How India pivoted from foreign to domestic risk capital
During the last decade or so, the Indian financial system has quietly pivoted from relying on foreign risk capital to mobilizing domestic risk capital, reversing a dependence that goes back to the mid 1990s. In this blog post, I will discuss how and why this change happened. In the next post, I will analyse how much further this process of supplanting foreign capital can proceed, and if so, what would be the consequences of such a "decoupling".
Let me begin with a bit of prehistory. In the era of the planned economy from the 1950s to the early 1990s, the government was the main engine of economic growth, and the principal task of the financial system was to mobilize household savings and channel it to the coffers of the government. An extensive bank branch network, a vast army of insurance agents, and the wide reach of post office savings products enabled the financial system to mobilize financial savings from every nook and corner of the country. The government preempted a huge fraction of these savings though regulatory mechanisms. For example, the cash reserve ratio (CRR) and statutory liquidity ratio (SLR) required banks to lend more than 40% of their deposits to the government. A consequence of this entire system was that household savings were almost entirely in the form of "risk free" fixed income products. The government was the principal risk taker in this environment assuming almost all of the risks of almost any large investment project whether it was the Bhakra Nangal Dam, the Bhilai Steel Plant or the Ashok luxury hotel.
A core element of the Indian economic reforms in the early 1990s was that the government stopped doing this and decided to shift this investment burden to the private sector. An immediate problem was the availability of risk capital since Indian household savings was almost entirely in safe bank deposits and other fixed income products which could provide only debt capital. The solution that emerged almost by accident was to tap foreign risk capital by allowing foreign portfolio investors to buy non controlling minority stakes in Indian companies. When China was attracting huge flows of foreign direct investment (foreigners holding controlling majority stakes), India enjoyed a massive inflow of portfolio capital. (Much later China too "copied" India's regulatory framework for foreign portfolio capital).
It is important to note that the pressing need was not for foreign capital as such, but for foreign risk capital. To take an illustrative example, suppose India's savings rate was around 30%, and its investment rate was 31% with the gap bridged by a current account deficit of 1% of GDP. This meant that if all foreign inflow stopped, India could theoretically finance nearly 97% of the investment (30/31 =0.97) using only domestic savings. The real problem was that most of the domestic savings could only provide debt capital, and private sector investment requires equity or risk capital. It was foreign risk capital that bridged this gap. Foreign investment flows (direct and portfolio) often amounted to more than twice the amount required to meet the current account deficit. India responded to this problem of plenty by accumulating foreign exchange reserves which mainly took the form of lending to the US government (directly or indirectly). So effectively, we took a lot of risk capital from the rest of the world and sent a substantial part of it back as debt capital.
Thus an arrangement designed to alleviate short term balance of payments pressures ended up alleviating the shortage of domestic risk capital. It worked very well for many years, and there is little doubt that it enabled rapid economic growth and the creation of world beating companies. But it was not a permanent solution. Historically, countries have relied on foreign capital in early stages of their development, but successful countries have always shifted to domestic capital over a period of time. For example, the Dutch financed England when it was building its empire in India and elsewhere (often in conflict with the Dutch). But soon England shook off this dependence and began financing other countries especially the United States which in turn developed capital markets that could finance the rest of the world.
India also has succeeded in creating adequate pools of domestic risk capital, but this required many reforms each of which took many years to bear fruit. First, was the complete overhaul of the stock market with modern technology and strong regulation. Second, was the creation of investment institutions including private sector mutual funds, insurance companies and retirement savings vehicles. Third and perhaps least appreciated was the fading away of the old generation, and the coming of age of a new generation willing to look beyond bank deposits and adopt newer products if they offered better returns. The great physicist Max Planck once remarked that science progresses one funeral at a time, and in a sense the financial system also develops one funeral at a time. Generational transition was not a reform in itself, but it was what enabled other reforms to start yielding results. (For example, when private sector mutual funds were first launched they were primarily vehicles for parking corporate cash surpluses in debt securities. Individuals too invested mainly in debt oriented mutual funds. It took tax reforms and generational change to transform mutual funds into equity oriented periodic savings plans). The fourth major reform was the set of regulatory changes that allowed retirement savings vehicles (the Employees Provident Fund, the New Pension Scheme and other pension funds) to invest in equities. This move was bitterly opposed by organized labour, and the only reason that this could be pushed through was the fact that by then the equity market was perceived to be reasonably clean and transparent.
As a result of this multi-decadal process, India has reached the point where it has a large pool of domestic risk capital. Reflecting this, the ownership share of foreign portfolio investors in Indian companies listed at the National Stock Exchange (NSE) peaked just before the Covid pandemic, and has declined steadily since then. (All the data in this paragraph is from the NSE India Ownership Tracker). During the early and mid 2000s, the ownership of foreign portfolio investors had doubled from less than 10% to over 20%. After a modest transient drop during the Global Financial Crisis, this number reached an all time high of a little over 22% at the end of December 2019. From that peak, foreign ownership has fallen to less than 17% taking it back to the levels that prevailed two decades ago. Domestic institutions (including mutual funds, banks, insurance companies) now hold a larger ownership (nearly 19%) than foreign portfolio investors. Individuals own nearly 10% of NSE listed companies and if we add their holding via mutual funds, then their total ownership rises to nearly 19% which is well above that of foreign portfolio investors. All this means that foreign capital flows no longer move Indian stock prices to the extent that they did in the past.
A number of questions arise at this stage. Could the trends of the last few years reverse at least partially in coming years? Conversely, could this process go much further? If so, would this lead to a decoupling of Indian capital markets from the rest of the world? What impact would that have on the cost of capital for Indian companies? Alternatively, could India start exporting risk capital to the rest of the world? I do not have answers to any of these questions, but I will try to analyse them in my next blog post.
Posted at 8:05 pm IST on Sat, 24 Jan 2026 permanent link
Categories: equity markets, international finance