India’s Forex Management Dilemma – Withholding Tax Cuts, Rupee Pressure and the Search for Foreign Capital

Forex Management Latest News

• Amid rising external sector pressures triggered by the ongoing West Asia conflict, weakening forex reserves, and sustained foreign portfolio outflows, the GoI and the RBI are considering a series of measures to attract foreign capital inflows. 
• One of the key proposals under discussion is reducing — or even eliminating — the withholding tax on interest earned by foreign investors on Indian government bonds.
• The debate reflects India’s broader challenge of balancing exchange rate stability, foreign exchange (forex) reserve conservation, inflation management, and investor confidence in a volatile global environment marked by high US interest rates and geopolitical uncertainty.

Why is India Concerned

• Pressure on India’s external sector:
  • India is currently facing multiple external vulnerabilities:
    • Declining forex reserves
    • Persistent foreign portfolio investor (FPI) outflows
    • Rising crude oil prices due to the West Asia conflict
    • Weakening rupee against the US dollar
    • High global interest rates, especially in the United States
  • The RBI’s forex reserves reportedly depleted by nearly $38 billion in two months, intensifying concerns over the sustainability of India’s external account.
• Key objective: The government aims to conserve forex reserves, stabilise the capital account, prevent excessive rupee depreciation, and improve India’s attractiveness for global investors.

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Proposal Under Discussion – Cutting Withholding Tax on Government Bonds

• What is withholding tax?
  • Withholding tax refers to the tax deducted at source on interest income earned by foreign investors from Indian government bonds.
  • Currently, foreign investors pay around 20% withholding tax. Earlier, a concessional 5% rate existed until 2023. 
  • India’s rate is considered among the highest globally. For example, in China it is 10% (temporary exemptions in place since 2018), Vietnam (5%), while Malaysia exempts government bonds from this levy.
• Additional complexities in India: 
  • Investors from countries with which India has double taxation avoidance agreements (DTAAs) pay lower rates.
  • Investors without Indian tax residency certificates face higher burdens. 
  • Tax is imposed on gross income. Losses cannot be adjusted against gains. 
  • This reduces the attractiveness of Indian debt markets.
• Objective behind reducing it – To attract FPI:
  • Lower taxation could Improve post-tax returns for foreign investors, increase demand for Indian government securities, bring in dollar inflows, strengthen the rupee, and reduce pressure on forex reserves.
  • Senior policymakers believe easing tax-related “friction” may improve India’s competitiveness vis-à-vis other emerging markets.

Why Policymakers Are Divided

• Concerns over effectiveness: A section of policymakers doubts whether tax cuts alone can attract significant inflows under current global conditions.
• Major concerns:
  • High US interest rates: US treasury yields remain elevated, making American assets more attractive and reducing risk appetite for emerging markets.
  • Geopolitical uncertainty: The ongoing West Asia conflict has increased global risk aversion and oil price volatility.
  • Limited immediate impact: Officials fear that foreign inflows may not rise meaningfully even after tax cuts, and India may appear economically vulnerable if the policy fails.

Forex Conservation Measures Already Initiated

• Import duty hike on gold: The government has increased import duties on gold, precious metals. As India imports large quantities of gold, it increases the current account deficit (CAD), and drains forex reserves.
• PM’s appeal: Reduce gold purchases, avoid extravagant foreign travel, use public transport and carpooling, minimise fuel consumption, etc. These measures reflect a broader strategy of economic austerity and forex conservation.
• Debate on fuel prices and austerity: 
  • Officials believe India has delayed fuel price adjustments and austerity measures compared to other Asia-Pacific economies (happened in the region 2 months ago).
  • As rating agencies and investors closely monitor fiscal discipline, suppressing fuel prices may worsen fiscal pressures, and undermine India’s macroeconomic credibility.
  • Thus, controlled fuel price increases are seen as increasingly inevitable.

RBI’s Forex Intervention Strategy

• Massive intervention in currency markets: The RBI has actively intervened in forex markets to stabilise the rupee.
• Gross forex sales by RBI: < $100 billion each in 2020-21 and 2021-22, $213 billion in 2022-23, $153 billion in 2023-24, $399 billion (record high) in 2024-25, and $166 billion in 2025-26 (first 11 months).
• Additionally: RBI held a net short forward position of $104 billion by February-end.

Rupee Depreciation and Capital Flight

• Rupee weakened by nearly 11% against the US dollar over the last year. Since the onset of the West Asia war, it has fallen another 5% (reaching a new low of Rs 95.96 against a US dollar on 14th May 2026).
• Foreign portfolio investors withdrew nearly $22.5 billion from Indian financial markets in 2026 so far.
• This has amplified pressure on equity markets, bond markets, and exchange rate stability.

Lessons from the 2013 Taper Tantrum

• Background:
  • When the rupee sharply depreciated due to the US Federal Reserve’s ‘taper tantrums’, RBI had opened a FCNR(B) [Foreign Currency Non-Resident (Bank)] deposit swap window for a period of just under three months.
  • During this window, banks raised $26 billion, helping boost the central bank’s forex reserves.
• Proposal for Special Deposit Schemes rejected:
  • Officials considered introducing a special foreign deposit mobilisation scheme similar to the RBI’s 2013 FCNR(B) swap window.
  • However, policymakers have currently rejected a similar scheme due to changing global conditions and associated risks.

Positive Developments

• Recovery in FDI: Despite capital market volatility, FDI flows showed improvement.
• Key trends: February 2026 witnessed net FDI inflows of $4.6 billion, highest level in nearly four years, and following the interim India-US trade agreement.
• Overall FDI position: Net FDI inflows during the first 11 months of 2025-26 reached $6.27 billion, compared to only $959 million in 2024-25. This suggests long-term investor confidence in India’s structural growth story remains intact.

Conclusion

• India’s current economic situation highlights the delicate balance between protecting macroeconomic stability and sustaining growth amid an uncertain global environment. 
• While tax reforms may help reduce investment barriers, they alone cannot offset global risk aversion and geopolitical uncertainty. 
• A combination of prudent fiscal management, calibrated monetary intervention, structural reforms, and external sector resilience will be essential for India to navigate the present turbulence while preserving long-term investor confidence.

Source: IE