Some thoughts on sustaining high growth rates in India

The flight of foreign portfolio investors since October 2024, coupled with the declining net FDI, has sparked a debate on what should be done to attract and retain foreign capital to India. This has assumed greater significance given the stagnation in domestic savings at about 30% of GDP.

It is an accounting reality that if the economy has to sustain high growth rates, it must have the capital to support the high investment rates required. Domestic savings must therefore be supplemented with foreign capital. But how much can foreign capital contribute?

A recent op-ed argued that to achieve the Vikasit Bharat 2047 goal, which necessitates a 9% annual growth over the next two decades, India must strive to attract foreign capital in the range of 15% of GDP.

This may be an opportunity to step back and assess the realistic envelope of foreign capital that India can target. As an analytical framing, this would entail examining both the demand and supply sides for the different types of foreign capital available, India’s track record in attracting them, and then making a judgment.

What are good comparators of countries having successfully attracted significant foreign capital? What is the envelope of foreign capital that is looking to invest in markets like India? What’s the level of capital that India can absorb without engendering too many distortions? Based on all these, what is the realistic foreign capital target for India? 

India’s net FDI inflows from foreign investors as a % of GDP have shown a continuous decline since 2020. 

Taken together, net FPI and FDI as a share of GDP have never exceeded 4%, have been declining since the pandemic, and have been negative over the last two years. (All graphics below generated using ClaudeAI). 

The highest FDI share of GDP was 3.6% in 2008, which has been more of an outlier since it has struggled to cross 2% in recent years. 

One important thing to keep in mind is that none of the bigger economies have managed to sustain FDI beyond 3% of GDP for long periods. India’s sustained 10-year average has been 1.5% of GDP. Even sustaining it at 2% will be a challenge, leave aside 3% and above. 

It is to be noted that the northeast Asian economies did not grow by importing foreign capital. South Korea grew at 8-9% for three decades with sustained FDI of about 0.7% of GDP; Taiwan, with 0.8%; Japan, with 0.2%; China, in its 1990-2010 peak-growth period, averaged ~3%. All four built investment rates of 35-50% of GDP through extraordinarily high domestic savings. The important takeaway is that, for sustained growth in a large economy, foreign capital has historically been a marginal supplement, and high growth has been delivered by domestic savings. Another important factor, which we shall discuss in detail later, has been their high investment efficiency.

Bringing together all types of foreign capital, the graphic below shows a realistic envelope of about 4.2% of GDP. Even this may be bordering on the optimistic, given India’s track record and global economic headwinds. 

In fact, reversing the recent trend of declining net FDI and FPI, and reaching even a 2% of GDP target for foreign capital would also be challenging. In the circumstances, a 6.2% to 6.5% target for GDP growth rate on a sustainable basis would be an achievement. Anything beyond that will require substantial breakthroughs. 

As a final word on foreign capital, it can be said that if India is to sustain high growth rates, it will surely have to attract foreign capital. But that will remain a marginal contributor. Instead, the heavy lifting will have to come by way of domestic capital, and especially by improving the efficiency of its utilisation. India must significantly increase domestic savings and also improve its capital allocation efficiency.

Since increasing domestic savings is itself a measure of broadbased economic growth and therefore endogenous (a point I have raised on several blog posts), capital allocation efficiency for any given investment rate becomes an important lever for sustaining high economic growth. The Incremental Capital Output Ratio (ICOR) measures the investment required to generate an additional unit of output, with a lower number indicating higher capital allocation efficiency. 

India's ICOR has been in the 4 to 5 range since the late nineties, and has never gone below 4 on a sustained five-year period. It briefly fell below 4 during the high-growth phase of mid-2000s. Further, in recent years, it has risen to 5-5.3. 

How does this compare with the East Asian economies in their high growth phases? 

