Global trade uncertainty, high capital costs may further hit FDI flows

Data released last week showed that India’s retail inflation rate declined to 2.8 per cent in May, the lowest in 75 months. Significant moderation in previous months enabled the Reserve Bank of India’s (RBI’s) Monetary Policy Committee (MPC) to reduce the policy repo rate by 50 basis points on June 6, as against the expectation of a 25 basis point cut. Along with front-loading the rate cut, the MPC noted that monetary policy is left with very limited space to support growth. Some private-sector economists have argued that the inflation rate in the current year will be significantly lower than the RBI’s projection of 3.7 per cent, potentially creating space for further rate cuts. While a lower policy rate will reduce the cost of funds and support economic activity, its impact on capital flows and the external financial position will require close attention. The Israel-Iran conflict, which could increase risk aversion in the near term, will also need to be closely monitored.  

Since the beginning of 2025, while the yield on benchmark 10-year Indian government bonds has eased by approximately 50 basis points, the yield on 10-year US government bonds has hardened in recent months. As a result, the difference between the two has narrowed to less than 2 percentage points. In other words, there is little incentive for foreign investors to invest in Indian bonds. Even less than 2 per cent annual rupee depreciation, which is always a possibility, could make foreign investors worse off. For context, the yield difference in 2020, the Covid period, was over 5 percentage points. 

The difference has narrowed primarily due to two key factors. First, inflation increased significantly worldwide, including in the US, in the aftermath of the pandemic. This forced central banks, including the US Federal Reserve, to raise policy interest rates. The RBI also increased the repo rate. However, while the process of disinflation has been completed in India, it is still underway in the US. Furthermore, the tariff increases by the Donald Trump administration and associated uncertainties that can influence inflation outcomes are affecting market expectations. A recent Organisation for Economic Co-operation and Development (OECD) forecast showed that the inflation rate in the US will peak at about 4 per cent — twice the Federal Reserve’s medium-term target— in the last quarter of the year, and is expected to remain above target in 2026. Higher inflation will restrict the Federal Reserve from reducing rates. 

Second, as highlighted by this column recently, the budget deficit in the US has moved to a structurally higher level and, according to the Congressional Budget Office’s extended baseline projections, its debt stock would go up from the present level of about 100 per cent of the gross domestic product to over 156 per cent by 2055.  The US deficit and the debt trajectory are making a section of the market uneasy, encouraging investors to demand higher yields. A combination of these factors is keeping bond yields elevated and has played a key role in narrowing the yield differential. 

While the tapered yield difference will likely deter foreign bond investors, other forms of capital flows could also be affected. Note that the US Budget deficit has increased structurally to over 6 per cent of gross domestic product (GDP), as against the past 50-year average of 3.8 per cent. Thus, the US government will require more resources to fund its deficit, which will affect the cost of capital and fund flows in general. 

 

For a country like India, foreign direct investment (FDI) is said to be the best form of foreign capital. Along with funds, it also brings technology and best practices. However, global FDI flow has stagnated in recent years. Global trade uncertainties and higher cost of money could further deter FDI flows. Meanwhile, India is also witnessing a much higher level of repatriation and disinvestment by foreign investors. In the last financial year, for instance, despite a gross FDI flow of over $81 billion, India was left with only about $350 million at net level. 

The global financial and economic conditions suggest the flow of foreign capital may not be favourable in the near to medium term. Therefore, to boost investment, which is absolutely necessary to support growth, India will have to work on at least three fronts. First, India will need to improve its attractiveness as an investment destination. Second, India will need to increase its savings rate to compensate for the potential decline in foreign capital flows and boost investment. Third, it will need to use the available savings more efficiently. One way of doing this is to reduce the general government demand for savings through a sharp and sustained reduction in the budget deficit. The world is changing, and India must adjust.