India's Cost of Capital: Why Capital Remains Expensive – Economic Survey 2025-26 Analysis
One of the most thought-provoking sections of the Economic Survey 2025-26 examines why the cost of capital remains relatively high in India despite improvements in macroeconomic fundamentals. This analysis goes beyond the usual proximate explanations to identify structural factors that keep borrowing costs elevated. For businesses, policymakers, and UPSC aspirants studying Indian economy, understanding this issue is essential as it affects everything from industrial competitiveness to infrastructure development.
Understanding the Cost of Capital
Before examining the Economic Survey 2025-26's analysis, it helps to understand what "cost of capital" means. In simple terms, it is the return that investors require to provide capital to businesses or governments. For businesses, this includes the interest rate on loans (debt capital) and the returns expected by shareholders (equity capital). For governments, it primarily refers to the yields on government bonds.
A high cost of capital increases the hurdle rate for investments. Projects that would be viable at lower interest rates become uneconomic. This affects corporate expansion plans, infrastructure investment, and ultimately economic growth and job creation.
India's policy rate (repo rate) at around 6 per cent, while lower than historical levels, remains higher than in many developed economies where rates have been near zero or even negative. Bank lending rates for businesses range from 8-12 per cent depending on the credit profile. These rates impose a significant cost on capital-intensive industries and affect India's manufacturing competitiveness.
The Structural Explanation: Current Account Deficits and Foreign Savings
The Economic Survey 2025-26 offers a structural macroeconomic explanation for India's high cost of capital that goes beyond the usual discussion of policy rates and inflation.
The survey states: "A country that persistently runs current-account deficits and depends on foreign savings must, by definition, pay a risk premium to global capital."
Let us unpack this statement. India runs a current account deficit, meaning the country imports more goods and services than it exports. This gap must be financed by capital flows from abroad – either as foreign investment or borrowings. Foreign investors providing this capital demand compensation for the risks involved, including currency risk, political risk, and liquidity risk.
By contrast, "economies that generate sustained external surpluses—through exports, productivity and financial depth—can finance investment cheaply and stably at home." Countries like Germany, Japan, South Korea, and China, which have historically run current account surpluses, have lower costs of capital. They have excess savings domestically and do not need to offer high returns to attract foreign capital.
This structural explanation suggests that India's cost of capital problem cannot be solved merely through monetary policy adjustments. Even if the RBI cuts interest rates, foreign investors will continue demanding a premium to hold Indian assets as long as the current account deficit persists.
The Export Imperative: Manufacturing Matters
Building on this analysis, the Economic Survey 2025-26 emphasizes the importance of manufacturing exports for reducing the cost of capital.
The survey notes: "Currency strength, in general, or currency stability during crises, has always eluded countries that could not become successful and significant exporters of manufactured goods. Countries with strong, stable currencies are known for their manufacturing excellence."
While India has excelled in services exports, particularly IT and IT-enabled services, the survey argues this is not sufficient. Services exports, while valuable, "do not systematically compel broad upgrades in state capacity, as successful firms can bypass weak institutions, relocate easily, and generate limited economy-wide pressure on governments to reform."
Manufacturing exports, by contrast, "impose hard fiscal, employment, or logistical constraints on the State." They require quality infrastructure, skilled workers, efficient ports and customs, and supportive regulations. This forces institutional improvements that benefit the entire economy.
The survey presents data showing that over the five years since 2020, the compounded annual growth rate of total exports has been 9.4 per cent, while that of merchandise exports has been only 6.4 per cent. Services have done the heavy lifting, but they are "not a substitute for the goods-based export ecosystems that ultimately underpin durable external and currency stability."
The Circular Problem: Cost of Capital and Manufacturing Competitiveness
The Economic Survey 2025-26 identifies a circular problem in India's economic structure. Manufacturing competitiveness requires low input costs, including capital costs. But capital costs cannot fall durably until manufacturing exports grow enough to reduce the current account deficit. Yet manufacturing exports cannot grow without competitive capital costs.
The survey articulates this dilemma: "A lower cost of capital does not accrue easily to countries that are structurally savings-deficient (i.e., run current account deficits) and face enduring political incentives for fiscally accommodative policies."
This creates a situation where "capital remains relatively expensive, and upstream producers find it more challenging to expand their scale or invest in efficiency; hence, they seek the lazier alternative of negotiated shelter." In other words, instead of competing globally, domestic manufacturers seek tariff protection and other favours from the government.
"Yet without such expansion and efficiency gains, exports do not grow sufficiently to ease the current account constraint, and the underlying savings imbalance persists. The effort to correct one weakness thus creates another — a reminder of the endogeneity of macroeconomic outcomes."
Energy Costs: Another Critical Input
The Economic Survey 2025-26 notes that for competitive businesses, the cost of capital is not the only input cost to consider. "Energy is as important, if not more so."
Indian businesses face challenges with energy costs due to several factors. Electricity tariff structures often involve cross-subsidies where industrial users pay higher rates to subsidise residential and agricultural consumers. This inverts the logic that should apply – large users typically should pay less per unit due to economies of scale.
The survey cautions that the "Net Zero transition has the potential to exacerbate this inversion." Rapid transition to renewable energy, if not managed carefully, could raise electricity costs for industry during the transition period. This is why the chapter on environment and climate change in the survey "argues for sequencing, system readiness and finance reforms to deliver a green, competitive growth path without compromising energy security or development objectives."