Each of these countries went through three to four distinct ICOR phases as it transitioned from labour-intensive take-off, through capital deepening, to maturity (or crisis). The lowest ICORs occurred during the take-off phase in Taiwan, Korea and Japan — and during China's pre-2007 reform years. The northeast Asian growth miracles (Korea, Taiwan, and Japan in the 1960s-80s) sustained ICORs of 2.6 to 3.7 through their fastest decades. China repeated the feat in the 1980s and 1990s with ICORs of 3.6-4.1, but its capital efficiency has deteriorated sharply since 2007, with ICOR roughly tripling from 3 to nearly 8. Investment efficiency deteriorated in every country either in the run-up to the 1997 Asian Financial Crisis or, in China's case, after the 2008 global stimulus. 

The scatter plot below maps every economy-period in the dataset onto a single chart. The the dashed green diagonals are ICOR isoclines - every point on a given diagonal has the same ICOR. The main finding is important - the Northeast Asian growth miracles operated in a narrow corridor of moderate investment rates and very high efficiency. India operates in a corridor of similar investment rates but lower efficiency. China sits at the extreme right - very high investment rates, with efficiency that was once strong but has badly deteriorated. 

India has never matched the East Asian miracle benchmark of ~3, and capital efficiency may well be the single largest constraint on its high growth ambitions. To put this in perspective, at India’s current ICOR of ~5, achieving 8% growth requires a 40% investment rate, well above India’s current ~33%, whereas at ICOR 3.5, the same growth would need only 28%. 

In other words, lowering the ICOR by one full point reduces the investment requirement for any growth target by 7-10 percentage points of GDP, a larger lever than raising domestic savings, and far larger than attracting foreign capital. Therefore, the path to faster Indian growth runs through pulling the cluster of Indian dots upward and leftward, i.e., raising growth without raising the investment rate. Unfortunately, it appears to be going in the opposite direction for now. 

So what drives lower ICOR?

In simple terms, it is about growth, which comes with lower investment and higher efficiency of capital conversion. 

For a start, on the inputs side, services and labour-intensive manufacturing have a lower ICOR than capital-intensive manufacturing and real estate-driven development. Also, higher human resource quality brings greater bang for buck from an incremental unit of investment. On the efficiency side, higher capacity utilisation, expeditious project completion, and factor market reforms - land acquisition, labour mobility, and credit allocation - contribute to lowering ICOR. Finally, institutional quality, involving predictable regulation, contract enforcement, and competitive product markets, all raise the marginal productivity of capital. 

These are also the main areas of reform that have been discussed ad infinitum. 

An important observation here is that we cannot overlook the reality that while it is essential to move up the value chain to high value manufacturing, it is virtually impossible to generate high growth from it without far higher investment rates. It underscores the criticality of labour intensive sectors like textiles and footwear in the sustainable economic growth of a country, especially a large one like India. This is also underscored by the importance of labour-intensive manufacturing in the high growth periods of the northeast Asian economies.

It is also important to note that China’s ICOR tripled in 15 years (from 3 to 9) as it shifted from labour-intensive manufacturing to capital-intensive infrastructure, property, and state-directed lending. Growth fell from 10% to 5% during the same period, exactly what the ICOR deterioration predicts.

The relevance of capital allocation efficiency also highlights the importance of human resource quality. This is even more so of if the services sector is to increase its role in sustaining high growth rates. 

Update on the AI spending boom

I blogged here on the emerging AI economy. This is an update on the trends in AI spending.

As the hyperscalers - Alphabet, Amazon, Meta, and Microsoft - ramp up their data centre investments to $720 bn in 2026, their age of bountiful cash flows is over. Three of them are expected to have at least a quarter of negative cash flows, and Alphabet will only just scrape above. 

At around 40% of their revenues this year, the cloud giants’ capital expenditures will surpass those of the oil industry during the shale boom in the 2010s and the telecoms industry during the dotcom bubble in the 1990s… Nowadays investors judge the success of these firms on the basis of concentrated revenue contracts stretching far into the future, rather than dispersed sales received today. Mostly these contracts involve selling computing capacity to model-makers like OpenAI and Anthropic, which are themselves incinerating vast piles of cash. Total future revenue agreements have risen to $2trn, from $730bn last year, at Amazon, Google, Microsoft and Oracle (Meta is a buyer, rather than a seller, of computing capacity)…

Since the start of last year the big five have raised $260bn from bond markets, a quarter of all such borrowing by listed American non-financial firms… Nearly a third of the haul from selling bonds this year is in currencies other than the dollar… Much larger obligations lurk off-balance-sheet. The biggest are $820bn of future payments to lease data centres yet to be built, up from $270bn a year ago. Commitments to spend money on other things, like packing their data centres with chips, have risen as fast. Amazon, Google, Meta and Oracle now disclose $680bn of such obligations. Other bills are tied to special-purpose vehicles: separate entities with their own balance-sheets. Last year one assembled to build Meta’s new data-centre in Louisiana issued the biggest single corporate bond in history.

