Investment outflows: India may need to adopt extraordinary measures to reverse this exodus

So we have a fast-growing economy with stable macro-stability markers, yet we face an exodus of foreign capital; this is a trick question, way out of syllabus. The solution set needs to go beyond the textbook too.

First, fix the yield spread. For five years running, the 10-year yield spread between rupee and dollar denominated assets have been at historic lows. From a 21st century average of 350-400 basis points, spreads have shrunk to 250 bps today.

Part of the reason is a narrowing inflation gap: the India-US inflation differential has narrowed (and often even flipped). Note how RBI was less hawkish when the US Fed started tightening its policy in 2022 to quell US inflation.

While theoretically defensible, in brasstacks terms a narrow yield spread is not consistent with India’s structural CAD and dependence on capital flows to bridge the former. Local interest rates need to trend higher, even if its an ephemeral rate spike, to keep rupee assets attractive vis-à-vis dollar rivals.

Second, fix the new transmission choke-point between currency and equity markets. When the rupee looks over-valued to market participants, outflows of foreign capital engender a depreciation shock absorber to currency over-valuation. It’s working as the book says, in this case.

Thanks to high oil prices and FPI selling, the rupee has depreciated more than 10% over the last year. Today, measured in terms of its Real Effective Exchange Rate, a relative-value index comprising major trade currencies, it looks undervalued.

But equity market over-valuation (relative to other emerging markets) hasn’t undergone a similar correction because of the ‘liquidity put’ of systematic investment plans of mutual funds (MFs); Indian MF flows have no deployment avenue but India’s equity market.

A vicious cycle is the immediate outcome. FPIs sell, saying Indian valuations are relatively high, but then domestic liquidity funds orderly exits without much price impact. Since relative valuations remain high, FPIs sell some more, putting further pressure on the capital account and rupee. Net net, the self-healing price mechanism of currency markets isn’t transmitted to the Indian equity market.

The fix isn’t easy or intuitive. Instead of gating capital outflows, it will be better to let flows head for overseas capital markets, so that currency-market impulses hit equity-market valuations, letting prices play their corrective role.

Third, fix tax differentials between corporates and investors that distort incentives. Corporate tax rates were lowered in 2019 with an express objective to spur private capex. Almost concurrently, capital gains taxes on investors were raised to backfill the revenue losses arising out of the corporate tax cuts.

The results since then have been sobering. The economy’s private investment rate has inched up only marginally, with the public sector doing much of the heavy lifting. Not only has private capex been sluggish, India’s corporate sector has also been lagging on research and development spends. As one consequence, India seems at a risk of being left behind in the global AI sweepstakes.

Recently, chief economic advisor V. Anantha Nageswaran flagged low private capex as a major concern. At the same time, higher capital gains taxes have made India, at the margin, less attractive for foreign investors.

When data proves a policy wrong, it makes sense to pivot.

The Indian investor has been both disciplined and adventurous. Ever-growing MF flows even as equity prices stay volatile, on one hand, and burgeoning interest among high net-worth individuals in venture capital and private equity on the other, testify to that.

It’s time to swap those tax incentives again. India should ease capital gains taxes and revise corporate tax rates upwards in its budget math. Making Indian assets tax-competitive with emerging market peers will increase market attractiveness for FPIs. More importantly, it will leave more capital with Indian investors to allocate more to, say, a fledgling Indian deeptech ecosystem in need of risk capital.

A world convulsing to find a new modus vivendi between politics and economics is throwing up tough new questions for all nation-states. India is faced with unique questions too. Our answers need to be Bayesian; they should change in the light of data, rather than staying fixated on dogma.

These are the author’s personal views.

The author is the chief investment officer of ASK Private Wealth.