The Reserve Bank of India's June measures have successfully stabilized the rupee following a period of volatility. According to reports from Business Standard, the central bank announced a series of measures to support the currency by encouraging foreign borrowing, which have shown positive results in market stability. However, the effectiveness of these measures depends on whether the underlying problems are temporary or permanent in nature. The RBI's strategy has bought India some time, but the challenge now is to use that time wisely by implementing a permanent strategy to attract foreign capital, especially FDI. As per Business Standard, the obvious question is whether this stability will last, with the answer depending on whether the problem is temporary or permanent. If it is temporary, borrowing can bridge the gap in dollar supply until conditions improve, but if the problem is permanent, borrowing only postpones the adjustment.
While the war in West Asia has pushed up oil prices, increasing India's import bill and putting pressure on the balance of payments, this factor represents only a small portion of the problem. As reported by Business Standard, the bigger challenge lies in the capital account, where foreign capital inflows have weakened steadily over recent years. Current capital inflow levels are no longer sufficient to finance even a modest current account deficit, marking a significant shift from the investment boom of the mid-2000s when inflows were more than sufficient to finance the current account deficit and allow RBI to accumulate foreign exchange reserves. Even if tensions continue for a few more months and oil prices rise back towards $100 a barrel, India's current account deficit should remain within its traditional "safe limit" of 2% of GDP. The bigger problem lies in the capital account, where India attracted substantial foreign capital for much of the period since the 1991 reforms, but over the last couple of years, capital inflows have weakened steadily and are no longer sufficient to finance even a modest CAD.
India's Viksit Bharat goal by 2047 requires the economy to grow at around 8% annually in real terms for the next two decades, which will necessitate much higher investment levels. According to Business Standard analysis, achieving this growth rate requires investment of 36-40% of GDP every year, with today's gross savings and investment both around 30% of GDP. This creates a gap of 6-10% of GDP annually that must be filled through foreign capital, equivalent to approximately $240 billion annually at current GDP levels of around $4 trillion. The incremental capital output ratio (ICOR) measures how many rupees of investment are needed to generate one additional rupee of GDP, with India's historically ranging between 4.5 and 5. At that rate, sustaining a real GDP growth rate of 8% requires investment of 36-40% of GDP every year, while today's India's gross savings and investment are both around 30% of GDP.
While the RBI's June 5 package includes measures like elimination of capital gains tax on foreign investors' bond purchases, much more needs to be done to attract foreign direct investment. As reported by Business Standard, three crucial policy actions are required: liberalizing India's trade regime through reduced import tariffs and simplified customs duty structures, rebuilding the bilateral investment treaties network that was dismantled between 2016-2024, and ensuring policy certainty by avoiding unexpected policy reversals like the RBI's March decision requiring banks to unwind offshore forward positions. FDI is particularly important because it is more stable than portfolio investment and brings technology and access to global production networks that India needs to build a competitive manufacturing sector. To encourage FDI inflows, three policy actions are crucial: liberalising India's trade regime with import tariffs coming down, simplifying the Customs duty structure, and phasing out Quantity Control Orders (QCOs) that make it harder for manufacturers to source imported inputs. Setting up a factory requires a large, long-term investment, and foreign investors are more likely to make such commitments when they are confident that any disputes will be resolved through a credible and predictable legal process.
Indian policymakers cannot guarantee foreign capital inflows but can ensure there are no avoidable reasons for investors to stay away. According to the analysis from Business Standard, India needs a permanent strategy to attract foreign capital, especially FDI, focusing on making investment easier, protecting investors through predictable rules, and avoiding policy reversals after investments are made. The retrospective tax dispute involving Vodafone damaged investor confidence, though the government has since ruled out such taxation, while more recent policy reversals have kept those concerns alive. The RBI's decision in March requiring banks to unwind their offshore forward positions, at an estimated cost of hundreds of millions of dollars, is one example of unexpected changes that increase the perceived risk of investing in India. This approach is essential for maintaining the stability achieved through current measures while addressing the fundamental challenges in attracting sustainable foreign investment flows. Investors making long-term commitments need confidence that the rules will not change after their investments are made, and policy certainty matters significantly for encouraging foreign capital inflows.
