To Attract Foreign Capital, Welcome It Loudly and Clearly

07 Nov 2026

Tags: Economy   Investment Models   Foreign direct investment structures

Source: The Indian Express

Context: India's net Foreign Direct Investment (FDI) declined from approximately $40 billion in FY2021 to almost zero in FY2025, raising concerns about the country's ability to attract and retain foreign capital.

• The Reserve Bank of India (RBI) released draft Foreign Investment Rules (FI Rules) to rationalise the foreign investment framework.
• Although the draft introduces operational improvements, the article argues that India's restrictive approach towards foreign capital requires a fundamental overhaul of the Foreign Exchange Management Act (FEMA), 1999.

Limitations of the Existing Foreign Investment Framework

• Restrictive legal framework: Section 6 of FEMA regulates capital account transactions, which are prohibited unless specifically permitted by the RBI or the Central Government. Thus, the framework operates on a presumption of restriction rather than openness.
• Sectoral restrictions: Foreign investment is prohibited in certain sectors, such as real estate business, and subject to caps in sectors such as digital media, broadcasting, multi-brand retail and pensions.
• Excessive transaction-level regulation: Even in sectors where FDI is permitted, the government regulates individual transactions by prescribing investment instruments, legal structures and permissible transaction prices.
• Mandatory valuation requirements: Transfers of unlisted shares between residents and non-residents require certified valuations before the transaction, restricting the ability of parties to negotiate prices freely.
• Such ex-ante controls create procedural delays and commercial uncertainty; concerns such as tax evasion should instead be addressed through appropriate post-transaction enforcement.
• India remains relatively restrictive compared with major economies. No OECD country maintains general capital and exchange controls, while countries such as Chile and Mexico have avoided extensive transaction-by-transaction regulation of capital flows.
• Earlier, these shortcomings were less visible due to strong global investor interest in India and low international interest rates, but they have become more significant under changing economic conditions.

Draft Foreign Investment Rules: Improvements and Limitations

• Positive features: The draft FI Rules introduce shorter provisions, an investor-centred framework and harmonised definitions.
• Limitations: These are primarily operational improvements and do not address the underlying restrictive philosophy of FEMA.
• Consequently, procedural rationalisation alone is unlikely to significantly improve India's investment climate without a fundamental change in the treatment of foreign capital.

Need for Reforming FEMA

• India needs to pursue two objectives to strengthen global economic integration:
  • Clear investment signalling: Communicate that foreign capital is welcome in India and provide certainty to investors comparing emerging markets.
  • Minimum transaction friction: Reduce regulatory barriers between an investor's commercial decision and the actual execution of the investment.
• The article highlights the need to move from a restrictive, permission-based framework towards a liberal and predictable capital account regime.
• Several expert committees have already examined these issues, including the Tarapore Committee, Percy Mistry Committee, UK Sinha Committee and Financial Sector Legislative Reforms Commission (FSLRC).

Three Principles for Reforming India's Capital Account Framework

• Cautious and temporary restrictions: Restrictions on capital flows should be imposed only when necessary to manage macroeconomic risks, remain temporary, have clearly stated public objectives and operate as emergency measures.
• Separate national security screening: National security concerns should be addressed through specialised screening mechanisms with adequate checks and balances, balancing security risks against the economic costs of restricting investment.
• Public consultation and regulatory accountability: Rulemaking should involve public consultation, cost-benefit analysis and periodic review of restrictions.
• National treatment: As recommended by the FSLRC, restrictions should primarily operate at the point of entry. Once foreign investors satisfy entry requirements, they should receive treatment comparable to domestic investors.
• Three tests for capital controls:
  • Neutrality of investment vehicle: Restrictions should not unnecessarily discriminate between different legal or financial instruments through which capital enters.
  • Neutrality of investor identity: Restrictions should not arbitrarily discriminate between investors.
  • Market-failure justification: Every restriction should address a clearly identified market failure rather than operate as a general regulatory barrier.

National Security and Foreign Investment Screening

• Press Note 3 (2020): India introduced restrictions requiring government approval for investments from countries sharing a land border with India, including investments routed through entities from such countries.
• The article argues that such decisions should not be taken solely by the Department for Promotion of Industry and Internal Trade (DPIIT), whose primary mandate is investment promotion.
• National security screening should involve multiple government departments with competing mandates to ensure balanced decision-making.
• International examples:
  • United States – Committee on Foreign Investment in the United States (CFIUS): Reviews foreign investments for potential national security risks.
  • United Kingdom – Investment Security Unit (ISU): Examines investments under the National Security and Investment framework.

Way Forward

• Undertake a first-principles reform of FEMA to shift from a default restrictive approach towards a liberalised and predictable foreign investment framework.
• Replace excessive ex-ante transaction controls with transparent, risk-based regulation and effective post-transaction enforcement.
• Introduce time-bound, evidence-based and periodically reviewed restrictions wherever national security or macroeconomic stability requires them.
• Ensure regulatory certainty, investor neutrality and minimal procedural friction to improve India's competitiveness in attracting global capital.
• The costs of excessive capital controls are often indirect and long-term, reflected in investments not made, businesses not established and employment opportunities not generated.

Important Concepts

• Net FDI: Net inflow of foreign direct investment after accounting for outward direct investment and repatriation/disinvestment. It indicates the net contribution of direct investment flows to the economy.
• FEMA, 1999: The Foreign Exchange Management Act replaced FERA, 1973, with the objective of facilitating external trade and payments and promoting the orderly development and maintenance of India's foreign exchange market.
• Capital Account Transactions: Transactions that alter the assets or liabilities, including contingent liabilities, of residents outside India or non-residents in India.
• Ex-ante regulation: Regulatory approval or compliance requirements imposed before a transaction takes place.
• National Treatment: The principle of treating foreign investors or investments no less favourably than comparable domestic investors, subject to applicable exceptions.
• Capital Controls: Regulatory restrictions imposed by governments on the movement of capital across national borders to address concerns such as financial instability, exchange-rate volatility or national security.