India needs lasting reforms to attract foreign capital, not stopgaps

Business Standard July 28, 2026 (With Alicia Garcia Herrero)

India's biggest economic challenge today is creating enough good jobs. Around 10–12 million young people join the labour force every year, but manufacturing—the sector that should create jobs at this scale—has remained stuck at 15–17 per cent of GDP for two decades. Expanding manufacturing will require higher investment, and domestic savings alone will not be enough to finance it. India needs more foreign direct investment (FDI) to bring in capital, technology as well as jobs. The recently concluded India-EU FTA offers an opportunity to do this. The question is whether India will take it.

The FDI numbers are sobering. While media discourse mostly focuses on the gross numbers, India’s FDI inflows as a share of GDP have fallen to less than 1 per cent, far below the 5.7 per cent average for ASEAN economies such as Vietnam and Malaysia. These countries have emerged as the biggest beneficiaries of the China+1 shift, while India has largely missed out despite being a bigger economy. Moreover, much of the FDI that India does attract goes into services rather than manufacturing, thereby limiting its impact on job creation.

To attract substantial manufacturing FDI, policymakers now have to persuade global firms to choose India for the next phase of their expansion. That will not be easy. It requires addressing the factors that have made India a less attractive investment destination over the past decade.

One important factor has been the growing uncertainty around investment protection. Between 2016 and 2024, India terminated bilateral investment treaties (BITs) with 77 countries, including 22 EU member states, and replaced them with a much narrower 2015 Model BIT. New investments from these countries no longer enjoy the safeguards that BITs typically provide against arbitrary state action, discriminatory treatment, uncompensated expropriation and unpredictable dispute resolution. As a result, foreign investors have less certainty today about investing in India.

In addition, India continues to impose average import tariffs of nearly 16 per cent, well above those in ASEAN economies. Recent bilateral FTAs lower tariffs for a few selected partners but they are a second-best substitute for the broader trade liberalisation that globally integrated manufacturers need. The growing use of Quality Control Orders (QCOs) has further raised costs by restricting access to imported inputs. India's decision to stay out of the WTO's Investment Facilitation for Development Agreement (IFDA) reinforces this perception, signalling caution at a time when global investors are looking for openness. These frictions matter when firms decide where to locate their next factory.

Investment protection deserves fresh thinking. For instance, commercial disputes are contractual matters. If a foreign investor and its Indian partner agree to resolve them through arbitration in Singapore or any another internationally recognised forum, the government should not prevent them from doing so. Giving contracting parties the freedom to choose a credible dispute resolution mechanism would send a strong signal that India is serious about attracting long-term investment.

This is where the recently concluded India-EU FTA becomes important. The EU is the world's largest source of outward investment, accounting for around 40 per cent of global FDI stock, and is already one of India's largest investors. The FTA gives European firms a stronger incentive to manufacture in India. But investment decisions are driven by more than market access. Without credible investment protection, the FTA alone is unlikely to attract the scale of manufacturing FDI that India needs.

Concluding an Investment Protection Agreement (IPA) with the EU should therefore become the next policy priority.

Europe also brings the kind of investment India needs. European manufacturing FDI is typically long term and comes with technology, R & D and jobs rather than just capital. European firms already earn higher returns in India than in the mature US and UK markets, yet their investment in India remains well below its potential.

The timing matters too. European firms are increasingly concluding that China no longer works for them. That capital is looking for a new home, and India, with its scale and young workforce, is the natural candidate to play the role China once did. But the window will not stay open indefinitely. If India hesitates, ASEAN countries or Eastern Europe are likely to absorb the investment instead.

The policy initiatives that India needs to implement are three-fold. First, conclude the IPA that is currently under negotiation with the EU, and do so pragmatically rather than insisting on procedures that trap investors in domestic courts for years. Second, reform the 2015 Model BIT to gear it more toward international norms. Third, lower tariffs on intermediate inputs, progressively dismantle QCOs, and join the WTO’s IFDA. These policy actions would help attract FDI not only from the EU but also from other interested countries.

The India-EU FTA has opened a door. But for European firms to build factories here rather than elsewhere, Indian policymakers need to take the necessary steps, and quickly too, in order to seize yet another China+1 opportunity and make India a more attractive place to invest. That would not only strengthen manufacturing, but also help address India's biggest economic challenge—creating enough productive jobs for its growing workforce.