This is an interesting summary of the dynamic driving this investment boom

The five firms (hyperscalers plus Oracle) have assumed the role of central planners, attempting to make the complex chain of returns on investment work across the AI economy: data centres are useless if businesses don’t find models worth paying for, which only happens if model-makers can raise enough capital to make them. In the process, the hyperscalers have sacrificed their own returns… Big tech has also liberally lent its creditworthiness across capital markets. Many firms that contract with the giants can take those contracts to the bank (literally) and raise more debt.

There are perhaps three overlapping risks - circular financing, vendor financing, and off-balance-sheet leverage - which are not a set of isolated deals but a single integrated capital structure spanning seven participant types. 

Claude generated this comprehensive diagram that captures the linkages across these seven layers.

A chipmaker (and hyperscaler) writes an equity cheque to an AI lab (purple, up the left side), the lab converts it into a purchase commitment back to that same chipmaker and the cloud landlords (orange, down the right side), the commitment becomes backlog that supports the vendors' valuations and their bond issuance (blue), and financiers fund the whole build through SPVs and private credit (amber). Money does not exit the system; it rotates.

Three properties convert a set of bilateral deals into a self-reinforcing system. First, circularity inflates apparent demand - taking equity from vendors and using it to support further borrowing has made the boom dependent on convoluted financial engineering (echoing the 1990s, when telecom-equipment makers like Lucent and Nortel advanced money to customers to buy equipment, only to face write-offs when bankruptcies hit). Second, a single weak node is load-bearing - if OpenAI cannot meet commitments, Oracle’s revenue, CoreWeave’s backlog, Nvidia’s and AMD’s sales, and the SPV lenders’ collateral all reprice together. Third, the risk has been pushed to where it is least visible (into private credit and SPVs) while equity markets have already capitalised the optimistic case. If demand does not materialise, no amount of financing ingenuity can address it, and given the amounts involved it is certain to have very large financial-market and economy-wide impacts, cascading through the balance sheets of corporates, financiers and households. 

The risks are concentrated and largely contingent — they crystallise only if AI demand disappoints, but if it does, they crystallise simultaneously across all seven categories because they share the same underlying bet. Everything rests on AI demand growing fast enough to justify >$1tn in lab commitments and ~$725bn in annual hyperscaler capex. If the revenue curve stays ahead of the cost curve, the circularity is just efficient capital allocation. If it doesn't, the same circularity becomes the risk transmission mechanism.

All this circularity is also generating its set of accounting distortions. Robin Wigglesworth points to the curious spike in the “other income” line of the hyperscaler's quarterly account statements, attributable to the changes in valuations of their investments in AI companies. 

Alphabet, for example, booked $37.7bn of “other income” in just the first three months of the year, accounting for over half the company’s net income over the period. Amazon reported “other income” of nearly $16bn in the first quarter, up from $2.7bn in the same period last year. That was nearly half its overall net income for the three months. Microsoft reported “only” $942mn of other income in the first three months of the year, but this line item has now made $7.2bn over the past nine months… what constitutes “other income” in this case: the ebb and (mostly) flow in the valuations of their sizeable private investments in companies like OpenAI and Anthropic…

Not only have private investments and increasingly engorged funding rounds become a meaningful driver of the hyperscalers’ aggregate earnings, but the money the hyperscalers have pumped into the likes of Anthropic and OpenAI has allowed the AI companies to sign huge computing deals with Alphabet’s Google Cloud, Microsoft’s Azure and Amazon Web Services… OpenAI and Anthropic now make up about half of the entire cloud computing order books at Oracle, Alphabet, Amazon and Microsoft.

