What’s behind the drought in foreign fund flows?

Nearly 35 years after India began liberalising its economy, opening the floodgates for foreign investors; gross foreign direct investment (FDI) flows in FY26 surged to an all-time high of $94.52 billion.

This might have been seen as yet another affirmation of investor confidence in the Indian economy at a time of extreme volatility and geopolitical turmoil heightened by the West Asia crisis. However, net FDI—calculated by subtracting repatriations by foreign companies and overseas investments by Indian firms—recovered from just about $1 billion in FY25 to $7.7 billion. That is still quite low, and much below the FY23 figure of $28 billion.

Meanwhile, India’s financial markets have seen record outflows of foreign capital over the past two-and-a-half months, amid surging crude oil prices and a fast-depreciating Indian currency.

The combination of weak net FDI flows and waning FII interest in India is not altogether new, it’s been happening for the last two financial years. However, the West Asia conflict has sparked new worries as weak capital inflows put further pressure on the current account deficit, which was already on an upward trajectory because of rising crude oil prices.

The exodus from Dalal Street had, in fact, begun in 2025, when foreign portfolio investors (FPIs) pulled out $18.9 billion from India’s equity market. That trend seems to have gathered pace. Till May 22 this year, they have pulled out $23.85 billion, significantly more than all of 2025. Overall, in FY26, foreign investments—both direct and portfolio investments—recorded an outflow of $9.02 billion, as against an inflow of $4.52 billion in FY25.

“India’s external capital dependency has become more visible over the past two years with a sharp slowdown in net FDI flows and an increase in FPI outflows coinciding with a higher current account deficit on high global energy prices,” said a recent report by Kotak Institutional Equities. This is a big change from earlier, large capital inflows until FY24 offset India’s high structural trade and current account deficits. “This vulnerability may persist without a structural fix to high CAD,” it warned.

Latest data from the Reserve Bank of India’s Annual Report shows the problem in its entirety and why India’s balance of payments deficit rose to $30.8 billion in FY26 from about $5 billion in FY25. India’s capital account registered a surplus of a mere $72 million in FY26 as net foreign investments shrank to $1.27 billion. The capital account had a surplus of $16.62 billion in FY25.

According to an analysis by Swayamsiddha Panda of Ambit Capital, FDI and FII flows, which averaged $3.7 billion per month over FY15-24, sharply reversed to an outflow of $0.5 billion since FY25. Further, while gross FDI inflows in January and February have averaged $7.3 billion per month, outflows (disinvestments and outward FDI) have also been elevated, averaging $5.7 billion per month.

A range of factors are at play and there seem to be no easy solutions to bring back foreign investor interest in India.

Macro Clouds

As the third largest crude oil importer in the world, the surge of global crude oil prices past the $100 per barrel mark has created fiscal concerns and added pressure on the current account. With waning investor sentiment, a falling rupee made imports more expensive and further muted sentiments. Besides, if the prediction of a strong El Niño affecting the monsoon this year does come true, consumption demand could be hit and that, in turn, will weigh on corporate earnings.

The cumulative effect of these trends, says Sunil Kumar, Partner of Tax and Regulatory Practice at EY India, is that FPI selling, which has accelerated in recent years, may continue in the current year too.

“Currency depreciation has adversely impacted returns in dollar terms, eroding overall investment attractiveness. At the same time, elevated US bond yields, about 4.5% for 10-year Treasuries, have emerged as a relatively attractive low-risk alternative for investors, thereby reducing the incentive to allocate capital to emerging markets such as India,” he says.

Analysts also point out that while Indian stocks have corrected amid the sell-off, valuations are still not cheap. That, coupled with the uncertain outlook, also makes FIIs wary. Amisha Vora, the chairperson and MD of PL Capital Group (Prabhudas Lilladher), says interactions with foreign investors indicate that the mood is still very subdued.

“Rising oil and falling rupee compounds our inflation and interest problem,” says Vora. She notes that India enjoyed a virtuous cycle post-Covid, where inflation was benign providing room for fiscal consolidation. Further, the cuts in the goods and services tax (GST) last year also spurred consumer demand. That led to expectations of a pick-up in capital expenditure by the private sector, but those hopes were dashed by the imposition of import tariffs by the US last year.

Another reason for the exodus of foreign capital, some experts say, is that India is yet to offer credible investment options in the artificial intelligence (AI) and tech space. Over the past year, there has been a surge in investments in AI-related stocks and sectors. There are hardly any listed Indian firms in the space. So, those chasing AI went elsewhere.

Former finance secretary Subhash Chandra Garg notes that FDI chases profitable opportunities. “The biggest driver of FDI is future-ready technology and investment muscle. These allow FDI firms to invest in a country, sell to the domestic market and export if opportunities present themselves. Likewise, companies with financial muscle to capture the domestic market invest as is being done by tech companies that are building data centres,” he says.

At present, large investments are mainly focused in three broad categories, Garg adds—energy transition like solar and electric vehicles (EVs); digital technology like semiconductors, computers and chips; and AI-embedded machines. “In all these sectors, India does not have the technological prowess to attract investments,” he points out.

