Navigating Volatility, India’s Foreign Portfolio Investment Landscape in FY26 and the Resilience of Domestic Capital
Introduction
The release of the Economic Survey 2025-26 has cast a revealing light on the intricate dynamics shaping India’s financial markets, particularly concerning Foreign Portfolio Investment (FPI). The report, tabled in Parliament, presents a nuanced narrative of volatility, strategic realignment, and domestic resilience. While projecting a cautiously optimistic outlook for future inflows, especially in the debt segment, the Survey meticulously details the challenges faced in the current fiscal year. This analysis delves into the multifaceted factors influencing FPI flows, the consequential impact on India’s balance of payments, the countervailing strength of domestic institutional investors, and the emerging trends that could redefine India’s attractiveness to global capital in the coming years.
The FY26 FPI Conundrum: A Tale of Net Outflows and Shifting Allocations
The period from April to December 2025 (H1 FY26) proved challenging for India’s equity markets from an FPI perspective. The data is stark: a net outflow of $3.9 billion in FPI capital. This outflow was not an isolated event but a result of a complex interplay of global and domestic factors that collectively dampened foreign investor sentiment towards Indian equities.
The Economic Survey identifies several primary drivers for this sell-off. First and foremost is the “relative underperformance of Indian equities compared to other major markets.” At a time when global investors are perpetually seeking alpha, the subdued returns from Indian indices, when benchmarked against surging markets elsewhere, prompted a portfolio rebalancing. This was compounded by lingering “trade and policy uncertainties,” which, while not explicitly detailed, often refer to domestic regulatory changes or geopolitical trade tensions that can give foreign investors pause.
Furthermore, the depreciation of the Indian rupee acted as a dual-edged sword. While a weaker currency can boost export competitiveness, for an FPI investor measuring returns in dollars, rupee depreciation erodes the value of their Indian equity holdings, creating a tangible currency loss on top of any market losses. The external environment was equally, if not more, impactful. An “abroad-based global risk-off sentiment amid elevated US bond yields” created a powerful gravitational pull on capital. As US Treasury yields rose, the appeal of safer, yield-bearing US debt increased, leading to a withdrawal of risk capital from emerging markets like India. This was part of a broader global phenomenon of capital flight to safety and quality.
Perhaps the most significant structural shift highlighted by the Survey is the “increased capital allocation towards AI-centric markets such as the US, Taiwan, and Korea.” The artificial intelligence revolution has created massive investment narratives in these countries, drawing disproportionate global capital towards their technology ecosystems. This thematic shift has meant that funds that might have previously flowed into diversified emerging market portfolios, including India, are now being channeled into concentrated bets on the AI supply chain, from semiconductor fabrication in Taiwan and Korea to software and hardware giants in the US. The Survey explicitly notes that FPI flows have been “tepid due to elevated uncertainty and increased interest in AI-related financial investments” in these nations.
Sectorally, this aversion hit export-oriented sectors like Information Technology (IT) and healthcare particularly hard. These sectors, traditionally FPI favourites due to their global revenue streams and robust fundamentals, faced headwinds from global economic slowdown fears and the aforementioned reallocation to pure-play AI investments abroad.
Debt: A Silver Lining Amidst Equity Outflows
In a notable divergence, while FPIs were net sellers in equities, they emerged as net buyers of Indian debt securities during this period. This highlights a strategic distinction in FPI behaviour. The attraction to Indian debt can be attributed to several factors: the inclusion of Indian government bonds in global indices, relatively high yields compared to developed markets, and a search for stable returns in a volatile equity environment. This trend underpins the Survey’s positive projection for FPI inflows into the debt market. This optimism is further bolstered by specific policy support, notably markets regulator SEBI’s relaxation of FPI investment norms, which has made it easier for foreign funds to participate in Indian debt markets. Additionally, ongoing India-US trade discussions are viewed as a potential catalyst for improving overall investor confidence and bilateral economic engagement.
The Macroeconomic Impact: Balance of Payments and Forex Reserves
The sustained FPI outflow, coupled with other macroeconomic flows, had a direct consequence on India’s external account. The Survey reports a Balance of Payments (BOP) deficit of $6.4 billion in H1 FY26, a sharp reversal from the surplus of $23.8 billion in H1 FY25. A BOP deficit indicates that the country’s total payments to the rest of the world (for imports, debt servicing, capital outflows) exceeded its total receipts (from exports, remittances, capital inflows). This deficit, as the Survey notes, was funded by a decline in foreign exchange (forex) reserves. India’s robust forex reserves, accumulated over years, act as a critical buffer against such periods of volatility, allowing the Reserve Bank of India to manage external imbalances without precipitating a crisis. However, a sustained drawdown is a reminder of the pressures created by volatile capital flows.
A Story of Two Metrics: Rising Asset Base but Declining Ownership Share
One of the most insightful paradoxes presented in the Economic Survey is the simultaneous movement of two key FPI metrics.
-
Rising Asset Base: The total asset base under the custody of FPIs rose to Rs 81.4 lakh crore (approx. $1 trillion) as of December 2025, marking a 10.4% increase from March 31, 2025. This growth was largely driven by valuation gains in equities and steady accumulation in debt holdings. In essence, despite net selling in equities, the market value of the remaining portfolio increased, and fresh investments in debt expanded the overall asset pie.