A vendor invests equity in its own customer; the customer uses that equity to pre-commit purchases from the vendor; the vendor books the purchase commitment as backlog; the backlog supports the vendor’s own valuation and borrowing. 

Even though AI expenditures are building the plumbing for the next-generation economy, something is unsettling about the scale and pace of spending. More worrying is the concentration and circularity of the transactions. Is AI spending going to be the mother of all circular trade bubbles?

The limits to reform as an accounting of activities

 This post will urge a note of caution on the trend of treating reform as a purely transactional accounting exercise instead of one which also requires the creation and internalisation of an account about the reform. I’ll borrow Lant Pritchett’s framework of distinguishing between accounting and account-based accountability. 

Consider two common examples that we encounter in our daily lives.

Gym memberships are among the commonest new year resolutions. The problem is that the initial enthusiasm ebbs quickly, and in just a couple of months, two-thirds of the enthusiasts drop out. People resolve the anxiety of being unfit by performing the procedure of “joining a gym”, without internalising the discipline that makes a gym useful. The goal of a healthy body was replaced by its most visible symbol.

Fire drills in office complexes are a periodic rite. People walk to the stairs, treating it either as a mild annoyance or a welcome break from work, and return after a few minutes. The drill is logged, and the compliance box is ticked. But ask anyone a few days later on where the nearest fire exit is, or what they should do if the corridor is smoke-filled, and few would have any idea. They went through the drill without internalising it, but merely as part of a record entry exercise and not to form a prepared mind. 

Much the same applies to many public policy reforms. Take examples like Ease of Doing Business, deregulation, independent certification and accreditation, and formalisation of the economy, to name just a few. 

EoDB is reduced to a set of tick-the-box automation or rule liberalisation, without imbuing the spirit of making it easy for firms to conduct their business. Deregulation is reduced to a process of procedural actions, without administrators actually imbuing the spirit of what constitutes good regulation (or deregulation). Third-party certification is similarly reduced to the form of compliance with a checklist of items, without regard for the realisation of the desired outcomes. Formalisation of the economy is pursued as a relentless effort to bring all economic transactions under the ambit of existing laws, never mind that it adds layers of costs that make the activity itself unviable. 

In each case, there are perverse outcomes. In EoDB, the procedural requirements are met without leaving businesses significantly better off in dealing with government bureaucracies. A spring cleaning of existing restrictive regulations does little to prevent the accumulation of new restrictive regulations. Third-party certifications lead to isomorphic mimicry, a form of compliance without its substance. And formality shrinks economic activity or drives it further underground. 

In all these cases, the bureaucracy reduces such reforms into a logistical exercise without regard to the human engagement aspects (internalisation of the spirit of the reform, or the account) and their impact on implementation quality. The important point is that a fairly complex issue gets reduced to a procedural/legal fix without the agents involved appreciating the spirit of why they are doing these fixes. There’s an accounting of the reform, without an internalisation of the account behind the reform. 

These distortions are more likely when these reforms are implemented on a mission-mode approach within tight timelines. The bureaucracies have no option but to commoditise the reform and its implementation. The instrumental nature of the design and implementation of the reform, coupled with the forced pursuit of targets and over-optimistic timelines, shrinks the space for internalisation of the account. 

Now, I am not suggesting that countries should stop pursuing the approaches they are following on these reforms. Nationwide implementations of such reforms invariably demand some form of commoditisation. But, focus on the accounting of the reform should not crowd out the need for internalisation of the account. Accordingly, the commoditised implementation should be complemented with measures to sensitise and instil the account of the reform among officials and stakeholders. This sensitisation should start at the top and should cascade downwards. The space and time required for this purpose must be made available.

Weekend reading links

1. German bread facts of the week.

Germany has what may be the most diverse bread culture in the world. The official bread registry overseen by Germany’s national bread institute (yes, really) lists more than 3,000 types. Specialities include pumpernickel, Dreikornbrot (three-grain bread) and Kürbiskernbrot (pumpkin-seed bread). There are specific regional iterations of rolls: Brötchen in the north, Semmeln in the south. In German the word “bread” is partially interchangeable with “meal”—a working lunch is Pausenbrot (break-time bread), dinner is Abendbrot (evening bread). Bavarians, who always do things differently, add Brotzeit (bread time).

