Macroeconomic management

Soon after the official data showed the Indian economy expanded at a robust 7.8 per cent in the first quarter this financial year, Prime Minister Narendra Modi reiterated his appeal to fellow citizens to avoid foreign holidays and unnecessary gold purchases. The appeal, in a way, highlights the complexity of India’s macroeconomic management. The data released by the Reserve Bank of India (RBI) on Tuesday showed that India’s current-account deficit (CAD) in the first quarter stood at $4.2 billion, or 0.5 per cent of gross domestic product. Seen in isolation, this can be termed a moderate deficit. India usually runs a CAD financed by foreign investment, which supplements domestic savings. However, during the quarter, the capital account also recorded a net outflow of $3.9 billion, largely due to outflows of portfolio investment. As a result, the balance of payments (BoP) was in deficit. A sustained deficit in the BoP can create pressure on the currency and lead to other macroeconomic risks. 

The issue for India is that it has witnessed BoP deficits over the past two financial years. The Iran war and disruption in energy supplies, resulting in higher prices, created the possibility of an expansion in the CAD. Since capital flows are under pressure owing to various reasons, including tensions in West Asia, there was a possibility that the BoP would remain in deficit this year as well. Given the situation, the RBI announced a swap scheme in June, including for the Foreign Currency Non-Resident (Bank), or FCNR (B), deposits. The response to the scheme has been better than most, including the RBI, had expected. As a result, it decided to close the scheme prematurely. The data shows that banks raised over $127 billion under the scheme. Total mobilisation, including external commercial borrowings and overseas foreign currency borrowings, stood at over $136 billion as of Wednesday. Thus, the second-quarter data is likely to show a big BoP surplus. However, it must be noted that, while the surplus will help tide over the near- to medium-term challenges, it does not address the fundamental problem of India not being able to attract enough stable foreign investment. Foreign portfolio investors, for instance, have sold Indian stocks worth over $42 billion since the beginning of 2025. In the first quarter this financial year, India received net foreign direct investment worth $6.1 billion. This number needs to go up substantially. The government is reported to be working on an improved framework for bilateral investment treaties. It would do well to announce it quickly and address the apprehensions of foreign investors. 

While the inflows through the FCNR (B) route have been encouraging and will help deal with the immediate problems on the external front, they are creating other kinds of complications. Surplus liquidity in the system has surged to over ₹6.6 trillion, the highest level since April 2022. The central bank has not had much success in absorbing excess liquidity through variable-rate reverse-repo auctions, partly because of the low offer rate.  The weighted average call rate, the operating target for monetary policy, has slipped below the policy repo rate. Money-market rates are declining at a time when the inflation rate is expected to increase. Thus, sustained excess liquidity might undermine the RBI’s inflation-management objective, and it may need to consider other ways of managing liquidity. An increase in the cash reserve ratio for a limited period could be an option. Thus, overall, while the economy may be growing at a robust pace, the external and financial sectors will require sustained policy engagement.