Confronting economic trade-offs

Market-driven prices and tax reforms can support monetary policy and attract foreign capital

In a difficult global environment, interest rates have risen, the rupee has weakened, and net foreign-capital flows remain uncertain. It is worth looking at the takeaways from the recent past to consider the road ahead.

 

What happened? With consumer inflation averaging just 2 per cent in 2025, the Monetary Policy Committee (MPC) cut the policy repo rate by 125 basis points (bps) to 5.25 per cent. In financial year (FY) 2025-26, the Reserve Bank of India (RBI) also bought government bonds worth 2.5 per cent of gross domestic product (GDP) to support growth and replenish liquidity drained by foreign exchange outflows. These record RBI bond purchases were 70 per cent higher than those in 2020-21, during the Covid pandemic, and were 85 per cent of the Centre’s net borrowing in FY26.

 

Indian bond yields consequently fell. The difference between India and US 10-year bond yields declined to multi-decade lows of below 2 percentage points. Given that the difference between inflation in India and the US also narrowed, this may seem reasonable. However, rates should be determined by demand and supply from willing borrowers and lenders. In India, the lender pushing down interest rates was the RBI, not willing savers. For discretionary savers, post-tax returns on fixed-income remained unattractive.

 

Repressing interest rates so forcefully has consequences. Discretionary savings shifted away from fixed-income investments to equities, contributing to pockets of overvaluation there. Net foreign-inflows struggled, partly due to these high equity valuations. Outward direct investments also rose. Narrower rate differentials compressed dollar-rupee forward premia, making hedging and speculation against the rupee cheaper.

 

Across FY25 and FY26, the RBI net sold $192 billion in currency markets, much of it to feed hedging and speculative dollar demand. As dollar outflows drained rupee liquidity, markets signalled the need for higher interest rates. Instead, the RBI’s bond purchases and other actions poured durable liquidity into a leaky bucket. Short-term instruments could have replenished liquidity without depressing long-term yields.

 

The rupee fell from 85 per dollar in January 2025 to 92.5 by mid-February 2026, before the Iran conflict took it towards 97. We sought low rates, currency stability, and capital inflows. Yet despite many large market interventions, subsidised foreign exchange (FX) swaps, and restrictions on currency trading, pressures persist.

 

Lessons for stakeholders:  Armchair advice, present company included, is easy to dispense. With that acknowledged, three lessons stand out.

 

First, as the last few years have demonstrated, the impossible trinity matters. Monetary independence, capital mobility and exchange-rate stability involve inevitable trade-offs. The 2014 Urjit Patel Committee recognised this, prioritising inflation control at the time while envisaging greater flexibility once inflation expectations were anchored. Yet the RBI’s August 2025 monetary framework review did not even mention this trilemma.

 

Second, clear communication about policy choices and trade-offs is essential for market confidence. Pursuing multiple, conflicting objectives simultaneously while avoiding trade-offs risks undermining credibility. We could then end up with the worst of all worlds.

 

Third, large interventions in interconnected markets risk unintended consequences. Consistency also requires reframing the debate from “let the rupee find its own level” to “let both the rupee and rupee interest rates find their own levels”.

 

The way forward: Allow market-determined rates. Rather than repressing interest rates with interventions and schemes, we should largely let discretionary savings fund borrowings. Free debt markets should also allow for freer and more stable currency markets.

 

To be fair, in FY27, the RBI has net sold ₹1.25 trillion of government bonds to absorb liquidity created by its FX swap scheme. The MPC raised the repo rate by 25 bps this month. Yet the current India-US 10-year bond yield spread is at 230 bps, well below its historical median of around 400 bps. It is unclear if this will attract savings into Indian debt.

 

For credibility, the MPC and RBI must demonstrate the same willingness to tighten monetary conditions as they showed in easing them. Moving banking liquidity towards neutral would give market forces greater scope to determine bond yields.

 

What about growth?  Higher interest rates can impact growth. However, a lower tax burden on fixed-income can allow for lower headline rates. Interest and some fixed-income capital gains are taxed at marginal income-tax rates, leaving savers with unattractive post-tax returns.

 

We could tax interest income, including from fixed deposits, at the lower of, say, 20 per cent or the applicable slab rate. Capital gains on debt funds could be taxed on a par with equities.

 

This would also let risk-return considerations, rather than taxation, drive savings allocation. Tax revenue losses may also be limited, since tax-sensitive savers likely avoid direct fixed-income already.

 

Remove impediments to foreign portfolio flows:   India is an outlier in taxing capital gains earned by foreign investors on non-controlling portfolio investments in equities and corporate bonds. Most countries allow such gains to be taxed where the investor resides. Indian tax residents investing in overseas securities largely pay capital gains tax only in India.

 

Residence-based taxation is, therefore, not a discriminatory tax exemption only for foreigners. Their gains remain subject to tax rules in their home countries. Tax treaties do not fully address this irritant. Many foreign investors cannot offset Indian taxes against their home taxes. They may also pay Indian tax on rupee gains even when their dollar returns are poor. Compliance adds further to costs and complexity.

 

India’s June 2026 tax relief for qualifying foreign investment in government securities offers a useful precedent. Extending such residence-based taxation to corporate bonds and equities would significantly ease foreign investment. An increase in the securities transaction tax for foreign investors, particularly on high-turnover derivatives, could offset the resulting loss in tax revenue. These reforms cannot guarantee foreign inflows in an uncertain world. But they would remove distortions and allow for more palatable policy trade-offs.

 

Strengthen tax policy consultation:  Capital-market tax reforms deserve comprehensive consultation, akin to the ones that regulators undertake.  This can bring in expertise and clarity and enhance policy credibility. India retains meaningful buffers and macroeconomic strength. Credible policies, backed by clear communication that confronts difficult trade-offs, will help us navigate these uncertain times.

 

     

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The writer is a former wholetime member of Sebi.

 

 The views are personal