucial software services sector.
For now, policymakers may be tempted to delay tough choices. The government may bear a big part of the energy price burden. Monetary policy could remain relatively accommodative, while a combination of reserves and regulatory steps could be used to manage exchange rate pressures.
All this might work, if either energy prices fall quickly, or if capital flows into India resume. However, hope is not a strategy.
Way Forward
Ultimately, India needs innovation, investment, and growth. To this end, appropriate fiscal and regulatory policy choices are needed. Foreign investors now need some comfort that the rupee will not see a runaway underperformance. However, India cannot simultaneously sustain low interest rates, high capital inflows, and a stable rupee.
Eventually, we must look to reduce financial repression. Large RBI bond purchases and low interest rates may appear to assist credit growth. However, debt markets are stunted when post-tax interest income returns fail to beat inflation expectations.
More market-determined interest rates would help in many ways. First, interest rate differentials between the dollar and the rupee would adjust to levels that encourage currency stability. Second, market rates would attract more foreign and domestic flows into debt. The resultant better split of domestic savings between equity and debt should reduce fears of equity market overvaluation and encourage FPI investments. Finally, more market-determined interest rates should foster fiscal accountability.
India’s taxation framework also needs changes. Domestic investors need an asset-agnostic low-tax regime to encourage appropriate asset allocation and capital formation.
India’s source-based capital gains tax and withholding framework is a major irritant for foreign investors and makes India a global outlier. We should move to a residence-based model for capital gains tax, in line with other major markets.
To simplify access to India, we should offer trusted funds passporting across asset classes. European UCITS (regulated retail investment vehicles), a gold standard for retail funds, could be a test case for passporting under the India-European Union Trade and Investment Agreement.
India has buffers to navigate the current context. However, there is no room for complacency. Policy must now shift from managing volatility to enabling investment and balanced growth.
The writer is a former whole-time member, Sebi.
The views are personal
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