Turning the tide: India must address fundamental gaps in external account

Easing West Asia tensions may stabilise India's external accounts, but policymakers must focus on boosting FDI, exports and long-term capital inflows

Even though considerable uncertainty remains over the final outcome of the agreement between the United States (US) and Iran, its announcement on Sunday has clearly eased pressure on the global economy. It has been reported that traffic in the Strait of Hormuz would gradually increase. It may take weeks, if not months, for supplies of crude oil and gas to return to normal levels, partly because several facilities in the region were damaged during the war. Nevertheless, prices of crude oil have eased and will be expected to come down further as supply pressure lessens. Lower energy prices and improved availability will benefit the global economy, particularly countries like India, which depend on imports for most of their crude-oil requirements. 

Hostilities in West Asia had put considerable pressure on the Indian economy, particularly in managing its external accounts. India runs a current account deficit (CAD), which was expected to widen to about 2 per cent of gross domestic product on account of higher prices of oil and gas. The broader uncertainty also resulted in capital outflows. As a result, India faced a deficit on both the current and capital accounts, resulting in pressure on the rupee. The rupee declined by over 5 per cent between March and May. To improve foreign-currency inflows, both the government and the Reserve Bank of India (RBI) announced a series of measures earlier this month. These ranged from correcting the anomaly in taxing foreign portfolio investment and incentivising external commercial borrowing to encouraging banks to raise fresh foreign currency non-resident (FCNR-B) deposits from non-resident Indians. Union Finance Minister Nirmala Sitharaman noted on Monday that more steps would be taken to bring foreign capital. 

The measures announced by the government and RBI should help bring considerable flows. Given that banks are competing to attract FCNR-B deposits, some estimates suggest this could result in inflows of up to $100 billion. The expected flows, along with the decline in uncertainty in West Asia, can justifiably be expected to reduce the pressure on the external accounts in the short run, which is also reflected in the rupee’s recovery in recent days. However, policymakers should not be content with the possible return of stability in the near term.  It is worth remembering that the external account was under pressure even last year, partly because of trade-related incertitude. Thus, India needs to work on multiple fronts, as increasing foreign borrowing under different heads may not yield a durable long-term solution. 

India usually runs a modest CAD, which is justifiable, given its level of development and investment needs. However, it needs stable long-term capital to fund its saving-investment gap. Foreign direct investment (FDI) is usually considered the most desired form of foreign capital. But the gross FDI flow in 2024-25 was lower than the level achieved in 2020-21. Besides, the level of repatriation and investment by Indian companies abroad has increased, reducing net FDI, which is critical from the balance of payments perspective. While some amount of overseas investment by Indian companies and repatriation by foreign companies is to be expected, the aim should be to increase gross flows substantially. Further, India must focus on pushing exports. It has done well to sign a number of trade deals in recent months. However, the impact of increased tariffs over the past decade or so is worth reviewing. Since the rupee has depreciated considerably over the past 18 months, which is likely to help tradable sectors, it is perhaps time to start reducing tariffs. Furthermore, in an increasingly uncertain world, currency management may also need to be reviewed.