A central bank that sets monetary policy based on forecasts is only as credible as its forecasts. That is where the real work needs to go, not in reopening the case for or against the inflation targeting framework itself.

Making India attractive to foreign capital: Beyond the RBI's June measures

Business Standard July 14, 2026

Last month, the Reserve Bank of India (RBI) announced a series of measures to support the rupee by encouraging foreign borrowing. So far, they seem to have worked. The rupee has stabilised. But the important question now is whether this stability will last.

The answer depends on whether the problem is temporary or permanent. If it is temporary, the RBI's strategy makes sense. Borrowing can bridge the gap in dollar supply until conditions improve. But if the problem is permanent, borrowing only postpones the adjustment. Eventually, the same problem will return and the country will have to deal with it from a weaker position, since it will have accumulated debts in the meantime.

So, is the problem temporary? Only partly. The war in West Asia has pushed up oil prices, increasing India’s import bill and putting pressure on the balance of payments. But this factor is only a small part of the problem. Even if the war continues for a few more months and oil prices rise back towards $100 a barrel, India's current account deficit should remain within its traditional “safe limit” of 2 per cent of gross domestic product (GDP).

The bigger problem lies in the capital account. For much of the period since the 1991 reforms, India attracted substantial foreign capital. During the investment boom of the mid-2000s, inflows were more than sufficient to finance the current account deficit (CAD) and still allowed the RBI to accumulate foreign exchange reserves. That is why a CAD of around 2 per cent of GDP came to be seen as safe. Over the last couple of years, however, capital inflows have weakened steadily and, at current levels, they are no longer sufficient to finance even a modest CAD.

There is another reason why foreign capital matters. The government’s goal of making India a "Viksit Bharat" by 2047 will require the economy to grow at around 8 per cent a year, in real terms, for the next two decades. Achieving that will require much higher investment. Domestic savings alone are unlikely to be enough. Foreign capital will, therefore, have to fill part of the gap.

Consider the incremental capital output ratio (ICOR). It measures how many rupees of investment are needed to generate one additional rupee of GDP. India's ICOR has historically ranged between 4.5 and 5. At that rate, sustaining a real GDP growth rate of 8 per cent requires investment of 36-40 per cent of GDP every year.

Today, India's gross savings and investment are both around 30 per cent of GDP. Raising investment to the level needed for sustained high growth would, therefore, require an additional 6-10 per cent of GDP every year. At today's GDP of around $4 trillion, even the lower end of that range amounts to roughly $240 billion a year in investment. Unless domestic savings increase substantially, India will need foreign capital to bridge this gap.

The obvious question, then, is how India can attract more foreign capital. The RBI's June 5 package, especially the elimination of capital gains tax on foreign investors’ bond purchases, is a step in the right direction. But much more needs to be done. For example, nothing has been announced so far to encourage foreign direct investment (FDI). This matters because FDI is not only more stable than portfolio investment, but also brings technology and access to global production networks that India needs to build a competitive manufacturing sector.

To encourage FDI inflows, three policy actions are crucial. The first step is to liberalise India's trade regime. Import tariffs need to come down. The Customs duty structure should be simplified. Quantity control orders (QCOs) that make it harder for manufacturers to source imported inputs also need to be phased out.

Second, policymakers need to rebuild the bilateral investment treaties (BITs) network that was dismantled entirely between 2016 and 2024. Setting up a factory requires a large, long-term investment. Foreign investors are more likely to make such commitments when they are confident that any disputes will be resolved through a credible and predictable legal process.

Third, policy certainty matters. Investors making long-term commitments need confidence that the rules will not change after their investments are made. The retrospective tax dispute involving Vodafone damaged that confidence. Although the government has since ruled out such taxation, more recent policy reversals have kept those concerns alive. The RBI's decision in March requiring banks to unwind their offshore forward positions, at an estimated cost of hundreds of millions of dollars, is one example. Whether or not the policy was justified, unexpected changes of this kind increase the perceived risk of investing in India.

The RBI’s June measures have bought India some time. The challenge now is to use that time wisely. India needs a permanent strategy to attract foreign capital, especially foreign direct investment. That means making it easier to invest, protecting investors through predictable rules, and avoiding policy reversals after investments have been made. 

Indian policymakers cannot guarantee that foreign capital will come. But they can ensure that there are no avoidable reasons for it to stay away.