Stress-tested India!

The Reserve Bank of India (RBI) recently released the half-yearly Financial Stability Report (FSR) for June 2026. The report has come in the middle of a live geopolitical shock, therefore requires closer scrutiny. The broad message from the RBI is reassuring - the Indian financial system remains sound, even as the world around it gets noisier.

The RBI has framed the report against two forces reshaping the global economy and financial system — growing geopolitical fragmentation, and the technological disruption unleashed by artificial intelligence. The global economy, RBI notes, has stayed resilient so far, helped in part by optimism around AI-driven productivity gains. But the near-term outlook remains clouded given how quickly the environment keeps shifting.

The RBI captures the balancing act well: despite repeated shocks, the global financial system has shown notable resilience, with markets settling down after an initial bout of volatility triggered by the West Asia conflict. But global financial stability risks, the report cautions, remain elevated — lingering supply-chain uncertainty could still tighten financial conditions and reignite inflation, while high public debt, bond market fragilities, stretched asset valuations and the growing footprint of leveraged non-bank financial intermediaries (NBFIs) could all amplify the next shock.

On India, the tone is more reassuring. Domestic financial stability risks remain contained despite the global turbulence, the RBI says, underpinned by a strong banking system, healthy capital and liquidity buffers, and steady credit growth. India’s macroeconomic fundamentals, it adds, are stronger than those of many peers — and stronger than in previous crisis episodes — which gives the economy real buffers to absorb external shocks.

Some of the key highlights of the June 2026 FSR are listed below:

Global scenario

·         Markets held up, but the risk list hasn’t shrunk. The global financial system has demonstrated resilience through successive shocks, with markets turning more sanguine after the initial jolt from the West Asia conflict — helped by a smaller-than-feared rise in oil futures, strong corporate earnings and the AI-driven investment boom. Even so, elevated public debt, bond-market fragilities, stretched valuations and the expanding role of NBFIs remain live vulnerabilities.

·         Asset valuations look stretched, and AI stocks are a concentration risk. A sharp correction in global equities — particularly if triggered by a reassessment of AI-related earnings and valuations — could spill over into domestic markets. Debt financing by AI-linked companies has also been rising, a theme the FSR flags for the first time this cycle.

·         NBFIs keep growing in size and interconnectedness. The report flags the systemic importance of non-bank financial intermediaries and their deepening linkages with the banking sector as an area warranting close monitoring.

·         Cyber risk has a new face — AI. In a dedicated survey of 33 scheduled commercial banks and 10 upper-layer NBFCs, AI-enabled cyberattacks emerged as the single most significant risk expected over the next twelve months — ahead of ransomware, phishing and third-party or supply-chain risk. Even institutions confident about their overall cyber preparedness flagged the speed, scale and sophistication that AI brings to the threat.

Domestic economy

·         Growth headwinds from the conflict are receding, but not gone. With the signing of an interim peace deal, some pressure has eased, though the Indian economy and financial system remain exposed to geopolitical tensions and associated shocks. The Monetary Policy Committee (MPC) has projected growth of 6.6% for 2026-27, while flagging that elevated oil and commodity prices, along with weaker global growth, remain downside risks.

·         Inflation has crept up. Headline inflation rose from 3.5% in April 2026 to 3.9% in May 2026 on the back of oil pass-through. A combination of the conflict-driven supply shock and a projected weak monsoon due to El Niño could push inflation toward the upper end of the tolerance band in Q3:2026-27 — the MPC has already revised its inflation projection for 2026-27 upward, from 4.6% to 5.1%.

·         The balance of risks has actually turned more favorable. This is credited to the interim peace deal in West Asia along with recent Government and RBI measures aimed at strengthening capital inflows — even as some impact from India’s dependence on imported energy remains unavoidable.

·         Capital flows have come under pressure. Net FDI flows turned muted amid rising global uncertainty, and net international investment position dynamics reflect the broader retreat in capital allocated to emerging markets during the conflict period.

Indian equity markets

·         Indian equities underperformed EM peers, then corrected further. Trailing its emerging-market peers for over a year, the domestic equity market fell further amid concerns about India’s exposure to the oil-price shock and a resulting softening in corporate earnings growth. India’s earnings-growth differential over EM peers has now dropped below its long-term average.

