RBI Currency Restrictions and Middle East Conflict Ignite Massive Foreign Capital Flight from Indian Markets

India’s aggressive foreign exchange restrictions have triggered a severe liquidity crunch and heightened complexity for overseas investors attempting to hedge against rupee volatility, drastically eroding the appeal of Indian sovereign debt while a war-driven blow to corporate earnings exerts fresh pressure on equities. One-year hedging costs in the onshore market have surged by approximately 30 basis points since the implementation of these measures, but the impact has been even more pronounced offshore, where Non-Deliverable Forward (NDF) hedging costs have climbed by nearly 70 basis points. In the immediate aftermath of the Reserve Bank of India’s intervention, NDF hedging costs spiked to their highest level in over 12 years. This regulatory shift has thinned liquidity in the NDF market, the primary channel for managing rupee exposure, rendering hedging both prohibitively expensive and difficult to execute. Matthew Kok, a portfolio manager at Eastspring Investments—an Asia-focused asset manager with $280 billion under management—noted that such high hedging costs effectively eliminate the carry and roll-down gains from Indian government bonds, stating that investors are being paid significantly less for the risks they assume. Consequently, Eastspring has moved to a neutral stance on Indian bonds.

The central bank's curbs have further soured investor sentiment at a critical juncture when soaring oil prices, fueled by the outbreak of the Iran war on February 28, were already compromising the economic outlook. India remains exceptionally vulnerable to Middle Eastern supply disruptions, importing roughly 90% of its petroleum requirements. Clearing house data reveals that foreign investors have liquidated approximately 211 billion rupees ($2.26 billion) of Indian government debt since the conflict began, with the pace of selling accelerating following the announcement of the FX restrictions. Nigel Foo, head of Asian fixed income at First Sentier Investors—part of the First Sentier Group managing $140 billion—emphasized that oil prices may no longer be the sole catalyst for a return of foreign capital, citing deep-seated concerns over currency stability. Foo suggested that sentiment is unlikely to shift quickly even if energy costs ease, noting that foreign investors are slow to return once they exit and that a meaningful rise in bond yields may be required to restore confidence.

Simultaneously, the equity market is reeling as higher oil prices amplify concerns over corporate profitability, prompting foreign investors to dump approximately $38 billion in Indian shares since the start of 2025. This exodus reached a fever pitch in March, with record monthly outflows totaling $12.7 billion. Angela Lan, senior strategist at State Street Investment Management, which oversees $5.5 trillion globally, observed that the Iran war has intensified pre-existing headwinds including elevated valuations, AI-led disruption risks, and softening earnings momentum. Major brokerages have responded by slashing earnings forecasts. Goldman Sachs reduced its India earnings growth forecast by a cumulative 9 percentage points over the next two years, while Nomura warned of a 10-15% downside risk to consensus estimates if oil prices remain elevated. Nomura further cut its December 2026 Nifty 50 target by 15% to 24,600, following the index's year-to-date decline of over 7%. Rita Tahilramani of Aberdeen Investments indicated that most of their Asia and EM portfolios remain underweight on Indian equities, warning that investors will likely stay in risk-off mode for the near term regardless of whether the conflict is resolved swiftly, as the conversion of $1 to 93.3625 Indian rupees underscores the mounting currency pressure.