External Shock, Internal Fault: Unfolding India’s BoP Stress

The rupee has slid past 96 to the dollar, and India’s forex (foreign exchange) reserves have depleted by over $38 billion since February. The macroeconomic policy consensus has been swift to identify the issue: the West Asia conflict has disrupted oil markets, triggering capital outflows from emerging economies and eventually destabilising India’s external position. This is what might be called an ‘external shock’ thesis, as the notion is that India faces a temporary balance of payments (BoP) stress caused by geopolitical turbulence, which is manageable through reserve intervention and monetary adjustment, reversible when geopolitical conditions stabilise.

This diagnosis is not entirely wrong. Oil prices matter enormously and geopolitical shocks do destabilise developing economies, especially those dependent on imported energy. But treating the present condition solely as an outcome of externalities misses the deeper structural problem. India’s prevailing growth model has destroyed its internal resilience precisely by pursuing the formalisation of the informal economy over the past decade. The external shock did not create India’s vulnerability. It has just exposed it.

Formalisation Logic That Led to Unemployment

Demonetisation and GST (goods and services tax) are typically framed as either well-intentioned formalising reforms or policy blunders. This misses their actual function. Both were measures to subordinate the informal economy to formal financial capital, while these were designed to destroy the cash-based, trust-dependent networks on which informal commerce operated, forcing survivors into formal credit systems.

The immediate effect of demonetisation and consequent liquidity crunch was felt most severely by the MSMEs (medium, small and micro enterprises). According to the All India Manufacturers’ Organisation survey, this resulted in a 20-30% decline in production and job losses of 32% in the micro-enterprise segment, 35% in the small business segment, 43% in the trader segment.

Moreover, as the Reserve Bank of India (RBI) acknowledged, with the implementation of GST, smaller firms without formal accounting capacity, incurred additional compliance costs. These were not policy failures or unintended side effects. The consolidation of informal enterprises, the elimination of small-scale producers, and the subordination of surviving firms to formal financial circuits were indeed the intended outcomes.

But what distinguishes this from earlier forms of primitive accumulation is that there was no corresponding creation of formal sector employment. In classical development, informal economies were destroyed to absorb pauperised labourers into the formal sector formed around industrial capitalism. In India’s case, they are destroyed, producers are displaced, and the formal sector simply does not absorb them. This is the crucial distinction that reframes the entire analysis.

Domestic Demand Base Weakened & Systematically Undermined

The domestic market contracted when informal sector producers and labourers lost income without alternative employment. The country’s gross domestic savings rate fell from 34.3% of GDP in 2011-12 to 28.6% in 2024-25, a four-decade low which indicated a sharp decline in household net savings that constituted 60.9% of aggregate domestic savings.  But consumption stayed and got financialised. With annual household borrowings accounting for 5.8% of GDP in FY 2023, marking the highest level since the 1970s, total household debt surged to 41.3% of GDP by March 2025, with 55.3% of this credit directed toward consumption rather than productive asset creation.

This indicates a fundamental shift in the form of domestic demand. It shifted from being income-financed to debt-financed, from broad-based to concentrated among those with access to credit. One cannot indefinitely sustain consumption by borrowing against stagnant incomes, because debt servicing will eventually crowd out consumption. The growth model must then find external sources of income, such as exports or capital inflows. As this new form of demand is contingent upon credit availability, it is inherently fragile and vulnerable to changes in external conditions.

Private Investment Weak as Domestic Market ‘Unreliable’

A skewed, debt-dependent domestic market does not attract long-term private productive investment, unless it is extractive. Why would one expand industrial capacity if demand is uncertain and dependent on households’ ability to service debt? Private investment in the industrial sector remained weak, with gross fixed capital formation supported largely by government spending, and it hovered around 29-30% of GDP in 2024. Net foreign direct investment (FDI) turned sharply negative. Despite gross inflows of $81 billion, it collapsed to just $0.4 billion in FY 2025 due to a surge in repatriation by foreign investors, and by the last quarter of 2025, net FDI had turned outright negative for four consecutive months. That indicated more capital leaving India than entering it.   

This leads to a paradoxical situation in which corporate profitability coexists with subdued private investment. Firms are still profitable because they have shed labour, minimised capital investment, and extracted maximum value from existing capacity. But this very strategy of cost-cutting, labour shedding, and capital minimisation means they do not invest in productive expansion. So, capital either sits as financial assets, or flows abroad.

Government spending and low-value-added exports have become the backbone of the Indian growth model. But this is a precarious arrangement, because it requires continuous external inflows (FDI, portfolio investment) to finance the current account deficit, or it requires export growth to offset import dependence. But without public capital investment in high-value-producing industries, export growth can only be attained by amping up the extractive economy, which will only lead to the depletion of natural and human resources. When external conditions tighten, this structure becomes untenable internally.