2. The number of Indians studying abroad has tripled in five years to 1.8 million in 2025.

3. Visakhapatnam's data centre ambitions are staggering in scale.

Andhra Pradesh has promised Google, Meta, Reliance, Tata Consultancy Services, and half a dozen others a combined 5 GW of data-centre capacity in Vizag alone. That is more than three times everything India has built in 30 years, in a city that had near-zero data-centre infrastructure six months ago... (the government) has committed to 6 GW across Andhra Pradesh in five years, a cable network twice the size of Mumbai’s, and three undersea cable-landing stations—essentially building a digital future on the eastern coast... The state’s own electricity planning documents project Vizag’s peak district demand at 2.2 GW by 2029. Google alone has applied for 2.1 GW from the local distribution company... 

Google is building a 1 GW campus across three sites: Tarluvada, Adavivaram, and the Rambilli-Atchutapuram cluster. Meta and information-and-communications-technology company Sify are reportedly building a 500 MW facility at Paradesipalem, a village 25km from the city. Reliance and alternative asset manager Brookfield’s joint venture has signed a $11 billion MoU for another GW. TCS, Adaniconnex and real-estate developer Anant Raj round out the cluster. Even if the announced 5 GW materialises, Vizag would rank among the largest data-centre clusters in the world. Northern Virginia, the global leader, sits at 6.6 GW. Beijing, London, Tokyo, Singapore—all around 2 GW each. Mumbai, India’s current data-centre capital, has around 600 MW of operational capacity.

The emerging constraint to these ambitions is power supply.

Deloitte has warned that data centres in Andhra Pradesh alone could add 2–3 GW of peak electricity demand by 2030—up to 20% of the state’s entire current peak load—risking grid instability if transmission infrastructure doesn’t keep up... The Andhra government’s Data Centre Policy 4.0 (the “4.0” a chosen suffix for most of the current TDP government’s industrial policies) offers electricity duty waivers for five years and a Re 1 per unit discount on industrial electricity tariffs for 15 years... state has committed over Rs 22,000 crore in incentives to Google alone... Vizag’s data-centre sites are on the eastern coast, far from the state’s renewable-energy generation zones in the south and west. “You would need entirely new, dedicated high-voltage transmission infrastructure. Not an upgrade to existing lines, but new corridors built from scratch,” said a former APIIC official. “In India, this typically takes years to tender and build. And I don’t see them speeding up the process for these mega projects.”

And the solution is to outsource electricity generation or sourcing to the data centre developers themselves. 

In a first for the state, it has granted a private entity, Google, a distribution company licence, allowing it to bypass the standard grid entirely and procure power directly from generators. Reliance is going further still, building its own 6 GW solar project to supply its data-centre operations... when Google contracts directly with generators at premium rates, those generators have less power to sell to the state discom at regulated prices. The discom, which still has the same demand to meet, has to make up the shortfall by either paying more on the open market (which it then recovers through higher tariffs) or simply cutting supply to consumers who have no alternative. If enough large consumers exit the grid, the discom’s revenue base shrinks while its fixed costs stay the same. Eventually, the grid gets more expensive for everyone who remains on it... The data centres planned in Vizag will operate on a hybrid model—hyperscalers will anchor the demand, local operators will build and run the physical infrastructure. Google is the end user. Adaniconnex builds the campus and co-invests in the power infrastructure. Airtel builds the cable-landing station and fibre backhaul.

4. The rise and rise of Chinese cars.

The market share of foreign firms in China has almost halved in five years, to around 30% in 2025. Moreover, in 2023 China passed Japan to become the world’s largest exporter of cars. In 2025 over 8m of its vehicles went abroad, nearly a third more than the year before. In Europe over the past five years, Chinese brands have gone from almost nowhere to nearly 9% of all sales, estimates Schmidt Automotive Research, a consultancy. Incumbents are also under siege in markets from Mexico and Brazil to Indonesia and Malaysia.

