An Agenda for Risk Mitigation in Context of Vulnerability to FPI

UPSC Syllabus: Gs Paper 3- Indian economy

Introduction

Markets often assume that India is highly vulnerable to oil shocks and FPI volatility. However, many indicators show stronger resilience than perceived. India has diversified growth drivers, stable domestic participation, and low external imbalance. Despite global shocks, macro fundamentals remain stable. The issue lies more in misreading risks than actual weakness. Focus is needed on reducing dependence on volatile capital, strengthening domestic drivers, and improving external stability.

Current Scenario: Perception of High External Risk

1. Overestimation of Oil and FPI Risks: Markets are pricing higher risks from oil shocks and capital outflows, even though the actual impact remains moderate. Markets are pricing higher risk than actual economic indicators suggest.
2. Strong Economic Size and Base: India’s economy of about $3.92 trillion ensures that even small inflows generate large absolute capital. This supports market depth and stability.
3. Shift Towards Domestic Ownership: In 2025, domestic investors overtook FPI, with foreign share at around 15%, a 20-year low. This reduces dependence on volatile external capital.
4. Consumption-Led Growth Model: Consumption contributes about 60% of GDP, making India less dependent on exports compared to China’s 40%. This stabilises demand during global shocks.
5. Diversified Growth Structure: Growth comes from manufacturing, services, agriculture, and exports. This reduces risk from any single sector or external factor.

Misinterpretation of Risks and Structural Concerns

1. Reliance on Outdated Indicators: Analysts focus on past vulnerabilities and averages. They ignore recent improvements in domestic participation and macro stability.
2. Currency Depreciation Misjudgment: Excess rupee depreciation was expected to improve trade balance. However, it did not improve Current Account Deficit (CAD) or inflows, showing limits of this approach.
3. Self-Fulfilling Exchange Rate Cycle: Falling exchange rates discourage inflows as investors expect further decline. This creates a cycle of continued depreciation and weak capital flows.
4. Incomplete Global Financial Responsibility: International institutions do not address volatility affecting emerging markets. They attribute it to domestic structural weaknesses.
5. Misreading of Savings Trends: Decline in financial savings is seen as weakness. But rise in physical asset savings and corporate savings keeps total savings above 30% of GDP.

Existing Strengths and Policy Initiatives

1. Technological Adaptation and AI Use: India is actively using small language models for cost-efficient AI solutions. These models are adapted for local needs, and productivity gains of around 30% are expected to raise income and demand.
2. Balanced Household Asset Structure: Indian households maintain a balanced portfolio, with only 15% in equity and mutual funds, while physical assets dominate. This reduces exposure to market volatility.
3. Disciplined Investment Behaviour: Indian households invest through SIPs and avoid panic selling. Their experience from past cycles and low use of leverage prevents forced selling during market downturns.
4. Shift Towards Domestic Equity Ownership: India’s foreign equity share is about 15%, which is lower than the US (18%) and much higher than China (3–5%), showing a balanced approach with rising domestic ownership and controlled external dependence.
5. Strong Domestic Investment Base: Investment rate is above 30% of GDP, among the highest globally. Most investment is private, as public investment is only about 4%.
6. Savings Structure Adjustment: India’s household sector includes the unorganised sector, which is actively borrowing and investing. While financial savings declined, physical asset savings increased, keeping total savings above 30%.
7. Low External Imbalance: India has maintained a low CAD of around 1% of GDP, showing limited dependence on foreign savings and better external stability.
8. Policy Response to Demand: India used GST tax cuts to stimulate demand, which showed strong response. This indicates that the government has both tools and intent to manage external shocks.
9. Export and Investment Diversification: India is expanding manufacturing through FTAs, defence exports, and construction demand. Agriculture and services exports further strengthen India’s diversified economic base.

External Sector and Exchange Rate Challenges

1. Limited Gains from Depreciation: Real exchange rate depreciated 10% below equilibrium, yet exports did not improve due to competitive global markets.
2. Higher Import Costs and Inflation: Depreciation increases prices of oil and commodities. This raises inflation and offsets benefits of real depreciation.
3. Capital Inflow Sensitivity to Currency Trends: Investors prefer stable or appreciating currency. They enter markets only when reversal of depreciation is visible.
4. Speculative Dollar Positioning: After global conflicts, investors increased dollar positions expecting further rupee fall. This adds pressure on currency.
5. Ineffective Balance of Payments Adjustment: Depreciation failed to improve CAD or inflows. This shows that currency adjustment alone cannot solve external imbalance.

Way Forward

1. Reduce Dependence on FPI: Increase stable inflows like FDI. India’s FDI to GDP is 14%, which can be raised towards global levels of around 20%.
2. Lower Current Account Deficit: Focus on reducing import dependence and strengthening export capacity. This reduces vulnerability to capital flow shocks.
3. Trade Diversification Strategy: Expand FTAs and diversify products, sources, and destinations. This improves resilience to global demand shifts.
4. Promote Green Energy Transition: Reduce oil import dependence, already declining from 8.5% to 5.5% of GDP. This lowers external vulnerability.
5. Improve Cost Competitiveness: Reduce logistics costs and improve efficiency. This strengthens export performance.
6. Balanced Exchange Rate Management: Avoid excessive depreciation and aim for stability. Nominal appreciation is better than inflation-driven adjustment.
7. Use of Multiple Policy Instruments: Central banks should use reserves and buffers actively. Diverse tools reduce risk from external shocks.

Conclusion

India’s vulnerability to FPI is often overstated due to misreading of data and trends. Strong domestic participation, high investment, and low CAD provide stability. The focus should shift to reducing external dependence and strengthening internal drivers. A balanced strategy combining stable capital inflows, diversified trade, and policy flexibility will ensure sustained growth with lower volatility.

Question for practice:

Discuss how India’s structural strengths and policy measures reduce its vulnerability to Foreign Portfolio Investment (FPI) volatility despite global economic shocks.

Source: Businessline