Context:

• Three months into the ongoing West Asia conflict, India has largely avoided severe energy shortages despite rising crude oil prices.
• However, the deeper macroeconomic concern lies not in energy availability but in mounting pressure on the Balance of Payments (BoP) and the depreciation of the Rupee.
• The present external sector stress is fundamentally different from previous crises because it is being driven by weakness in the capital account rather than an unsustainable current account deficit (CAD).

A Different Kind of BoP Crisis:

• Traditionally, India’s external sector crises emerged from a widening CAD financed through volatile capital inflows.
• Once these inflows dried up, the Rupee came under pressure, forcing economic adjustment through import compression and tighter policies.
• The current episode differs in two significant ways -
  • Persistent BoP deficits:
    • For the first time in decades, India’s BoP has remained in deficit for two consecutive years and may continue for a third year.
    • This indicates a structural and chronic weakness rather than a temporary external shock.
  • Capital account stress, not current account stress:
    • India’s CAD has remained relatively moderate, averaging below 1% of GDP over the last three years. The main pressure has arisen from declining capital inflows.
    • Pre-pandemic, capital inflows averaged around 2.5% of GDP, but they have steadily weakened since 2023 and virtually dried up in 2025.
• This distinction is critical because policy responses differ depending on whether the problem originates from excessive imports or insufficient capital inflows.

Collapse in FDI - The Core Concern:

• The collapse in Foreign Direct Investment (FDI) is the heart of the problem. Net FDI, which previously averaged 1.5% of GDP, has sharply weakened since 2024.
• Global “push factors” dominate:
  • India’s FDI inflows since 2010 have been strongly correlated with US 10-year treasury yields:
    • Low US yields encouraged capital inflows into emerging markets like India.
    • Rising US yields over the last two years have reduced foreign investment appetite.
  • This suggests India’s FDI has depended more on global liquidity conditions than on domestic structural attractiveness.
• Weak domestic “pull factors”:
  • The last major period of strong India-specific investment attraction was between 2005 and 2010, driven by a robust private corporate capex cycle.
  • In contrast, countries such as Vietnam have consistently attracted high FDI irrespective of global conditions due to stronger manufacturing competitiveness and export integration.

West Asia Conflict and the “Pincer Effect”:

• The West Asia crisis has intensified existing vulnerabilities. Even if the Strait of Hormuz reopens quickly, crude oil prices are expected to remain above $100 per barrel.
• This is because global inventories need replenishment while demand remains strong. This could push India’s CAD close to $100 billion this fiscal year.
• India therefore faces a “pincer effect”: Higher global bond yields reducing capital inflows. Higher crude oil prices are worsening the trade balance.
• The root problem remains the sustained slowdown in capital flows, with the oil shock acting as an amplifier.

Rupee Depreciation as the First Line of Defence:

• The government and the Reserve Bank of India (RBI) have allowed gradual Rupee depreciation.
• Benefits of a weaker rupee:
  • A depreciated currency discourages imports, improves export competitiveness, narrows the CAD, and boosts domestic production through “expenditure switching.”
  • Theoretically, slowing FDI and rising oil prices justify a weaker equilibrium exchange rate.
• Why may depreciation alone become counterproductive?
  • If the Rupee falls too rapidly foreign investors may increasingly hedge their Indian assets.
  • Hedging demand increases pressure on the Rupee, and further depreciation triggers even more hedging.
  • This creates a destabilising feedback loop that can push the currency away from economic fundamentals.

Why Demand Compression is Risky?

• Contrast with the 2013 crisis: The economy was overheating, and inflation was high. Therefore, tightening policies helped reduce the CAD.
• Today’s conditions are different:
  • Core inflation has remained around 2–3%,
  • Economic slack persists,
  • Private investment recovery remains weak, and
  • Geopolitical uncertainty is delaying the capex cycle.
• Risk of demand compression:
  • In this environment, reducing public expenditure to fund fuel and fertiliser subsidies could weaken growth further and make policy pro-cyclical.
  • Excessive demand compression may also discourage growth-sensitive capital inflows, worsening the underlying problem.

Structural Lesson for India:

• The most important long-term lesson is the urgent need to attract stable and durable FDI. This should be combined with controlled Rupee depreciation.
• Key imperatives:
  • India must undertake sustained structural reforms to improve manufacturing competitiveness, ease of doing business, export integration, logistics and infrastructure, and investment climate.
  • Stable FDI is essential not only for economic growth but also for macroeconomic stability and resilience against external shocks.

Conclusion:

• India requires calibrated foreign capital augmentation measures alongside long-term structural reforms that enhance competitiveness and attract stable investment.
• Resorting prematurely to fiscal and monetary tightening may suppress growth without resolving the underlying capital account weakness.