India’s growth story faces toughest test yet in Modi government’s third term

Narendra Modi, in his 12th year as prime minister, remains popular in India, but the world’s fastest-growing major economy is no longer so popular among global investors.

India’s growing reputation as anti-artificial intelligence trade, combined with the economic strain on India’s economy from the protracted Middle East conflict, are leading to a record exodus of foreign investors, experts say.

“India is no longer the obvious one-sided growth story that investors assumed it was a few years ago,” said Alexandra Herman Prasad, chief economist at Oxford Economics. He added that while the economy “remains strong by global standards”, it faces headwinds from weak consumption, weak investment sentiment, rising energy costs and the screening of global capital.

Foreign portfolio investors have sold $29.5 billion worth of Indian stocks so far this year, after selling $18.9 billion last year.

In terms of foreign direct investment, India attracted total capital of over $90 billion in the 12 months to January 2026, an increase of 13% year-on-year. However, this was overshadowed by increased capital repatriation by foreign companies and increased overseas investment by Indian companies, leaving net FDI at “nearly record lows.”

This weakened it considerably indian rupee At a time when global oil prices are on the rise, prices against the dollar are rising, creating a dangerous situation for India, which imports more than 85% of its oil needs.

As the impact of the Middle East crisis is felt by consumers, growth is expected to slow and inflation to rise, further reducing India’s appeal among global investors. Last Friday, the Reserve Bank raised its inflation forecast for the financial year to March 2027 to 5.1%, warning that economic growth was likely to slow to 6.6% from its previous forecast of 6.9%.

To stem the flow of capital, the Indian government last Friday announced a series of measures, including a capital gains tax exemption for foreign investors in the Indian bond market. Experts say these reforms are timely, but India needs major reforms to attract global investors.

“I think it’s helping mood music, but I don’t think the symphony is going to change,” Stephen Davis, CEO and founder of Javelin Wealth Management, told CNBC’s Inside India on Tuesday. “We need to wait a little longer to see if we can come up with policies that are a little more market-friendly,” Davis added.

According to the CSIS India Reform Scorecard, which measures the progress of the Modi government on 30 major reforms over its entire term, the government has finalized just two reforms in the past two years (at the start of its third term), a much slower pace than during Modi’s first and second terms.

“Land acquisition processes and legal redress for disputes have not improved appreciably,” Richard Rossow, senior adviser and chair of India and emerging Asian economies at the policy think tank CSIS, told CNBC. He added that while labor regulations had only marginally improved, access to reliable and affordable electricity and water “remains central to India’s industrialization goals.”

The Modi government’s recent handling of India’s economy has faced criticism. While some experts are calling for reforms, others say India is lagging behind in the global AI race.

Indian economist Surjit Bala, a former member of the prime minister’s economic advisory council, said last month that Mr Modi’s party should use the economic stress from the Middle East crisis to push for reforms. However, so far no major steps in this direction have been announced.

In an open letter to Prime Minister Modi in April, global equity research firm Bernstein warned that advances in AI threaten quality jobs in India’s information technology sector and could impact domestic consumption. He added that the country also faces the risk of becoming a “permanent consumer of the AI ​​economy” because, unlike China and the United States, it does not own an AI model.

Venugopal Ghale, managing director and head of India research at Bernstein, told CNBC last week that India has missed the AI ​​boat and the only proxy AI play India can participate in is through data centers. But it won’t replace the high-quality jobs lost in the IT sector, he says.