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18 hours ago
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ARTICLE AD BOX
Summary
Shankar Sharma argues that India’s forex reserves are overwhelmingly built on “rented capital”, SIP inflows are facilitating foreign exits, and the country may soon have to choose between protecting the rupee and protecting the stock market.
India is trying to defend both the rupee and the stock market simultaneously—an expensive ambition for a country running persistent current account and lately, balance-of-payments deficits, especially when much of its forex reserves are rented capital.
Suppose you take a ₹10 lakh loan from your bank. The cash in your account may look like an asset, but it is still a liability.
That is the best way to understand India’s forex reserves: unlike China’s earned surpluses, much of them are borrowed liquidity.
True earned reserves come from sustained current account surpluses. India rarely runs one. Our dollars largely come from: foreign portfolio investors (FPIs/FIIs), foreign direct investment (FDI), borrowings, and overseas remittances.
A large portion of India’s reserves are therefore better understood as “rented capital” rather than earned surpluses.
The key macro number is the balance of payments. It remained negative during FY09, and turned positive in FY14. But projections for FY26 and FY27 look positively sepulchral, with estimated deficits of roughly $30 billion and $70 billion, respectively.
Historically, major market corrections have often been followed by strong foreign inflows.
India’s macro dilemma
Which brings us to India’s present macro dilemma. Why is India beginning to resemble a Fragile One or Two economy?
As I wrote in Moneycontrol in February 2025, the SIP boom was providing exit liquidity for departing FIIs, risking a macro crisis.
Eighteen months on, that is precisely what appears to be happening.
The ballast provided by SIP flows has prevented a substantial fall in Indian equities in rupee terms. But the boil has merely surfaced elsewhere, in the rupee’s brittle performance.
So a question arises: which is the lesser evil — a collapsing stock market or a collapsing currency? The intelligent choice is: a collapsing stock market.
A melting stock market does almost no lasting harm to the real economy. Even in developed countries with higher equity ownership, the impact is often transient.
But the same cannot be said of a currency unravelling. A forex crisis touches every household. It raises prices, increases the country’s cost of capital and damages perceptions of stability.
Also, currency meltdowns almost never recover fully.
The Indian stock market has absorbed the FII punches relatively well because of mutual fund flows. But the rupee has been tottering around like a punch-drunk fighter.
Consider the counterfactual. Had domestic investors not poured savings into mutual funds, FIIs would not have received exits of this magnitude at relatively stable prices. Without domestic liquidity, markets would have corrected far more sharply.
But India would also have lost far fewer dollars. Instead, we would have seen hollow anthills of inflated market capitalizations crumble to saner levels.
Historically, in periods of macro stress, the stock market has acted as the corrective spring mechanism that made dollar exits unviable.
Today, however, domestic liquidity is cushioning that adjustment.
That is the dilemma India faces today. There is relatively little India can quickly do on the capital account front to bring in large dollar inflows, except raise high-cost NRI deposits.
SIPs and the macro trap
But we can, theoretically, tourniquet outflows. India recently disincentivised gold purchases. That affected far more Indians than equity investing does.
So why not SIPs? Of course, this is a very vocal constituency, so it's not going to be easy.
Recall that in the 1990s, we had zero taxation on FIIs and around 20% on domestic investors. It is probably time to consider raising taxation, even if temporary, on stock market investments for domestic mutual fund investors and simultaneously, permanently reducing taxation on future investments for FPIs.
Consequence? The stock market probably crashes. Countries survive stock market crashes. But countries routinely go bankrupt because of currency crashes.
With our import cover (merchandise + services) down, on a forecast basis, to just about six months now, India doesn't have the luxury of time.
The estimated FY27 balance-of-payments deficit of $70 billion could amount to roughly 12% of net forex reserves after adjusting for forward sales. In FY09, that figure was about 8%
India cannot afford to offer foreign capital fully convertible currency exits amid a massive balance of payments deficit. A price must be extracted for exits. A crashing stock market is that price.
In fact, a crushed stock market almost always guarantees massive foreign inflows. We saw this after FY09 ($20 billon inflows) and again after FY14 ($10 billion inflows) . Domestic investors will take hits, but the market always recovers once the macro crisis recedes.
The Reserve Bank of India cannot burn forex reserves defending the rupee, giving foreign capital minimal-cost exits. Nor can Indian investors blow up their savings, giving foreign capital zero-cost exits.
India cannot fight a two-front war—defending both the exchange rate and elevated equity valuations simultaneously.
That twin burden risks becoming an incendiary Molotov cocktail.
Sensible forex policy is predictive and proactive. Otherwise, it is just hopeful astrology.
Shankar Sharma is a well-known investor and founder of GQ FinXRay, an AI company. Shlok Rathod and Alok Kumar provided the data.
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