5. China promulgates its version of US CFIUS.

In recent weeks the State Council, or China’s cabinet, has issued two menacing decrees. One threatens trade curbs in response to actions that undermine Chinese supply chains (potentially including shifting orders to foreign factories). The other vows countermeasures against firms that apply foreign sanctions against Chinese companies, which in effect criminalises compliance with American law.

6. If the US sanctions individuals, they will be denied access to the services offered by among others, Amazon, Alphabet, Meta, Microsoft, Visa, Mastercard, Paypal, Apple, Slack, WhatsApp, Zoom, YouTube, Uber, Instagram, UPS, Fedex, Booking.com, and Expedia. FT writes about the scenario of US extending sanctions to services. 

Weaponising services would mark a clear escalation from trade disputes over goods and have huge repercussions for both sides. For decades, Europe’s economic relationship with the US has been defined by deep integration: goods flowing westward across the Atlantic, services coming back the other way. The EU’s surplus for goods in 2023 was €156.6bn; the EU’s deficit for services that same year was €108.6bn. As geopolitical tensions rise, that interdependence is seen by many EU capitals as a weakness that needs to be fortified as fast as possible.

7. A New York Fed study finds that around 90% of the Trump tariffs have been borne by US consumers and companies. 

Further, the complexity of the tariff regimes and its multitude of carve-outs means that the effective rate is lower than the headline tariff.

8. Global economic imbalances are back. Two graphics capture them starkly. The first is how China and the US represent the two sides of the problem. 

Global public sector indebtedness is at historic highs. 

This is a good description of the way out, though it is unlikely to happen on its own. 

As a first-best response, the Centre for Economic Policy Research’s fourth Paris Report recommends fiscal consolidation in the US, boosting household consumption in China and an increase in productive investment — modelled on former Italian premier Mario Draghi’s report — in Europe. These measures would encourage more balanced patterns of global saving and investment.

9. A ten-fold increase in export restrictions since the pandemic.

According to Global Trade Alert, the number of distortive export restrictions and bans has increased dramatically since the pandemic. Before Covid, an average of 22 export restrictions were being introduced a year. Since 2020, that average has shot up to 228.

The myth of ring-fenced "private" markets

One of the biggest enduring myths in the financial markets is the distinction between public and private markets, and the article of faith that private markets should be lightly regulated. The time may have come to question this article of faith. 

The issue has become a topic of interest in light of the turbulence being faced in the private credit markets, and also the steps in the US and elsewhere to allow public funds to invest in alternative assets. It is also important, given the growing share of private capital markets, amplified as it is by the secular decline in interest rates (in turn a consequence of several factors, including ageing populations, financial market integration, and globalisation). 

On the former (private credit markets), the FSB has just published a report on private credit, pointing to several vulnerabilities arising from complex interlinkages with banks, borrower credit quality concerns, and valuation opacity. 

This activity has grown rapidly, to an estimated $1.5-2.0 trillion in assets at end-2024 and is heavily concentrated in a few jurisdictions… Banks and private credit funds are connected through financing arrangements and strategic partnerships. Across FSB members, the available data captures direct exposures of around $220 billion of drawn and undrawn bank credit lines to private credit funds, while some commercial estimates range from $270-$500 billion… there are also potential vulnerabilities from a range of other indirect exposures including through banks providing revolving credit facilities to companies that are simultaneously borrowing from private credit funds and the growing use of synthetic risk transfers.

The former Bank of England Governor, Andrew Bailey, writes,

Private credit has significant interlinkages with banks, asset managers, insurers and private equity. These multiple layers of leverage across the ecosystem deserve deeper scrutiny. While direct bank exposure to private credit funds may be limited, indirect connections are extensive. Banks are establishing partnerships with asset managers that have a credit focus and often provide revolving credit facilities to companies simultaneously borrowing from private credit funds. Insurers actively invest in private credit markets while also establishing indirect connections to private credit through participation in reinsurance arrangements. Private equity managers increasingly own the insurance companies. These interlinkages can be difficult to detect, assess and manage — and so can the related risks.