·         FPIs sold at a scale not seen in over two decades. FPI equity outflows of US$ 30.7 billion in 2026 exceeded the prior record of US$ 18.9 billion set in 2025 — the highest outflow observed in the past two-and-a-half decades. FPI ownership of Indian equities has fallen to a two-decade low, and for the first time is now below that of domestic institutional investors (DIIs).

·         Domestic investors were the shock absorbers. Despite the sharp correction, the 5-day worst-drawdown in Nifty 50 during this episode was the mildest across comparable crisis periods studied by the RBI, thanks in large part to rising support from mutual funds, insurers and pension funds.

·         The Nifty 50 rally of the last two years has partly unwound. A returns-decomposition exercise (Gordon Growth Dividend Discount Model) shows that between September 2024 and June 2026, a rising equity risk premium — reflecting heightened investor risk aversion — has eaten into the gains that were earlier driven by risk-premium compression. The correction has, at least, brought valuations closer to their historical average, even though Indian equities continue to trade at a premium to EM peers.

Financial system stress in India

·         The stress indicator ticked up, but stayed low by historical standards. The Financial System Stress Indicator (FSSI) rose during the conflict period, but the level of stress in the domestic financial system remains relatively low compared to previous crisis episodes.

·         Banks are in their best shape in decades. Scheduled commercial banks (SCBs) remained resilient, with the gross non-performing assets (GNPA) ratio falling to a multi-decadal low of 1.8% in March 2026 and the net NPA (NNPA) ratio at 0.4%. Return on assets (RoA) stood at 1.3% and return on equity (RoE) at 12.6%, while the capital to risk-weighted assets ratio (CRAR) and common equity tier 1 (CET1) ratio stood at 17.7% and 15.3% respectively — both comfortably above regulatory minimums. Credit growth accelerated to 14.5% y-o-y and deposit growth to 11.5% y-o-y during 2025-26.

·         Stress tests say the buffers can take a hit. Macro stress test results indicate that the banking system remains well-positioned to absorb potential shocks, with aggregate capital ratios projected to stay comfortably above regulatory thresholds even under hypothetical adverse scenarios.

·         NBFCs and other intermediaries also pass the test. Non-banking financial companies (NBFCs) remained financially sound, supported by strong capitalization, healthy profitability and improving asset quality. Stress tests of mutual funds, clearing corporations and the insurance sector similarly point to continued resilience, even as rising interconnectedness across entities and sectors is flagged as a channel that merits close surveillance.

The moot point in FSR is whether India’s buffers — strong bank balance sheets and resilient domestic flows — are enough to keep absorbing repeated external shocks without the strain showing up in the real economy. On the RBI’s own assessment, so far, they have.

Watchlist for investors

The macro environment in India looks stable and resilient, despite the scare of war and trade uncertainties. The south-west monsoon has started on a buoyant note, and IMD reconfirmed its forecast of above normal (106% of LPA) for the current season. Enhanced dividend payout by the RBI has lessened fiscal slippage concerns. Concerted efforts by the RBI to improve system liquidity have also yielded positive results. Fiscal strength, benign inflation outlook, and improved liquidity have resulted in the benchmark 10yr bond yields falling to the lowest level since 2021; reversal in FPI flows since March 2025; stability in currency and improved growth outlook.

Despite notable stability there are few areas of concern that investors should be mindful of. In particular, I shall be watching the development of external situations closely.

External situation - not worrying presently, but could deteriorate

India's external sector has shown resilience in recent years, but there are signs of strain. The merchandise trade deficit hit a near-record high of $26.42 billion in April 2025, driven by a 19.12% surge in imports outpacing a 9.03% export growth. This reflects a structural issue in India's trade balance, with heavy reliance on imported crude oil, gold, and electronics. While presently foreign exchange reserves are ~US$686 billion in January 2025, covering over 10 months of imports, the creeping depreciation of the rupee and global uncertainties (e.g., aggressive trade negotiation and geopolitics) add pressure.

