Arun Kumar
If capital is going out of the economy due to the large differential in returns between Indian and foreign stock markets, the recent steps to attract foreign capital into India are unlikely to succeed since they will make only a marginal difference.
Earlier this month, the Union finance minister, Nirmala Sitharaman, stated that India’s domestic economic situation remains positive and resilient even today. The RBI also held the repo rate unchanged and flagged India’s resilience in spite of the supply shock. But both were worried about outflow of foreign capital from India and announced steps to stem it.
The FM was visibly worried when she said, naysayers are creating a “cynical narrative” about the Indian economy by “fear-mongering”. This was not targeting the opposition or the economists in the middle but aimed at those sympathetic to the government who called India a ‘fragile economy’. These economists listed the steady decline of the rupee, persisting current account deficit, withdrawal of foreign capital from India, rising level of inflation and declining economic growth.
US President Donald Trump, realising that the continued closure of the Strait of Hormuz was about to trigger a big global shock, agreed to the talks with Iran. The extended disruption cost the global market an estimated 1.15 billion barrels of supply so that the US emergency reserves hit a 43-year low. The talks would ease some of the pressures on India. Additionally, will the steps taken by the RBI and the finance ministry help address the loss of confidence in India which was causing capital to go out of the country, even before the attack on Iran by the US and Israel?
Free markets
Rising prices of essentials, shortage of gas for cooking and reduction in employment have adversely impacted the marginalised sections. There has been migration from cities to villages and protests by farmers and workers. The impact of energy shortage could have been minimised through a strategy ensuring the continued production of essentials (like, food and clothing) while letting the production of non-essentials (like, jewellery) decline. Unfortunately such steps were not taken.
Illustration: Pariplab Chakraborty.
The ‘free markets’ economists referred to by the FM do not have faith in such government interventions. They believe that markets will take care of economic problems. Therefore, the government and the RBI should not intervene. For instance, if the rupee is declining, it should be allowed to find its own level. Alan Greenspan, the second longest US Fed Chief who passed away recently, considered to be a god by the world of finance, had argued that markets are self-correcting. So, when the US markets were booming in the 1990s and early 2000s, he did not intervene. But, in Senate hearings post the sub-prime crisis, he admitted that the model was flawed and he was mistaken.
During a balance of payment problem, currency depreciates, capital goes out of the economy and the poor get hit by inflation and shortages. This hit India. During the pandemic, the Sri Lankan economy went into a tail spin with shortage of foreign exchange leading to food and energy shortages and rioting. After the collapse of the Soviet Union in 1990, the Ruble sank and Russians faced severe problems.
During the crisis in 1997-98, Southeast Asian economies collapsed. India also faced a similar Balance of Payments crisis between 1989 and 1991. Free markets in Southeast Asia did not correct the situation. Will they do so in the current situation in India? The one Southeast Asian nation that escaped lightly was Malaysia where the government had intervened to stabilise the situation.
Destabilising finance
Destabilised financial markets in a globalised world trigger an economic decline. Often this instability is caused by big players in the financial markets who move in concert when they see an opportunity. They speculate to make the currency fall far more than what is justified by the economic difficulties.
The decline in the currency lowers the dollar return on foreign investment. This triggers a shift of investment to more profitable markets and compounds the outflow and the decline in the currency. Exporters seeing the decline, delay bringing back their dollars. Importers, to save cost, increase their imports. Both these aggravate the shortage of dollars and the currency further depreciates. A vicious cycle is set up with the currency depreciating, capital going out and foreign exchange reserves declining.
Free market analysts counter argue that as the currency depreciates, imports should decline and exports should rise, thereby reducing the current account deficit. But will this effect be large enough to counter the outflow of capital and thereby check the decline of foreign exchange reserves. If not, speculation becomes self-fulfilling and more and more capital flows out as was the case during the crisis in Southeast Asia in 1997-98 or in India in 1989-91. Further, uncertainty rises leading to decline in investments and the economy’s rate of growth falls.
Market failure
Leaving the currency free to find its own level is narrowly pro finance and against the interest of the majority. Timely action by the government and the Central Bank can check speculation and keep the situation under control.
It is a case of market failure which also occurs in the case of public goods, merit wants and externalities. To correct for it, government intervention is required. In an ideal world, things are simple but reality is far from ideal, as is the case with foreign exchange market which requires deft management.
Markets run on the ‘dollar vote’. That marginalises the marginal. That is also true for market for foreign exchange. The poor play no direct role in it – they neither buy nor sell foreign currency nor do they have expectations about its future value or invest on that basis. But, they suffer when speculators manipulate the market to trigger the currency’s collapse.
India’s fragility
Speculators were taking advantage of India’s fragility. The RBI governor had said in December 2025 that India is in a sweet spot with good growth, low inflation and low budget deficit – a Goldilocks moment. Why then has there been a loss of confidence in the Indian economy?
Foreign Portfolio Investment (FPI) has been leaving India since September 2024. Net Foreign Direct Investment (FDI) declined in 2024-25 to $1 billion. This outflow is the result of higher returns available abroad. Stock markets in the US, South Korea and Taiwan have boomed on the back of tech companies doing exceptionally well. S&P has reached record high. The Korean stock market has risen 110% in 2026 alone. In contrast, the Indian stock market has declined because the Indian tech companies are facing head winds due to both rapid spread of use of AI by companies they were servicing and their big lag behind other global tech companies developing AI.
The free market economists have an alternative explanation. Namely, the government changed the Bilateral Investment Treaties (BIT) in 2016 which has created difficulties for foreign investment in India. But, net investment was high till 2024-25, till 8 years later? And, gross FDI has risen to record levels now. It is net FDI that has declined due to Indians and those foreign investors who had come earlier who are taking out capital. New foreign capital is still coming for example, in the creation of data centers. So, it is the relative return that is to blame for outflow of capital since 2024-25.
Investment climate
India’s investment climate has also deteriorated due to internal factors. Crony capitalism gives preferential treatment to favourites and creates difficulties for others. Added to that is a shortage of demand as shown by RBI’s capacity utilization data for the organized sector. This is due to rising inequality. Both these lead to slow down of investment whether Indian or foreign.
Finally, an image of an economy doing well has been based on flawed data. The IMF also flagged problems in the quality of India’s national accounts. Flawed data gets papered over in normal times. It is in a crisis that the true picture emerges, as has happened now. The precariousness of the lives of the unorganized sector workers which was hidden gets exposed as is visible in the protests by workers, farmers and the youth. This too was the case during the pandemic.
Conclusion
If capital is going out of the economy due to the large differential in returns between Indian and foreign stock markets, the recent steps to attract foreign capital into India are unlikely to succeed since they will make only a marginal difference. Letting the rupee slide will only destabilise the currency. Why not curtail the Liberalised Remittance Scheme (LRS) which is bleeding foreign exchange? Further, checking black economy-related flight of capital and import intensive luxury consumption could save much foreign exchange and stem the decline in the value of the Rupee.
About the Contributor
Arun Kumar, Retired Prof of Economics, JNU is the author of Indian Economy since Independence: Persisting Colonial Disruption’. 2013 and ’Indian Economy’s Greatest Crisis: Impact of Coronavirus and the Road Ahead’. 2020
This article was first published in The Wire as What Can (Realistically) Help the Indian Economy Now? on June 25th, 2026.
Disclaimer: All views expressed in the article belong solely to the author and not necessarily to the organisation.
Acknowledgement: This article was posted by Harshini S, a Research and Editorial Intern at IMPRI.
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