Capital scarcity and inefficient allocation of investment funds remain among the principal reasons India’s economic performance falls short of its ambitions. On both counts, the situation has worsened in recent years. The incremental capital output ratio has risen above 5, implying that the economy’s sustainable growth rate without risking overheating is only around 6.5%. While domestic savings remain the foundation of capital formation, foreign direct investment (FDI) is critical for a capital-deficient economy.
India needs large pools of patient, non-debt capital to build infrastructure, expand technology-intensive manufacturing, and support high-growth digital industries that will underpin future growth. Foreign investments that merely replace domestic capital create far less value. Historically, much of such capital has flowed into software, telecom, and services, seeking a share of existing profits rather than creating new productive capacity in manufacturing or infrastructure.
At first glance, FDI inflows appear reasonably healthy. India attracted more than $80 billion each in three of the last five financial years, with inflows touching a record $94.5 billion, or 2.6% of GDP, in FY26. India’s position as the world’s 15th-largest FDI destination compares favourably with China’s fourth rank, considering the vast difference in economic size. Moreover, countries such as Singapore, Luxembourg, and Hong Kong owe much of their FDI prominence to their role as financial intermediaries.
The real concern lies elsewhere. Net FDI inflows have slowed sharply. From a negligible 0.03% of GDP in 1991, net inflows rose steadily after liberalisation and peaked at 3.62% in 2008. They remained around 1.5-2% of GDP through much of the following decade before declining rapidly. By FY25, inward and outward flows had nearly converged. In FY26, net FDI amounted to just $7.65 billion, or barely 0.2% of GDP.
Part of the widening gap between gross and net FDI reflects rising outward investments and faster repatriation of capital and profits. Equally important is the composition of India’s FDI stock. A significant share consists of brownfield investments, where foreign investors acquire existing assets without necessarily participating in management or creating new capacity. Such investments can be exited relatively easily.
By contrast, capital committed to greenfield factories or infrastructure projects remains invested over much longer periods, with returns tied to the project’s life cycle. In this sense, a portion of India’s FDI resembles portfolio capital, blurring the distinction between long-term direct investment and so-called “hot money”. This also explains recurring policy debates over the regulatory treatment of the two. The argument that rising outward investments simply reflect India’s economic maturity is unconvincing when domestic capital expenditure remains subdued. To some extent, these outflows also indicate a tightening of domestic resource allocation, driven partly by risk diversification among wealthy investors.
Despite optimistic rhetoric, foreign investors remain unconvinced about India’s prospects as a manufacturing powerhouse. Persistent constraints such as skill shortages, technology gaps, infrastructure deficiencies, and institutional inefficiencies continue to weigh on investment decisions. Greater tax certainty, easier compliance, and predictable exit mechanisms are among the reforms investors consistently seek. The reported proposal to reduce the period foreign investors must spend pursuing remedies in Indian courts from five years to two before accessing international arbitration is a welcome step. However, any revision of the Bilateral Investment Treaty framework should also remove the requirement that investors exhaust local remedies before seeking arbitration abroad. Given India’s judicial delays, that condition remains a significant deterrent to long-term foreign investment.