The situation isn't critical yet, thanks to robust reserves and services exports, but the trend warrants caution as external vulnerabilities could escalate if global conditions worsen

Trade balance remains delicate

India's merchandise trade deficit for FY25 (April 2024–March 2025) has widened significantly, reaching $202.42 billion for the first eight months (April–November 2024), compared to $194.6 billion in the same period of FY24. This deterioration is driven by a faster rise in imports (8.3% growth to $486.73 billion) than exports (2.2% growth to $284.31 billion). November 2024 alone saw a record-high monthly deficit of $37.8 billion, fueled by a 27% surge in imports to $69.95 billion, largely due to a 4.3-fold jump in gold imports, alongside increases in electronics (17.4%), petroleum products (7.9%), and vegetable oil (87.8%). Exports, however, contracted by 4.8% to $32.1 billion in November, a 25-month low, partly due to declining petroleum prices.

The overall trade deficit (goods and services combined) is estimated at $94 billion for FY25, per posts on X, reflecting a structural imbalance. The trade deficit with China has surged to $99.2 billion, driven by an 11.5% rise in imports ($113.5 billion) and a 14.5% drop in exports ($14.25 billion). Conversely, India’s trade surplus with the US grew to $41.18 billion, with exports up 11.6% to $86.51 billion. The services trade surplus, estimated at $131.3 billion for April–December 2024, provides some relief, driven by strong IT and financial services exports. However, the current account deficit (CAD) is projected to widen to 1.4–2% of GDP in FY25, with Q3 FY25 potentially hitting 2.8% due to the November trade shock.

Trade deals with the UK, and potential trade deal with the US could impact trade balance negatively in the short term.

Despite intense efforts, India’s reliance on imported crude oil (88% of energy needs), gold, and electronics, alongside structural manufacturing gap, has not diminished materially. There have been some efforts to boost domestic manufacturing through monetary and fiscal incentives, but so far most of the investment has occurred in low value add businesses.

BoP Challenges

H1 FY25 (April–September 2024) BoP surplus was $23.8 billion, but 3QFY25 negative BoP of US$37.7bn on persistent FPI outflows and poor net FDI flows, raise some concerns over BoP for FY25; even though the projected current account surplus and potential stabilization in capital flows have shown promise in 4QFY25.

The BoP is expected to remain manageable, with a full-year CAD of 0.8–1.4% of GDP ($30–55 billion). A Q4 current account surplus could offset earlier deficits, but sustained FPI outflows and trade imbalances pose risks.

Global uncertainties (widening trade deficit, FDI slowdown, remittances slowdown due to the proposed remittance tax in the US, and domestic structural gaps pose strong headwinds for India’s BoP.

FDI slowing

Gross FDI Inflows in India were $81.04 billion in FY25, a 14% increase from $71.1 billion in FY24. FDI equity inflows rose by 45% to $29.8 billion (Rs. 2,58,873 crore) in H1 FY25 (April–September 2024), reversing three years of contraction.

However, net FDI inflows dropped to a record low of $0.353 billion in FY25, down 96.5% from $10 billion in FY24, due to large-scale repatriations and increased outward investments by Indian firms. Repatriations surged to $44.5 billion in FY24 and continued to be significant in FY25, driven by profitable exits through initial public offerings (IPOs) like Hyundai Motor and Swiggy, and divestments (e.g., Singtel’s Airtel stake, BAT’s ITC divestment). A key Swiggy investor reportedly earned over $2 billion post-IPO.

FDI slowdown could have some structural element as relative to GDP, net GDP has been declining for the past five years, and has fallen to the lowest level in more than two decades.

 

Net FPI equity flows negative since 2021

Net FPI equity flows (Primary market and secondary market) into India have been negative for the past four and half years (January 2021-YTD2025) now. A strong global liquidity event could perhaps reverse the trend, but so far there is little visibility of net FPI flows improving materially in the near term; notwithstanding the positive flows in the past three months.

Oil price and weaker USD offer some relief

Declining oil prices in early 2025 have eased pressure on India's import bill, given its heavy reliance on imported crude (85% of energy consumption). A weaker USD also reduces the cost of dollar-denominated imports and debt servicing. However, relying on these external factors is risky, as oil prices are volatile (e.g., influenced by OPEC decisions or geopolitical tensions), and the USD's trajectory depends on U.S. monetary policy. India needs to accelerate domestic energy production (e.g., renewables, green hydrogen) to reduce this vulnerability.