Irritants Remain

Apart from the immediate worries, tax-related frictions, policy uncertainty and cumbersome procedures are seen to be deterring investors.

Experts note that investors look for three factors before investing in a country—transparency, consistency and predictability. They often find India lacking on all these counts. From ease of procuring licenses and registrations and even land, to tax policy and predictability, these are all crucial factors while deciding on long-term investments.

One of the biggest pain points in terms of taxation is India’s capital gains tax. “While India offers large and expanding market opportunities, differences in tax treatment, including capital gains taxation applicable to FPIs as compared to certain competing jurisdictions, are influencing investment allocation decisions,” Kumar points out.

FPIs face a multitude of taxes, including a long-term capital gains tax of 12.5%, from April 1. Along with the securities transaction tax, they see this as a double whammy and have urged the government to reconsider them.

Rajiv Kumar, former Vice Chairman of NITI Aayog and Chairman of the think tank Pahlé India Foundation, says it’s a matter of rebuilding investor confidence. “Today, investors—foreign and domestic—are not confident of the country’s business environment and, hence, are not willing to put in money. While the government talks about ease of doing business, not much has changed on the ground,” he says. He points out that much of the improvement, in terms of ease of doing business, needs to be done at the state level. “Actual implementation of initiatives to ease doing business will help improve both FDI and domestic investments.”

According to Kumar, while the fall in net FDI is a concern, the bigger worry is the outflow of domestic private capital. This needs to be studied and corrected, he says.

In fact, capital investments by the private sector have been tepid, with the government stepping in to keep growth on track. Chief Economic Advisor V Ananth Nageswaran recently said that though the profits of BSE 500 and NSE 500 firms had grown at 30.8% annually after Covid, private sector capital formation remained disappointing.

In FY25 and FY26, repatriations by foreign firms and overseas investments by Indian companies rose steadily. Several foreign acquisitions by Indian companies have added to outbound domestic capital flows. Data from Grant Thornton Bharat reveals that there were 162 such deals in 2025 by Indian companies amounting to $18.2 billion.

Big ticket listings like the $3.3 billion listing of Hyundai Motors India Ltd, whose proceeds the South Korean parent took home, or the IPO of Swiggy that provided an exit to foreign private equity (PE) and venture capital (VC) players, have also weighed on the net FDI tally. There’s a large amount of such PE and VC holdings in Indian companies, especially new-age firms and start-ups that may be pulled out when these firms go public.

The Kotak Institutional Equities report quoted earlier pegs such holdings at $32 billion at current valuations in large listed entities and even more in unlisted ones. “We note that the bulk of gross FDI outflows of overseas entities over the past few years is due to selling by PE/VC investors and listing by MNCs of their subsidiaries in India,” it said.

To be clear, RBI officials, in an article in the central bank’s May 2025 monthly bulletin, called the rise in net outward FDI and repatriation FDI “a sign of a mature market where foreign investors can enter and exit smoothly, which reflects positively on the Indian economy”. That may be true, but there is now a mood of cautiousness and questions have arisen on why India is no longer a preferred investment destination.

Both Rajiv Kumar and Garg make the case for enabling more Chinese investments in India, pointing out that China has the money, technology and interest to invest here.

The government recently changed guidelines on investments from countries sharing land border with India, including expedited decisions within 60 days on proposals for investments from companies from land border sharing countries (LBCs), barring Pakistan, in some sectors. It had also approved a definition of beneficial ownership under which investors with non-controlling LBC Beneficial Ownership up to 10% will be permitted under the automatic route subject to some conditions. In effect, this will enable more Chinese investments in critical sectors, but some say more needs to be done and concerns on national security can be dealt with separately.

In discussions with industry players and policymakers, the lack of a bilateral investment treaty did not seem to focus significantly as a challenge for foreign investors although many agreed that it adds a further layer of comfort.

Will a ceasefire reverse flows?

The government and the RBI have been taking several measures to improve investor confidence and attract foreign investors. These measures range from curbing volatility in forex markets to setting up 100 industrial parks in a plug-and-play mode. A focus on boosting exports and deregulation is also a key priority for the government. That was also flagged recently by Prime Minister Narendra Modi at a meeting with his Council of Ministers.

Analysts believe there could be some improvement once the conflict ends, but a full recovery in investor confidence could be some time away. They add that the excitement of earlier years is missing.

Kumar of EY India notes that all these factors are compounded by considerations of valuations. “Although the premium at which India has traditionally traded has moderated from earlier peaks, it remains relatively elevated around 20 times as compared to China where it’s about 14 times. This affects relative attractiveness in a globally competitive market,” he says. The Kotak report notes that India has underperformed most global markets for five years and said it expects FPI flows to stay muted.

More measures are expected in the coming weeks to boost the economy, stabilise the rupee and rein in the CAD. Whether these will indeed reverse the flow of capital remains to be seen.

@surabhi_prasad | @TheNachiket