In a global economy marked by heightened volatility and fragmentation, it is tempting to judge a country’s external strength through the narrow lens of daily currency movements or fluctuations in capital flows. Periods of stable capital inflows and manageable current account deficits (CAD) are often seen as validation of macroeconomic strength, while episodes of currency weakness or volatile portfolio flows quickly revive anxieties. This narrow view, however, obscures deeper structural realities. Chapter 4 of the Economic Survey 2025-26 encourages a longer-term perspective, asserting that external stability is not determined by episodic inflows or short-run currency management, but by the structure of the economy — how growth is financed, how foreign exchange is earned, and how capital is deployed.
India’s persistent merchandise trade and CAD create a chain of vulnerabilities in growing economies. High trade deficits are often a by-product of growth itself, reflecting strong import demand for capital goods, energy, and intermediate inputs needed to expand productive capacity. Even strong export growth pulls in imports through global value chains (GVCs). Import growth, therefore, is an inevitable and often desirable feature of development.
The country’s CAD has been on a downward trajectory, but has persisted. There remains an overall trade deficit as services’ trade surplus and remittances do not offset the deficit in merchandise trade. A moderate CAD is neither unusual nor undesirable for a capital-scarce economy, but it creates continued reliance on foreign savings. When domestic savings fall short of investment needs, economies must borrow from abroad. Global investors, in turn, demand a risk premium to compensate for external vulnerability. This shows up as a higher economy-wide cost of capital.
The Survey undertakes a comprehensive empirical analysis to examine the interplay between a country’s current account balance (CAB) and its long-term interest rates. Drawing on cross-country evidence, it is found that a one percentage point improvement in a country’s CAB is associated with a 2.8 basis-point reduction in long-term interest rates. Improvement in CAB is found to be nearly twice as effective as financial deepening in lowering the cost of capital over time. The implication is clear: A meaningful reduction in the cost of capital hinges more on external surplus than on financial deepening recommendations that dot the opinion pages.
These dynamics also shape the quality of foreign investment. Elevated capital costs and persistent CAD tend to tilt inflows toward short-term or speculative capital, rather than long-gestation, productivity-enhancing FDI. This distinction matters. Despite record gross FDI inflows of $81 billion in FY25 and $64.7 billion during April-November 2025, India’s net FDI turned negative during parts of 2025. Firms continue to generate profits from established operations in India, yet hesitate to commit fresh capital in an uncertain global environment.
The solution lies not in frowning upon profit repatriation or overseas direct investment by Indian businesses, but in converting confidence into commitment. Global investor surveys consistently rank political stability and macroeconomic fundamentals as primary determinants of FDI. The country excels in both areas but could leverage these advantages more effectively. By strengthening its external balance while deepening its financial system, India can lower the cost of capital, crowd in high-quality investment, and align short-term macroeconomic stability with its long-term growth ambitions.
Currency outcomes reflect these underlying forces. Between April 1 and January 22, 2026, the Indian rupee depreciated by approximately 6.5% against the US dollar, amid trade pressures and capital outflows. Forecasts suggest continued sensitivity in 2026, especially if trade disruptions or tariff shocks intensify. While currency depreciation can support export competitiveness, it also raises import costs and inflation risks, underscoring the limits of exchange rate adjustment as a sustainable strategy.
The Survey emphasizes that exchange rates are best understood as signals rather than policy objectives. It reflects a combination of trade balances, capital flows, risk perceptions and geopolitics. Historical experience across economies suggests that sustained currency strength is typically associated with persistently high domestic savings and current account surpluses. Countries such as Japan, South Korea, Singapore, Germany and Switzerland saw their currencies strengthen gradually as their external surpluses became entrenched. Conversely, economies that transitioned into persistent current account deficits, including the US and the UK, have generally experienced weaker currency trajectories over time, notwithstanding episodic phases of strength. In particular, the transition from persistent deficits to durable external resilience has usually been mediated by the structure of export growth. Drawing on East Asian experience, it has been shown that strong growth in manufacturing exports preceded improvements in current account positions, reserve accumulation and, over time, greater currency credibility. Export capacity mattered not only for earning foreign exchange, but also for ensuring that earnings were large, diversified and resilient during periods of global stress.
The export capability envisioned here primarily refers to manufacturing exports — not service exports in which India has achieved remarkable success. Services exports face intrinsic limitations. They are less employment-intensive at scale, create fewer backward linkages, and do not anchor physical supply chains. They are necessary, but insufficient to counterbalance the import intensity of industrialisation. Manufacturing exports, by contrast, create supplier ecosystems, absorb large workforces, and generate durable trade surpluses when scaled. They remain the only proven route through which late-industrialising economies have achieved lasting external strength.
Looking ahead, the challenge is not merely to attract capital, but to sustain and anchor FDI in productive, export-oriented ecosystems. International experience shows that economies that successfully convert FDI into sustained growth integrate investment with trade, global value chains and domestic capability building. Trade deals and investment facilitation can expand opportunities, but their effectiveness ultimately depends on the ability to produce competitively at home, manage input costs and ensure policy predictability.
Viewed together, the current account, cost of capital, exchange rate, and FDI are not independent policy domains. They are interlinked outcomes of the same structural choices. Managing the external sector, therefore, is not about short-term firefighting. It is about playing the long game, building the capacity to earn foreign exchange, finance investment at lower cost and sustain growth in a more fragmented and uncertain global economy.
V Anantha Nageswaran is chief economic advisor to the Government of India; Gargi Rao and Pavit are officers of the Indian Economic Service. The views expressed are personal