…but relying on externalities may not be a great idea

Dependence on favorable oil prices or a weaker USD is unsustainable, as these are beyond India's control. A stronger focus on structural reforms—such aggressive boost to manufacturing, enhancing export competitiveness, and reducing import dependency—would provide a more stable foundation. Additionally, diversifying trade partners and pursuing free trade agreements (e.g., with the EU, Japan) could mitigate risks from global volatility.

In conclusion, India's external situation is not yet alarming but shows clear signs of deterioration. The delicate trade balance, negative BoP, and volatile capital flows highlight structural weaknesses, particularly import dependency and sensitivity to global shocks. While forex reserves and services exports provide resilience, reliance on external factors like oil prices or USD weakness is risky. Fiscal slippages and food inflation add domestic pressures.

Funding crisis deepening for emerging economies

The latest report of the United Nation Conference on Trade and Development (UNCTAD) highlights that the funding deficit for the developing economies to meet Sustainable Development Goals (SDGs) is rising. As per the report, the gap is now about US$4trn, up from US$2.5trn in 2015 when the SDGs were adopted.

The amount of global foreign direct investment (FDI) has been on decline since peaking at US$2.05trn in 2015. In fact, a percentage of world GDP, FDI peaked at 4% of global GDP in the year 2000 and has been on decline since then. In the year 2023, global FDI fell to US$1.3trn or 1.27% of global GDP.

 

As per a recent Moody’s report, “Global foreign direct investment flows have shrunk in recent years. The COVID-19 pandemic, supply-chain chaos, surging inflation, and tighter funding conditions have taken a toll on global FDI. Investment flows are also being reshaped by economic fragmentation, trade and geopolitical tensions, industrial policies, and supply-chain diversification. But many of the ups and downs in FDI in recent years are due to tighter regulations to thwart the usage of tax havens. These have curbed the flow of investment through conduit economies, especially in Europe. While retreating inflation and easing monetary policy settings might offer some relief, economic fragmentation will hinder the smooth flow of FDI. Climate change will increasingly shape FDI flows in longer term.”

UNCTAD report emphasizes that “Tight financing conditions in 2023 led to a 26% downturn in international project finance, which is crucial for infrastructure investment in areas such as power and renewable energy. As a result, investment in sectors linked to the Sustainable Development Goals (SDGs) fell by more than 10%. The report highlights that agrifood systems and water and sanitation registered fewer internationally financed projects in 2023 than in 2015, when the goals were adopted.”

FDI in China and India shrinking, despite India’s manufacturing push

The Moody’s report highlights that “The drop in FDI flows to developing economies was largely because of shrinking investment in China and India. The world’s second-largest recipient of FDI, China, saw a downturn in 2023. Inflows turned negative in the third quarter as withdrawals and downsizing outpaced new investments. More recent data showed a fresh decline in the second quarter of 2024. FDI into India has also seen better days, falling in recent years despite the country’s push into manufacturing and notable investments from tech giants such as Apple Inc. On the bright side, FDI into Southeast Asia has held at a high level.”

Most renewable energy funds allocated to the developed economies

Although renewable energy investments have nearly tripled since the adoption of the Paris Agreement in 2015, most of the money has gone to developed countries. While developing countries need about $1.7 trillion each year in renewable energy investments – including for power grids, transmission lines and storage – they only attracted about $544 billion in 2022.

The report shows that more than 30 developing countries still haven’t registered a large international investment project in renewables.

And in most of the 10 developing countries with the highest levels of international investment in renewable energy, investment in renewables represents between one tenth and one third of total FDI.

OECD rules impacted FDI

Changes in taxes and regulatory requirements appear to have materially impacted the FDI flows – amount as well as direction. Moody’s report mentions that OECD members “have strengthened regulations to make it harder for companies to locate profits in zero-tax jurisdictions. Also, a revised corporate tax rule in the U.S. in 2018reduced the incentive for U.S. multinationals to reinvest earnings and hold intangible assets abroad, leading to a significant drop in outward FDI that year. These efforts, later bolstered by laws to establish a global minimum tax, have dampened FDI flows to and from low-tax jurisdictions in Europe.

This appears to be macro trend. Nonetheless, it may have implications for the investment portfolios of several investors, especially those investors who are overweight in capital intensive businesses relying on foreign capital for growth. If the decline in FDI flows sustains the current trend, we may see downward revision in growth projections and hence valuation multiples. It is therefore advisable to watch this trend closely over the next couple of years.