The Role of Government: Enabling Competitiveness
Given the structural nature of the cost of capital problem, what role can government play? The Economic Survey 2025-26 argues that government must focus on creating conditions for competitiveness rather than providing direct subsidies or protection.
"The exogenous factor is the government, with its ability to frame laws, set rules, raise or lower taxes and tariffs, provide and price utilities, grant approvals and licenses within a reasonable timeframe and incentivise indigenisation without sacrificing efficiency and engendering competitiveness."
The survey emphasizes that where upstream inputs (like steel, aluminium, or textile fibre) are costly and capital-intensive, "lowering their cost of capital is a more efficient way to support them than raising import protection, because it preserves downstream export competitiveness."
Tariff protection that insulates domestic producers from global competition "functions as a tax on downstream manufacturing and export performance." This lesson from East Asian development experience is particularly relevant for India today.
State-Level Factors Affecting Borrowing Costs
An interesting insight in the Economic Survey 2025-26 relates to state-level fiscal health and its impact on borrowing costs. The survey notes that India's 10-year bond yield is 6.7 per cent, while Indonesia's is 6.3 per cent, despite both countries having the same BBB credit rating.
The survey suggests: "States' fiscal priorities, perhaps, are casting a shadow on the sovereign's borrowing cost, as investors focus on the fiscal parameters of the general government rather than just those of the Union government."
While the Union Government has achieved significant fiscal consolidation, several states have increased revenue deficits and unconditional cash transfers. Indian government bonds are now globally indexed, meaning international investors assess India's general-government finances, not just Union finances. Weak fiscal discipline at the state level "can no longer be treated as locally contained—it increasingly affects the cost of sovereign borrowing."
Monetary Policy Developments in FY26
The Economic Survey 2025-26 does acknowledge positive developments on the monetary policy front. The Reserve Bank of India has pursued an accommodative stance, with repo rate cuts and liquidity injections supporting lower interest rates.
Markets have responded positively to the government's fiscal discipline. The spread over US bonds has declined by more than half, indicating improved investor confidence. Alongside the lower repo rate, declining sovereign bond yields have created a more favourable borrowing environment.
However, the survey's structural analysis suggests that these cyclical improvements, while welcome, do not address the fundamental issue. Unless India becomes a surplus-generating economy through manufacturing exports, the cost of capital will remain structurally higher than in export-surplus economies.
Path Forward: Transforming into a Surplus Economy
The Economic Survey 2025-26 concludes that "India's long-run challenge, therefore, is not merely to manage liquidity or credit cycles, but to transform itself into a surplus-generating economy. Only then can its cost of capital fall durably."
This transformation requires multiple parallel efforts: boosting manufacturing through PLI schemes and ease of doing business reforms; improving infrastructure and logistics to enhance export competitiveness; building human capital through skill development; and pursuing trade agreements that open markets for Indian manufactured goods.
The recently concluded free trade agreement with the European Union is cited as a step in this direction, expanding market access for India's labour-intensive manufactured exports while enabling deeper integration with Europe's technological capabilities.
UPSC Relevance: Cost of Capital and Economic Policy
For UPSC aspirants, the cost of capital topic connects multiple areas of the syllabus:
- Monetary policy and interest rate determination
- External sector and current account dynamics
- Industrial policy and manufacturing competitiveness
- Fiscal policy and government borrowing
- Trade policy and export promotion
Practice MCQs on Cost of Capital - Economic Survey 2025-26
Q1. According to Economic Survey 2025-26, the structural reason for India's high cost of capital is:
(a) High inflation
(b) Persistent current account deficits requiring foreign capital
(c) Inefficient banking system
(d) Low savings rate
Answer: (b) Persistent current account deficits requiring foreign capital
Q2. The Economic Survey 2025-26 argues that which type of exports is essential for durable currency stability?
(a) Services exports
(b) Agricultural exports
(c) Manufacturing exports
(d) Software exports
Answer: (c) Manufacturing exports
Q3. According to Economic Survey 2025-26, India's 10-year bond yield compared to Indonesia (same rating) is:
(a) Lower by 0.4%
(b) Same
(c) Higher by 0.4%
(d) Higher by 1%
Answer: (c) Higher by 0.4% (India 6.7% vs Indonesia 6.3%)
Q4. The survey argues that tariff protection for upstream industries:
(a) Helps downstream exporters
(b) Functions as a tax on downstream manufacturing
(c) Has no effect on costs
(d) Reduces the cost of capital
Answer: (b) Functions as a tax on downstream manufacturing and export performance
Q5. For India's cost of capital to fall durably, the Economic Survey 2025-26 recommends:
(a) Aggressive interest rate cuts
(b) Currency devaluation
(c) Transformation into a surplus-generating economy
(d) Capital controls
Answer: (c) Transformation into a surplus-generating economy through manufacturing exports
Conclusion
The Economic Survey 2025-26's analysis of India's cost of capital issue offers a structural perspective that goes beyond conventional monetary policy discussions. By linking the cost of capital to current account dynamics and manufacturing exports, the survey provides a roadmap for addressing this challenge. The path forward requires not just monetary accommodation but a fundamental transformation of India's export structure toward manufacturing. This insight has important implications for industrial policy, trade policy, and the broader pursuit of Viksit Bharat.