RBI Must Enlarge Its Buffer of Foreign Exchange Reserves

Today's level doesn't look adequate with risks arising from capital flows more than trade gaps

- KAUSHIK DAS

On June 27, the Reserve Bank of India (RBI) released balance-of-payments data for the January-March quarter and full year 2024-25. One notable point was the sharp drop in foreign direct investment (FDI) inflows in 2024-25. Gross inflows/investments into India stood at $81 billion, or 2.1% of gross domestic product (GDP), last fiscal year. This figure was lower than the peak of $85 billion (2.7% of GDP) attained in 2021-22. But gross FDI inflows excluding repatriation of equity and other capital fell significantly to $29.6 billion (0.8% of GDP) from a peak of $56.2 billion in 2021-22 (1.8% of GDP).

Essentially, the repatriation of equity and other capital has increased from $28.6 billion (0.9% of GDP) in 2021-22 to a hefty $51.5 billion (1.3% of GDP) in 2024-25, thereby lowering gross FDI inflows substantially.

But why? We find strong evidence that a sharp increase in US interest rates since 2022 is the main driving factor. India's long-term structural and investment story is positive, but higher US interest rates have led to a surge in repatriation to that country.

This implies that if the US Federal Reserve cuts interest rates further in 2025 and 2026, the tide should turn in favor of India, with incremental repatriation likely reducing from this fiscal year onwards. This should then support gross FDI flows into the Indian economy, which have long helped finance India's current account deficit. But RBI will be mindful of maintaining a sufficiently wide interest-rate spread with the US Fed Funds rate to disincentivize the repatriation of capital back to the US.