India’s tightrope act

Indian policymakers are in a tough spot. The unexpected growth slowdown calls for a strong policy response, but the government and the Reserve Bank of India (RBI) may be pulled in different directions. The imperative to lower the fiscal deficit and balance a weakening rupee against the need for rate cuts will be a tightrope act. Policy coordination and some courage will help.

Finance Minister Nirmala Sitharaman will unveil the Union Budget on February 1. Although there is a growing wish list of measures to revive the economy, fiscal prudence will demand refraining from any deep stimulus. To ease the public debt burden, India’s fiscal deficit-to-gross-domestic-product (GDP) ratio must fall.

India's central and state governments collectively owe more than 80 per cent of GDP to debtors — higher than most emerging markets and well above the 60 per cent threshold considered prudent for India’s economy. Servicing this huge debt is challenging. Interest payments consume more than one-third of government revenue, leaving limited resources for development. Fiscal prudence is the only option.

Important

Credible budget projections are also important. The Modi government has consistently underbudgeted and overdelivered by maintaining conservative assumptions about growth, taxes and commodity prices. It has surpassed its budget revenue targets for several years, creating buffers for unforeseen expenses. Deviating from this could send a negative signal to bond markets, including foreign investors who can now invest in the Indian government securities market due to index inclusion.

To reduce the fiscal deficit ratio, the government might have to trim spending by roughly half a percentage point of GDP in 2025-26, if not more. With the economy already slacking, the budget is unlikely to provide much growth support. The government may even need to shift its hallmark infrastructure-led spending strategy to address welfare issues amid weak consumption. The net tax burden, which includes personal income taxes and indirect taxes minus subsidies, is now more than 20 per cent the size of private consumption.

Monetary policy takes the spotlight next, with a review due on February 7. The Reserve Bank of India (RBI) believed economic growth was holding up well, so it could afford to keep the monetary policy rate high, to target inflation driven by vegetable prices. But from the viewpoint of growth, monetary policy has likely remained tight for longer than needed.

Given the unexpected economic slowdown, the RBI had to drastically cut its growth forecast for 2024-25 from 7.2 per cent to 6.6 per cent in December. Even this may still be optimistic, as all major components of growth (consumption, investments, and exports) have slowed. Credit growth in interest rate-sensitive sectors, such as real estate, consumer durables, and credit cards, is now declining.

The drop in vegetable prices over January has conceivably eased the RBI's constraints. If all else remains unchanged, inflation is on track to hit the 4 per cent target by mid-2025. A forward-looking central bank should shift its focus to growth and start cutting the policy rate. However, this plan relies on 'all else' remaining unchanged.

Options

The rupee's fall might curb the RBI's ability to confidently adopt a dovish policy, essential for the economy. A weaker rupee means higher inflation, as imports become pricier. This hits hard when imports make up about 25 per cent of domestic consumption and investment, and key commodities like crude oil are getting costlier. Three options are on the table.

The first is to use foreign exchange reserves to prevent rupee depreciation and boldly cut policy rates. But this will hurt the rupee’s competitiveness, which has become a concern lately, and clashes with government efforts to boost manufacturing and exports. Defending the rupee aggressively against a persistently strong US dollar might even backfire by sharply depleting foreign exchange reserves.

The second is to allow the rupee to depreciate and delay cutting policy rates. However, this will dampen domestic demand and growth, creating the perception that the RBI is falling further behind the curve. Falling growth can be a receding tide that sinks all ships.

The third is to start lowering policy rates while letting the rupee weaken gradually—navigate the challenges as they come. Some Asian peers, like Bank Indonesia, are choosing this path. Falling food prices could subdue higher import costs for now, keeping overall inflation on a downtrend. The trade-off? A less aggressive rate-cutting cycle than the economy needs.

Policymakers are hitting local and global constraints, making it tough to boost a slowing economy. Policy coordination, a reform mindset and some courage will help. Fiscal discipline and tolerance for a weaker rupee could give the RBI confidence to cut policy rates from February. And even if the resulting policy boost doesn’t offset the cyclical slowdown, a period of slower growth presents an opportunity for India to pursue meaningful reforms and strengthen its medium-term economic credentials.

Dhiraj Nim is an Economist at ANZ Research