On the latter (public financial institutions’ exposure to private markets), in August 2025, President Trump signed an executive order directing regulatory agencies to reexamine existing regulations and open the $9 trillion US retirement market to cryptocurrency, private equity, and other assets like property. Following this, on March 30, 2026, the US Department of Labour issued orders allowing 401(k) plans easier access to alternative assets. 

So why are private capital markets lightly regulated?

The standard response is that they are targeted at sophisticated, institutional investors who are presumed to have the ability to conduct their own due diligence and bear the risks, including high illiquidity. To this extent, it is argued, they do not pose the kind of negative public externalities and systemic risk that is associated with institutions that are public-facing (which take deposits, savings, premiums, etc., from retail investors). Any losers are those well-heeled investors who have the ability to absorb their losses. 

Is it really the case? What does the evidence inform us?

The reality is, as the following figures and statistics show, that retail investors are increasingly participants, both directly and indirectly, in the private capital markets. Here is a simple illustration of the channels of exposure of public-facing financial institutions to the private capital markets.

What makes this arrangement questionable is that the people at the top of the chain, the actual end-bearers of the investment risk, are not the ones doing the investing. Whatever counts as "sophistication" sits with the agents in the middle layer, not the principals at either end. However, the costs and consequences are borne primarily by the capital providers.

The table below is a summary of the various institutional investors, their respective linkages to the private capital market, and their systemic risk channel. 

The table below is a summary of these investors and the extent of their exposures to private capital markets.

The sheer volume of private funds is staggering. Between 2020 and 2023, assets in private funds grew by 34%, from $20.8 trillion to nearly $28 trillion. This is only slightly less than the just under $31 trillion in assets held by public investment vehicles (mutual funds, ETFs, and closed-end funds). In 2024, 87% of companies with revenue greater than $100 million are private, and private funds have approximately tripled in size in the last decade to $26 trillion in gross assets, comparable to the $23 trillion US commercial banking industry. But their capital comes overwhelmingly from public institutions. 

US public pension plans have allocated 34% of their holdings into alternative assets, including private equity, hedge funds, real estate, and commodities. The channel runs directly from workers’ retirement savings into PE buyouts of companies, hospitals, and infrastructure, with liquidity terms that have no resemblance to the pension’s own annual payout obligations. Similarly, the assets of private equity-influenced insurers have grown significantly in recent years, with these entities owning significantly more exposure to less-liquid investments than other insurers. By 2024, financial and ABS private placements reached 8% of assets for PE-owned insurers, while they were only 4% for non-PE-owned insurers. Apollo’s Athene, KKR’s Global Atlantic, and Blackstone’s insurance partnerships route annuity premiums, the most conservative class of retail savings, into direct lending. 

The numbers alone make it abundantly clear that private capital cannot be a ring-fenced ecosystem of alternative assets with little public externalities. Private markets have become too big to be ring-fenced. Given the linkages discussed above, any stress in the private capital markets will immediately cascade across to public stakeholders and the markets as a whole. 

It is now the hidden layer of the public financial system. Its debts appear in pension statements, its managers appear in index funds, its loans back annuities, and its performance propagates through bank balance sheets and university budgets. The “private” part is increasingly a regulatory and disclosure category, not an economic one.

There’s also the political economy that perpetuates the fiction around a ring-fenced private market. For one, private market intermediaries and investors benefit from favourable taxation regimes like carried interest and a lower capital gains taxation rate. There’s also the trend of diminishing public markets and expanding private markets, with its implications on access and equity, given the entry barriers for retail investors to access private markets. 

Both these dynamics threaten to create two distinct financial systems, with one serving retail investors and the other serving those well-off. Worse still, while the latter can access the former and benefit from it without bearing the proportionate costs, the former must bear disproportionate costs and consequences of excesses arising from the activities of the latter. 

The time has come to view private markets as no longer confined to sophisticated high-net-worth and institutional investors, but ones with deep interconnections with the public financial markets, and therefore demanding greater oversight and regulation. The matter for debate should only be the extent of regulation. 

Unfortunately, such a regulation as a preemptive process is unlikely given the political economy dynamics. However, it is only one big crisis away from such regulation. This painful learning pathway may be unavoidable and the only route to private market regulation.