Net FDI in India has gone down from $40 billion in FY2021 to effectively zero in FY2025. There are attempts to address this, including a rationalisation of the foreign investment framework through the draft Foreign Investment Rules (FI Rules) released by the RBI. The draft Rules are a mixed bag, with some positive changes such as shorter sections, an investee-centred framework and harmonised definitions. However, these are operational revisions that are in themselves insufficient for achieving the RBI’s objective of creating a “contemporary, user-friendly investment framework” or materially improving India’s investment climate. The binding constraint is India’s suspicious approach towards foreign capital, and it requires a deeper, first-principles overhaul of the Foreign Exchange Management Act (FEMA).AdvertisementTo make progress on global economic engagement, the Indian state needs to do two things. One, it should signal, loud and clear, to foreign funds evaluating competing emerging market options that capital is welcome in India. Two, it should keep the friction between a commercial decision and its execution near zero. These objectives are hard to reconcile with the present law. Under Section 6 of FEMA, capital account transactions remain prohibited unless specifically permitted by the RBI or the government, so everything built above it, including the draft FI Rules, essentially serves as a schedule of exceptions to a default state of restriction.India operates an extended web of capital controls under FEMA. Foreign capital is prohibited in sectors such as real estate business, and capped in others such as digital media, broadcasting, multi-brand retail and pensions. This makes India an outlier among significant economies, alongside China. No OECD country maintains general capital and exchange controls, and even emerging economies such as Chile and Mexico have avoided transaction-by-transaction regulation of the capital account.Even in fully open sectors, the Indian state regulates individual transactions between private parties, prescribing the instrument the money may come through, the legal form the recipient may take, and the price the parties may agree on. For instance, transfers of unlisted shares between residents and non-residents require certified valuations before transaction, with the draft FI Rules further narrowing the latitude. This can force parties to transact at mandated prices rather than negotiate commercially, causing serious friction. If the concern is tax evasion, it should be addressed after the transaction, not through ex-ante controls.AdvertisementAlso Read | We have a model investment treaty. And are losing billions because of itThese difficulties were papered over in earlier years and avoided scrutiny due to global interest in India and low interest rates worldwide. However, the same gaps are creating significant economic problems today and require a better design of the FEMA. Much of this work has been done in existing expert committee reports by Tarapore, Percy Mistry, U K Sinha, and the FSLRC.Three key principles follow.First, any restriction on capital flows should be exercised with caution, imposed temporarily, based on publicly stated objectives, and used as an emergency measure for managing macroeconomic risk. For national security objectives, screening mechanisms should be set up with adequate checks and balances. This should bring together departments with competing mandates to weigh the national security risk against the cost of restricting capital. Press Note 3, for instance, which restricts investment by nationality, should not have been issued by DPIIT alone, whose mandate is to promote investment. The US and UK offer good examples in the CFIUS and Investment Security Unit, respectively.you may likeSecond, rulemaking should involve public consultation, cost-benefit analysis and review. The FSLRC argues that restrictions should operate principally at the point of entry, and that once entry requirements are satisfied, foreign investors should receive national treatment comparable to domestic investors.Third, controls should be tested against three criteria: Neutrality as to the vehicle through which money enters, neutrality as to who is investing, and a discipline tying each restriction to an identified market failure.Restrictions on capital carry costs that emerge slowly, as investments not made and firms not built. India’s approach must internalise this through a first-principles overhaul of its primary foreign exchange statute. Without that, tactical adjustments such as the draft FI Rules are unlikely to alter the status quo.The writer is research lead, XKDR Forum