US interest rate hikes shrink Indian FDI and reserves

Source: The post US interest rate hikes shrink Indian FDI and reserves has been created, based on the article “RBI must enlarge its buffer of foreign exchange reserves” published in “Live Mint” on 24th July 2025

UPSC Syllabus Topic: GS Paper 3- Indian Economy

Context: The Reserve Bank of India’s 27 June release of balance-of-payments data for FY 2024–25 revealed a sharp fall in foreign direct investment (FDI) inflows. The decline, linked to global interest rate trends, raises concerns about India’s capital account stability and forex reserve adequacy. US interest rate hikes shrink Indian FDI and reserves

Trends in FDI Flows

1. Sharp Decline in Gross and Net FDI: Gross FDI inflows dropped to $81 billion (2.1% of GDP), lower than the 2021–22 peak of $85 billion. More critically, excluding repatriations, gross FDI fell to $29.6 billion (0.8% of GDP) from $56.2 billion (1.8%) in 2021–22.
2. Rising Repatriation Drains Net Inflows: Repatriation of equity and other capital rose sharply to $51.5 billion (1.3% of GDP) in 2024–25, compared to $28.6 billion in 2021–22. This significantly dragged down net FDI to below $1 billion—a record low from the $14 billion peak in 2020–21.
3. Outbound FDI Shows Growth: Outbound Indian FDI climbed to $29.2 billion in 2024–25, up from $17.6 billion in 2021–22. Though the GDP share rose only marginally (0.7% vs. 0.6%), it reflects Indian companies’ growing global presence.

Influence of US Interest Rates

1. US Rate Hikes Drive Capital Repatriation: The steep rise in US interest rates since 2022 has prompted capital outflows from India back to the US. Despite India’s positive structural outlook, this has weighed on inward FDI.
2. Future Cuts May Reverse the Trend: If the US Fed reduces rates further in 2025–26, repatriation is expected to decline. This could support India’s FDI inflows and ease financing of the current account deficit.
3. RBI’s Role in Maintaining Interest Differentials: RBI must maintain a real interest rate differential of 100–150 basis points over US rates to attract capital. Its recent 100bps rate cut is seen as sufficient; further reductions could risk narrowing the gap.

Forex Reserves and External Vulnerabilities

1. Current Forex Reserve Position: India’s gross forex reserves are around $700 billion, but after adjusting for $65 billion in short forward positions, net reserves stand at $635 billion—lower than the $645 billion at March-end 2024.
2. Growing External Debt and Short-Term Pressure: India’s external debt rose by $67.5 billion to $736.3 billion by end-March 2025. Short-term debt with one-year residual maturity also increased to $303 billion, raising pressure on reserve adequacy.
3. Reserves Must Rise for Cushion: With rising GDP, imports, and external liabilities, reserve adequacy ratios have weakened. RBI must rebuild reserves to better protect the rupee from sudden depreciation in volatile global conditions.

Reassessing Vulnerability Metrics

1. Limitations of Traditional Reserve Ratios: Traditional metrics based on import cover or current account deficit understate risks. The rupee’s stress stems more from capital outflows than trade imbalance.
2. International Investment Position Shows Real Risk: India’s liabilities ($1,469.2 billion) exceed its assets ($1,139.2 billion) by over $300 billion. The reserves-to-liabilities ratio has remained below 50% for 15 years, exposing structural weakness.
3. Urgency for Reserve Rebuilding: Given India’s negative net International Investment Position, building forex reserves is essential. A strong reserve position will improve resilience against global shocks and capital flow volatility.

Question for practice:

Discuss how rising US interest rates have impacted FDI inflows and foreign exchange reserves in India.