While India’s domestic economy has remained resilient in the face of global turmoil over the past year, the rupee has emerged as a sticking point for many foreign investors.
Supported by credit growth, domestic demand and broader structural tailwinds, the economy is estimated to have grown at 7.7% for the year ended in March – the latest reading. But currency weakness, foreign outflows and oil-price sensitivity have all weighed on sentiment.
Recent policy action marks a clear turning point, with the Indian authorities moving decisively to ease those pressures, support the rupee and restore confidence among overseas investors.
This shift could prove to be a defining moment for India’s long-term growth story.
The local currency problem
The key issue for some foreign investors hasn’t simply been Indian market performance in local currency terms, but the translation back into dollars.
A falling rupee can quickly erode otherwise attractive returns and a local bond yield or equity gain becomes less compelling if much of the return is lost through currency depreciation.
Over the past 12 months, the rupee has depreciated by 11%, with 5% of that decline coming in recent months as global geopolitical tensions have escalated.
Compounding this, the yield premium investors earn on Indian bonds over US treasures has narrowed to roughly 2.4%, while the five-year spread is around 2.7%, according to Jefferies.
In practical terms, foreign investors have had less compensation for taking currency risk, raising the hurdle for overseas capital. However, Indian authorities have now introduced measures intended to address this, as set out below.
Removing the Indian debt drag
The first policy response has been to improve the appeal of Indian government bonds. Indian authorities have removed withholding tax and capital gains tax for foreign investors in certain bonds, directly improving the after-tax return available.
Removing that drag makes Indian debt more attractive and may signal that policymakers want to reopen the door to foreign capital while the rupee is under pressure.
The early response has been constructive. Foreign funds bought $4.4bn of government bonds in June vs. $1.6bn YTD to May. This suggests overseas investors are already reassessing allocations.
Foreign currency deposit window
The second measure is potentially more significant. The Reserve Bank of India has opened a foreign currency deposit window aimed at non-resident Indians, allowing overseas Indians to place foreign currency deposits with Indian banks while the RBI absorbs the currency hedging cost.
This creates a route for dollar inflows without asking the depositor or the bank to take the same foreign exchange risk.
There is precedent for this policy. India used a similar FCNR-B deposit window in 2013 during the taper tantrum when the rupee was under heavy pressure.
Jefferies estimates that the 2013 scheme mobilised $34bn in total foreign currency inflows, equivalent to around 12% of India’s foreign exchange reserves at the time. FCNR-B deposits rose from around $15bn before the scheme to around $40bn during the window.
Reuters has reported that Indian banks could raise $35bn–$40bn through the current scheme. Given the Indian economy diaspora and remittance base are all considerably larger than they were in 2013, the eventual inflow could provide a useful buffer for the currency and wider balance of payments.
The bigger picture
While India is attempting to ease the macro pressure, the domestic story remains very much intact. As a major energy importer, India remains sensitive to higher crude prices, which can increase the dollar import bill, pressurise the external balance and weigh on currency confidence.
Recent data, such as increased foreign debt flow in June and a ~20-basis-point fall in the 10-year yield, suggest the policy measures are having their intended effect.
For foreign investors, this helps separate the macro issue from the underlying investment case as the domestic economy remains supported by solid credit growth, resilient demand and structural reform.
And while global equity markets have become increasingly concentrated around AI-related exposure and emerging market indices are becoming increasingly tilted towards technology, India might offer a different, diversified source of growth – a large, domestic-demand-led emerging market with deep structural drivers, a wide corporate universe and a reform-minded policy backdrop.
If the rupee stabilises, this could encourage international investors to refocus on those fundamentals.
Putting the micro back in focus
The rupee has been a genuine challenge for foreign investors in India.
Recent policy action does not remove every external risk, but it does show a clear willingness and commitment to supporting the currency, restoring confidence and bringing capital back.
While the macro picture has been a problem, these decisive actions are aimed at lowering the hurdle for overseas capital and could help isolate India's robust domestic growth from external noise.
Andy Draycott is portfolio manager of the Chikara Indian Subcontinent fund. The views expressed above should not be taken as investment advice.