Struggle to find a balance

There is little doubt in anyone’s mind that having the largest youth population (…and still growing) in the world and much improved infrastructure India is a place of immense interest to (i) the global businesses who are looking for an attractive market for their products; and (ii) enterprises who are looking to diversify their production/services base to a place with abundant and cheap skilled workforce, natural resources, favorable policy framework, and decent infrastructure. The foreign governments which run on the support of these businesses (or the governments who run these businesses themselves) are obviously keen to widen and deepen their relationship with the Indian businesses and government.

Fast growing economic and geo-political influence of China in global affairs has also enhanced India’s importance as a key balancing factor in the global strategy of developed countries and strategic alliance partners.

With this growing interest of the global community, it is natural that India has become subject of greater scrutiny by the global media, political observers, regulators, civil society watchdogs, various interest groups & lobbies, etc.

This scrutiny is usually not limited to regulatory compliances and corporate governance issues. It actually goes much beyond that. For example—

·         The businesses who are investing (or planning to invest) billions of dollars in India facilities, would want to ensure that policy making becomes (and remains) conducive to their interest. It is therefore common for them to make attempts to influence the policy making function through various means, all of which may not be ethical or fall within the contours of established diplomatic norms.

·         The foreign governments relying on the capabilities of the Indian administration and businessmen for protecting and furthering their strategic and economic interests would obviously dislike an independent policy thinking in India. Forceful attempts would be consistently made to engage India in global protocols, treaties and alliances so that the policy making in India remains aligned to their interest.

·         The technology innovators would try hard to ensure that their IPRs are protected, Indian technology firms do not engage in developing competing designs/products etc.; Indian manufacturers and service providers engage in low value add jobs only while the innovators keep the bulk of the margins.

·         The lobbies working on behalf of the competitors and adversaries would rake social issues like intolerance, inequalities, human and minority rights’ violation, lack of sustainability in large infrastructure projects, etc. All of these concerns may not be mala fide, but definitely most of these are sponsored.

How would India deal with these foreign interest groups shall ultimately define the quality and sustainability of our socio-economic progress. If the government and businesses could maintain a balance between India’s developmental and growth needs and concerns of the global partners, we could witness some brilliant decades for India and Indians. However, if we fail in achieving a balance and give into the pressures of various interest groups; or refuse to engage with them sticking to our own position, we would definitely risk missing this great opportunity.

As of this morning, the struggle to find the balance remains intense…more on this tomorrow

Focus on strengths

Unpredictability has been one of the key characteristics of the incumbent Indian government ever since it assumed office in May 2014. The government, especially the political leadership, has taken numerous decisions that have surprised most of the citizens and global observers.

Overnight decision to replace all large currency notes in circulation (demonetization); surgical strikes in PoK; air strikes in Pakistan territories; abrogation of article 370 of the constitution and bifurcation of the state of Jammu & Kashmir to carve out Ladakh as a separate union territory; criminalization of the practice of triple talaq; amendment in the citizenship law; abolition of planning commission; restructuring of corporate tax rates; and most recently the decision to impose a total lockdown in the country to control the spread of COVID-19 virus etc are some of the examples of unpredictable decision making.

The tendency to surprise the stakeholders has not remained limited to the powerful political establishment alone. Bureaucracy has also borrowed abundantly from their political master. It has been issuing administrative orders, which have been often described by the stakeholders as "draconian" and "incongruent" the stated policy objectives of the government.

Under these circumstances, attracting major new foreign investment could be a challenging task. Many global businesses are certainly lured by the size and potential of Indian markets, availability of skilled worker at comparatively lower cost; improving physical infrastructure and abundance of natural resources. However, unpredictability of policy; corruption, law & order issues; judicial overreach (in recent years); and dogmatic bureaucracy have so far kept them from making larger commitments.

In past few years, thus, the FDI in India is mostly focused on stressed infra assets (roads, airports, renewable energy, etc); digital platforms; services like telecom and retail, and assembly plants for electronics and furniture etc. Investment in IT, automobile & pharma sector that started in 1990s has mostly saturated and new investment now is just a trickle.

Over the years, India has been turned into back office and assembly line of the global corporations. Many of these businesses shall lose their relevance in the emerging world driven by artificial intelligence, dematerialized transactions, and xenophobic nationalism.

