India is trying to defend both the rupee and the stock market simultaneously. That is an expensive macroeconomic ambition for a country running persistent current account and lately, balance-of-payments deficits. Especially when a large part of its forex reserves are not earned surpluses, but rented capital.
Suppose you take a ₹10 lakh loan from your neighbourhood bank. The cash sitting in your account may look like an asset. But economically, it is still a liability.
That, in pure accounting terms, is the best way to understand a large part of India’s forex reserves. Instead of "earned" savings, unlike China's, India’s forex reserves are largely borrowed liquidity and counter-intervention cushions.
The distinction between a true structural surplus and India’s more fragile version comes down to three realities.
First, much of this is “borrowed capital”, not “earned surplus”. These are largely IOUs— liabilities—much like the ₹10 lakh loan sitting as cash in your account.
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), including venture capital funds and private equity flows, which constitute a large, approximately 75%, share of total FDI into India
External commercial borrowings (ECBs)
Invisibles—remittances from overseas Indians and related flows
Of these, remittances are perhaps the only truly durable component of our forex reserves. Venture capital- and private equity-driven FDI certainly isn’t.
A large portion of India’s reserves are therefore better understood as “rented capital” rather than earned surpluses.
The key macro number here is the balance of payments. It remained negative, though contextually understandable, during the global crisis of 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.
It is worth remembering that after every major market correction, foreign capital tends to return aggressively. In FY10, following the global financial crisis, FII inflows surged to roughly $20 billion. In FY14, after the taper-tantrum period, they returned with another roughly $10 billion.
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 again?
As I wrote in Moneycontrol in February 2025, the mutual fund SIP boom was increasingly providing exit liquidity for departing FIIs. In the process, it risked triggering 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 increasingly brittle performance.
So a crucial 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.
In a country like India, where direct equity ownership is relatively limited, the impact of a market implosion on the real economy is likely to be even smaller.
But the same cannot be said of a currency unravelling. A forex crisis touches every single household. It increases prices. It raises the country's cost of capital. It damages the safe haven perception of a country. Remember the debt and currency "Tequila" crises that swept through Latin America in the 1980s? Their reputational scars still endure.
Also, most stock market meltdowns eventually recover, and often quite quickly.
But currency meltdowns almost never do. There are remarkably few examples over the last three decades of currencies fully recovering to pre-crisis levels after a major collapse.
Let's look at the situation clear-headedly. 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. Selling pressure without willing domestic liquidity would have triggered a far sharper market correction.
But India would also have lost far fewer dollars. Instead, we would have seen hollow anthills of inflated market capitalizations crumble to saner levels.
That would have been a pretty good macro outcome for the country.
Historically, in periods of macro stress, the stock market has acted as the corrective spring mechanism that made dollar exits unviable.
Think about it: which sensible FII sells billions in a market that has tanked 30-40%? The overvalued instantly become undervalued.
Sell decisions become "no point selling" certitudes. Better still, they easily get morphed into "market is cheap, let's buy" eureka moments. This can happen over a weekend of drinking in Manhattan.
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, at least 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.
Remember, however, that in the 1990s, we had zero taxation on FIIs and around 20% on domestic investors. We needed dollars then. We need them again now.
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. No country went bankrupt because of a stock market crash. 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, the comparable figure was about 8%
Factor in also a worsening remittances outlook, a massive $ 50-70 billion balance of payment debit, and the inescapable, structural reduction of our biggest trade surplus of about $45 billion with the US following our tacit commitment to increase imports to $100 billion a year.
We simply cannot afford foreign capital a fully convertible currency exits while running 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 billion) and again after FY14 ($10 billion). Domestic investors will take temporary hits, but the market always recovers once the macro crisis recedes. Everybody wins.
The Reserve Bank of India can't blow up our 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.
You do not fix a blister by pressing it. The pressure merely surfaces elsewhere — as it increasingly has in the rupee.
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.