The Indian financial markets, already under pressure from sustained foreign portfolio investor (FPI) outflows, have come under further strain since the outbreak of the West Asia conflict.
Outflows have accelerated across both equity and debt markets since late February. FPIs have withdrawn ₹2.08 lakh crore from equities and net sold government securities worth ₹9,591 crore under the Fully Accessible Route (FAR), according to CCIL data.
The trend follows a difficult FY26, when equity outflows reached a record ₹1.8 lakh crore, according to NSDL data. In the debt market, net purchases of government securities stood at just ₹10,356 crore, the lowest level in five years.
Structural Headwinds
Market experts attribute the outflows to a combination of factors, including rupee weakness, geopolitical uncertainty, slowing corporate earnings growth and the absence of significant AI-driven investment opportunities in India. In debt markets, higher global bond yields have reduced the relative attractiveness of Indian securities.
According to V K Vijayakumar, chief investment strategist at Geojit Investments, taxes on FPIs in India remain higher than in countries such as Malaysia, Indonesia and South Africa.
While a reduction in taxes could encourage investment, he noted that the sustained FPI sell-off since early 2025 has been driven by broader concerns, including India’s perception as an AI laggard, superior returns in competing markets, rupee depreciation and elevated US bond yields. “As long as these factors persist, FPIs are likely to continue selling despite tax incentives,” he said.
Market participants argue that the trend reflects a structural shift rather than a temporary reaction to geopolitical developments, warranting policy intervention. Reports indicate that the government is considering measures such as tax relief on bond investments to ease pressure on the rupee, whose weakness has raised concerns about imported inflation.
Tanay Dalal, senior vice-president, business and economic research at Axis Bank, said a structural increase in the supply of both real and financial assets would be a more durable solution for sustaining foreign investor participation.
“Over the longer term, improving earnings visibility through productivity-enhancing reforms will be critical in making current valuations more attractive to foreign investors,” he said.
Index Inclusion Remedy
Dalal added that reducing taxes on debt investments by FPIs could facilitate India’s inclusion in major global bond indices such as the Bloomberg Global Aggregate Index and the FTSE World Government Bond Index. Such inclusion could attract $45-50 billion in inflows over two years, helping offset ongoing capital outflows. However, these inflows will not significantly strengthen the rupee because of strong underlying demand for dollars.
A recent report by Emkay Global Financial Services said capital gains tax reforms and simplification measures could improve FPI sentiment, particularly if accompanied by lower taxes on bond investments. However, it cautioned that policy support alone may not reverse outflows, as foreign investors remain concerned about weak earnings momentum and elevated market valuations.
The report added that a meaningful improvement in flows is unlikely unless the West Asia conflict eases and crude oil prices moderate, reducing macroeconomic pressures and restoring confidence in the earnings cycle.
“At above 7% on the 10-year bond, scrapping the tax could draw some foreign investors back,” said Alok Singh, treasury head at CSB Bank. “Combined with an undervalued rupee and yields about 60 basis points higher than a year ago, that could attract some FPIs that exited over the past year.”
Soumyajit Niyogi, director at India Ratings, said tax cuts could support inflows over the medium to long term but are unlikely to have a meaningful near-term impact because investor sentiment remains weak and geopolitical risks remain elevated.
“The key is to make bonds more attractive through a wider interest-rate differential, but that comes with a trade-off,” Niyogi said. “While higher rates may support bond inflows in the short term, they could also weigh on economic growth and long-term foreign direct investment prospects.”
He added that bond markets have already begun pricing in the possibility of rate hikes amid inflation concerns arising from higher fuel prices.