The rising unpredictability of policy is making even the current flow of investment, which is much below the potential of Indian economy, uncertain. Many global banks having their mission critical back offices in India are wondering whether they should work on alternate plans, given the onerous lockdown conditions. God forbid, if the second wave of COVID-19 hits, as many experts are emphasizing, and another round lockdown becomes necessary, these contemplations may certainly be brought to drawing boards.

Unfortunately, we have so far failed in attracting any meaningful foreign investment in social infrastructure like education, healthcare, skill development, water, sanitation, traditional food, promotion and development of local culture & languages, etc. - the things that will make India a self reliant and developed economy. Investments in these areas will be India specific, profitable, and sustainable for long duration. The employment opportunities in these areas will be far greater, rewarding and sustainable as the local people will be engaging in these activities from the position of their strengths. A cursory stroll through YouTube will show you thousands of young and middle aged housewives, from small towns and metropolis alike, sharing their culinary skills with the people. Many of these women are celebrities in their own right followed by thousands of enthusiastic cooks. There are thousands of household women entrepreneurs who supply homemade lunch Tiffin to office goers and hostel residents.

Investing in these experts of local cuisines could be far more rewarding & sustainable than investing in a food delivery platforms and junk food outlets.

Industry and Services sector transformation agenda implemnetation still at take off stage

In the three year agenda released in 2017, NITI Aayog noted that "unemployment is the lesser of India’s problems. The more serious problem, instead, is severe underemployment. A job that one worker can perform is often performed by two or more workers. In effect, those in the workforce are employed, but they are overwhelmingly stuck in low-productivity, low-wage jobs...Therefore, what is needed is the creation of high-productivity, high-wage jobs."

The action agenda therefore emphasized on increased emergence of larger, organized-sector firms that can create high paying jobs. To meet this end, promoting exports was considered a better option rather than trying to substitute imports by producing in India.

The agenda paper accordingly highlighted that "A focus on the domestic market through an import-substitution strategy, however attractive it may seem, would give rise to a group of relatively small firms behind a high wall of protection. They will not only fail to exploit scale economies but also miss out on productivity gains that come from competing against the best in the world. The electronics industry offers a case in point. Our domestic market in electronics as of 2015 is only USD 65 billion. In contrast, the global market is USD 2 trillion. Our policy of import substitution under high protection has given rise to a group of small firms none of which is competitive in the world markets. In contrast, a focus on the global market can potentially result in output worth hundreds of billions of dollars and hence a large number of well-paid jobs."

NITI Aayog underlined the demographic advantage and wage competitiveness of India vis a vis China, while spotting an attractive opportunity in shift of businesses from China. It noted "Today, with Chinese wages rising wages due to an ageing workforce, many large-scale firms in labour-intensive sectors currently manufacturing in that country are looking for lower-wage locations. With its large workforce and competitive wages, India would be a natural home for these firms. Therefore, the time for adopting a manufactures- and exports-based strategy could not be more opportune. Keeping this context in view, the Action Agenda offers detailed proposals for the implementation of an exports-based strategy. Among other things, it recommends the creation of a handful of Coastal Employment Zones, which may attract multinational firms in labour-intensive sectors from China to India. The presence of these firms will give rise to an ecosystem in which local small and medium firms will also be induced to become highly productive thereby multiplying the number of well-paid jobs."

The Action Agenda in particular offered "specific proposals for jumpstarting some of the key manufacturing and services sectors, including apparel, electronics, gems and jewellery, financial services, tourism and cultural industries and real estate."

After two and half years, the implementation of the agenda is found lacking on almost all fronts.

(a)        Industrial production growth has slipped.

(b)   Work force participation rate has slipped to multi decade low. Unemployment rate is highest since 2011. Labor productivity growth is at lowest level in a decade.

(c)        Exports are mostly stagnant. Imports are marginally higher.

(d)   No significant progress is seen on coastal zones, increase in port capacities. The work on dedicated freight corridor has progressed but still running much behind the revised schedule.

(e)    Some impressive projects have been announced by some major global manufacturers. However, on ground little progress is visible. In 2018 the import of telecommunication equipments was highest in five years. FDI has been lower in 2018 and 2019 as compared to 2017.