Column | Financial Stability Takes Priority Over Offshore Retail Equity Diversification: Michael Debabrata Patra

Indian mutual fund houses are urging the government to ease the $7bn cap on their collective overseas investments, arguing that the restriction limits domestic investors' ability to diversify globally and access markets unavailable in India. The government, however, has prioritised capital controls and domestic stability over financial liberalisation.

To assess whether this restriction is really in India's interest, finance experts Michael Debabrata Patra and Dhananjay Sinha offer their perspectives. Click here to read Dhananjay Sinha's view.

The 2003–07 period in India was marked by surges in capital inflows in response to progressive liberalisation of the economy and a strong growth dynamic that took hold. The policy response comprised providing new avenues for foreign capital, an accumulation of foreign-exchange reserves and consequential sterilisation of excess domestic liquidity, and opening up of various avenues of capital outflows.

In 2003, the Reserve Bank of India (RBI) allowed domestic mutual funds (MFs) to buy foreign assets for the first time.

Capital-market regulator Securities and Exchange Board of India (Sebi) administered an overall industry cap of $1bn, with sub-limits on net assets of individual fund houses. With capital inflows remaining strong, this overall limit was progressively raised in 2006 and 2007.

By September 2007, the limit had reached $5bn and a separate limit of $1bn was allowed for exchange-traded funds (ETFs). In April 2008, the non-ETF limit was raised further to $7bn, with the ETF limit remaining unchanged.

This process of liberalisation of outward MF flows was interrupted by the global financial crisis in the wake of stock-market crashes globally and severe capital flight from emerging market economies. Since then, India has seen bouts of capital outflows and exchange-market pressures. Periods of capital inflows have been short-lived and intermittent. Accordingly, the incentive to engage in further recalibration of the investment limit has not been compelling.

Moreover, since 2020, India has witnessed the phenomenon of an ebullient retail boom that has eclipsed international investing completely.

Policy Priorities

The Indian approach to capital-account liberalisation has always been that of a process, not an event. Each round of liberalisation has been guided by two comprehensive committee reports on the subject chaired by the late SS Tarapore, former RBI deputy governor. This philosophy remains the raison d'être of the policy approach to managing capital flows.

Hence, the first point to be made on the subject is that the limit on overseas investments by domestic MFs is not set in stone, even though it has not been revisited over the past 17 years because of the enabling conditions not coming together, as explained earlier.

Second, the period since the global financial crisis has seen surges of volatility, unending geopolitical strife, fragmentation, weaponisation of trade, finance and immigration, heightened global uncertainty and polycrisis.

India has not been immune and, in fact, has been quite adversely affected. Crises have been global, but the responsibility for financial stability is national. As the guardian of the external accounts of the economy and of domestic macroeconomic and financial stability, the authorities have found it prudent to prioritise the building up of strong foreign-exchange reserves as buffers against global spillovers. This has naturally taken precedence over cross-border retail equity diversification.

Safety Net

Third, periods of capital outflows can easily become generalised, as was seen in 2025 when portfolio flows rotated eastwards out of India, chasing the artificial intelligence theme. In such periods of financial stress, India can ill afford a synchronised exit of foreign and domestic funds.

Fourth, the $7bn limit provides retail investor protection from systemic risks that are completely outside the domestic regulatory jurisdiction. In the case of a corporate fraud or market failure or currency volatility in India, the Sebi and the RBI can intervene to protect domestic investors.

That safety net is undermined if domestic retail capital is heavily exposed to global market failures over which domestic regulators have no jurisdiction to recover funds or enforce transparency.

Fifth, there are structural issues to deal with. The reality is that the pressure on the limit—and the calls to raise it—is heavily driven by a small concentrated group of asset management companies (AMCs) that were early, aggressive movers in launching international funds. Many smaller or newer AMCs still have unutilised individual headroom within the regulatory framework.

The Way Forward

Meanwhile, the Sebi has been dynamically managing the limit to eliminate friction and enable true global diversification. Currently, an Indian MF can legally purchase units of an overseas fund provided that the latter’s total allocation to Indian stocks does not exceed 25% of its net assets.

If the underlying Indian assets in the foreign fund appreciate significantly and push past the 25% threshold, the Indian AMC has a six-month observation and rebalancing period to liquidate or adjust its exposure to bring the portfolio back into legal alignment.

All assets deployed by the Indian MF must enter a single, unified investment vehicle overseas with no sidecars, sub-funds or segregated portfolios allowed.

Furthermore, to maintain independence and prevent hidden fee arrangements, no commercial advisory agreements are permitted between the Indian AMC and the underlying foreign fund manager.

The $7bn limit is not off the table; it is just on the back burner. The way forward can be likened to a sink holding water. When water from a tap is a few drops or a trickle, a stopper is required to accumulate water in the sink. However, when water is gushing from a tap, the stopper has to be removed to prevent the sink from overflowing.

Michael Debabrata Patra is former deputy governor, Reserve Bank of India