-
Declining Ownership Share: Conversely, the share of FPI ownership in NSE-listed equities declined to 16.9% for Q2 FY26. This indicates that while the rupee value of their holdings grew, the pace of that growth was outstripped by the expansion of the overall market capitalization or by the aggressive buying of other investor classes. This decline is attributed to “global risk aversion and sectoral realisations,” meaning FPIs were taking profits or exiting certain sectors, and their reduced participation led to a smaller proportional stake in the Indian equity universe.
The Domestic Bulwark: DIIs to the Rescue
The true testament to the deepening maturity of India’s financial markets lies in the role played by Domestic Institutional Investors (DIIs). In the face of FPI volatility, mutual funds and insurance companies provided a formidable counterbalance. Through consistent and often contrarian buying, DIIs absorbed the selling pressure from foreign investors, providing much-needed liquidity and stability to the markets. This has fundamentally altered the market structure. As of September 2025, DII ownership within NSE-listed equities stood at 18.7%, surpassing the FPI share of 16.9%. This marks a pivotal shift where domestic capital has not just supplemented but effectively replaced foreign capital as the dominant stabilizing institutional force. The relentless flows into systematic investment plans (SIPs) of mutual funds and the increasing financialization of household savings channeled through insurance companies have created a durable domestic pool of capital that is less fickle than global hot money.
Conclusion and Future Outlook
The Economic Survey 2025-26 paints a picture of an Indian economy at a financial crossroads. It is navigating a global landscape where capital is being seduced by the siren song of AI and higher yields in safe-haven assets. The resultant FPI equity outflows and BOP deficit underscore the vulnerabilities associated with reliance on foreign capital. However, the narrative is far from bleak. The strong positive outlook for debt inflows, supported by regulatory easing, offers one channel for stable foreign capital. More importantly, the rise of DIIs represents a structural strengthening of the Indian financial system, insulating it from external shocks and giving domestic fundamentals greater sway over market directions.
The future of FPI flows into India will likely hinge on a few key developments: a sustained demonstration of robust domestic economic growth, clarity on policy and reform fronts, a competitive positioning within the global technology value chains beyond just IT services, and relative stability in the rupee and inflation. As global AI investment mania potentially consolidates and yields stabilize, India’s core strengths—its demographic dividend, digital infrastructure, and growing domestic consumption—could once again attract discerning global portfolio investors. Until then, the domestic investor, empowered by systematic investment culture, stands as the steadfast guardian of India’s market integrity.
Q&A Based on the Economic Survey 2025-26 Analysis
Q1: What were the main reasons cited by the Economic Survey for the net FPI outflow of $3.9 billion up to December 2025?
A1: The Economic Survey attributed the net FPI outflow to a confluence of factors: 1) The relative underperformance of Indian equities compared to other major global markets, reducing their attractiveness. 2) Ongoing trade and policy uncertainties. 3) Depreciation of the Indian rupee, which eroded dollar-denominated returns for FPIs. 4) A global risk-off sentiment driven by elevated US bond yields, which pulled capital towards safer assets. 5) A significant thematic shift of global capital towards AI-centric markets like the US, Taiwan, and Korea, diverting funds away from emerging markets like India.
Q2: Despite equity outflows, why does the Survey project a positive outlook for FPI inflows into the debt market?
A2: The positive outlook for debt inflows is based on two key supportive factors. First, regulatory easing by SEBI, which has relaxed investment norms for FPIs in the debt market, making it more accessible. Second, the ongoing India-US trade discussions, which are expected to improve overall bilateral economic sentiment and investor confidence. Additionally, India’s inclusion in global bond indices and its relatively high yields continue to make its debt market attractive for foreign investors seeking stable returns.
Q3: Explain the apparent contradiction where the FPI asset base grew by 10.4% but their ownership share in NSE equities fell to 16.9%.
A3: This is a simultaneous outcome of valuation effects and changing participation levels. The 10.4% growth in the total asset base (to Rs 81.4 lakh crore) was driven largely by valuation gains in the existing equity portfolio and fresh accumulation in debt holdings. However, the decline in ownership share to 16.9% indicates that FPIs were net sellers in the equity market. Their selling, combined with either a faster expansion of overall market capitalization or more aggressive buying by other investors (like DIIs), reduced their proportional stake in the Indian equity universe, even as the absolute value of their custodial assets increased.
Q4: How did Domestic Institutional Investors (DIIs) mitigate the impact of volatile FPI flows in FY26?
A4: Domestic Institutional Investors, primarily mutual funds and insurance companies, played a crucial counter-cyclical role. They consistently purchased Indian equities, absorbing the selling pressure from FPIs. This provided continuous liquidity, prevented deeper market corrections, and offered much-needed stability. Their actions effectively counterbalanced the volatility of foreign capital flows. As a result, by September 2025, DII ownership (18.7%) in NSE-listed companies had surpassed FPI ownership (16.9%), highlighting their growing dominance and role as a market stabilizer.
Q5: What was the macroeconomic consequence of the FPI outflows and other factors on India’s external account in H1 FY26?
A5: The net FPI outflows contributed to a significant deterioration in India’s Balance of Payments (BOP). In H1 FY26, the BOP swung to a deficit of $6.4 billion, a stark contrast to the surplus of $23.8 billion in H1 FY25. This deficit indicates that the country’s total outflows exceeded its total inflows. To finance this deficit, India had to draw down its foreign exchange reserves, as reported in the Survey. This underscores how volatile portfolio flows can directly impact the country’s external sector health.