Current Account Deficit Not Cyclical, but Structural

India has remained completely dependent on sustained imports of energy, electronics and heavy machinery that cannot be comfortably financed by surpluses generated by its low-value-adding export base. With the world economy slowing, estimates suggest that India’s current account deficit will widen significantly in FY 2026-27 from 2.3% to 2.9% of GDP, compared with approximately 0.9% of GDP in FY 2025-26.

This deficit persists not because of oil price spikes, though those matter. It persists because the economy cannot generate the required internal income to pay for its imports. The deficit is financed through two mechanisms: services exports (which employ only a small, skilled segment of the workforce) and capital inflows. Neither mechanism is reliable indefinitely.

Moreover, service exports are volatile and totally dependent on global demand. More importantly, these do not solve the employment problem. Capital inflows depend on global investors’ appetite for emerging market risk. When that appetite shifts due to US interest rates, geopolitical uncertainty, or reassessment of Indian fundamentals, the inflows slow or reverse. When these reverse, the deficit can no longer be financed externally. The economy must pay in reserves, which weakens the rupee. This is far from a currency crisis caused by an external shock. It is a consequence of a permanent structural imbalance, a persistent balance of payment stress.

External Crisis Reveals Internal Vulnerability

The RBI has sold dollars from its reserves through 2025-26 to manage rupee depreciation, leading to a decline in forex reserves. Though the forex reserves currently sit in a manageable position, this reflects a permanent structural condition in which an economy cannot sustain itself without continuous external support. The question is not whether the rupee will stabilise. It will, when reserves are high and capital inflows resume. The question is whether the underlying vulnerability will persist. And the answer is, unless the development model changes, yes.

Even if the oil prices decline, the current account deficit will not simply disappear. Domestic demand will not expand without employment generation. Employment will not be generated without productive investment in labour-intensive sectors. And that investment will not happen under financial capitalism’s logic. So, the external vulnerability is permanent, the deficits are structural, and external shocks will repeatedly expose what was always true: India’s neoliberal growth model cannot sustain itself internally.

Finance Capitalism’s Logic Against Institutional Fixes

There exist obvious institutional solutions to this situation. It would require institutionalisation of wage floors to protect workers, sectoral support for labour-intensive manufacturing, public productive investment, and employment protections. But financial capitalism systematically opposes these measures.

Wage floors compress profit margins, sectoral support directs investment away from high-return capital-intensive sectors, public productive investment competes with private capital, employment protections restrict labour flexibility and so on.  Given financial capital’s mandate to ensure higher shareholder returns, cost minimisation, and capital mobility, these supporting institutions become obstacles rather than solutions.

The growing dominance of financial actors within domestic policymaking has resulted in something more fundamental than merely blocking the alternative policies. First, it led to a perverse integration of the Indian economy into global financial circuits, rendering the initiation and mainstreaming of alternative developmental strategies politically implausible. This integration was neither inadvertent nor neutral. It was pursued through the logic of State-led formalisation under financial capitalism, without any parallel construction of employment-protecting institutions.

This does not lead to development but to extraction. Subordination of producers to financial systems, displacement of workers into unemployment and precarious work, deepening of indebtedness and the concentration of growth benefits within capital and the urban professional classes.  More significantly, the dominant financial actors have restructured what counts as sound policy in the first place and have normalised the ‘external shock’ thesis. It is a diagnosis that financial capitalism produces itself. If the sources of instability are always to be located outside the prevailing development model, one would not require to examine the model itself.

What Changes If We Accept This

If the crisis is external, the solution is reserve management and monetary adjustment. If the crisis is internal, the solution requires institutional transformation, which will entail constraining financial capital, redirecting investment toward labour-intensive sectors, implementing wage protection, and rebuilding the domestic demand base.

Accepting the internal dynamics that contribute to this sticky balance-of-payments stress leads to landing on a completely different policy terrain. That leads not to technical adjustments but to political choices. The political changes would then require displacing the constituencies that disproportionately benefit from the current structure from their dominance over policy. It requires state capacity that has been substantially eroded by financialisation and liberalisation.

But the greater difficulty is that those who need to be displaced are precisely those for whom the ‘external shock’ thesis is not only technically convenient but materially necessary. If one accepts the internal account, it will lead to a direct confrontation with self-interest.

Mainstream economic analysis of India’s prevailing development model has neither neglected nor failed to see structural vulnerabilities. Rather, it has repeatedly succeeded in framing them as temporary, external, and manageable. It has been able to protect the model from the scrutiny which its own outcomes demand. Correcting this diagnosis is, therefore, not a technical exercise but a political one, which requires popular political will and action. And the first step would be to refuse the existing analytical comfort.

The writer is a former public policy professional and currently a doctoral researcher at the Department of Development Studies, SOAS University of London. The views are personal.