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What are the prospects of the Indian economy in the New Year? Away from the optimism of better times, there are some clear goals that remain part of a policy continuum. These are: non-inflationary growth, price stability, a resilient external sector, and fiscal prudence. This is a base list to measure performance, but the report card on most of these counts is not exactly the best. The growth and inflation dynamic in particular present a challenge, with significant risks in a year where the geo-political climate itself is complex and loaded with unknowns.
Reviving non-inflationary and sustainable growth will remain a challenge till some of the underlying issues are addressed
India’s GDP (the expenditure method), which is the demand side growth, is significantly lower at 6.0% in H1 of 2024-25 compared to 8.2% in H1 of 2023-24 and 9.0% in H1 of 2022-23. Growth emanating from the supply side (Gross Value Added, GVA) also recorded a lower imprint of 6.2% in H1 of 2024-25 as compared with 8.0% in H1 of 2023-24 and 8.1% in H1 2022-23.
Data reveals that the decline on the supply side primarily has its roots in the secondary sector (industrial sector) comprising mining (3.9% in H1 2024-25 against 8.8% in H1 2023-24), manufacturing (4.5% in H1 2024-25 against 9.6% in H1 2023-24), electricity (unchanged at 6.8%), and construction (9.1% in H1 2024-25 against 11.0% in 2023-24).
The MPC’s projection of bringing down the inflation rate to 4.0% in Q2 of 2024-25 is rather optimistic. This is because of uncertainly and unpredictability of energy prices, pressure from input costs, further pressures from risks to weather events emanating from climate change, risks to food inflation and an expected rise in international commodity prices
From the demand side, the decline in GDP from 8.2% to 6.0% was accounted for by a fall in Government Final Consumption Expenditure (GFCE) from 6.2% in H1 of 2023-24 to 2.0% in H1 of 2024-25, coupled with a decline in Gross Fixed Capital Formation (GFCF), which represents investment in the economy. GFCF fell from 10.1% in H1 of 2023-24 to 6.4% in 2024-25. However, Private Final Consumption Expenditure (PFCE) increased to 6.7% in H1 of 2-24-25 from 4.0% in H1 of 2023-24.
The numbers tell us of a decline in investment on the one hand and industrial output on the other. Is this decline transitory, durable, cyclical or structural? The fact that growth was up at 8% indicates that the fall is less on account of structural reasons and more in the nature of a transitory or cyclical turn. That begs the question: Will the economy turn around on its own as the cycle changes, or will it need a policy impetus?
It is here that we see the case for a rate cut, but with a note of caution. What is important in this context is lowering the cost of borrowed capital but more importantly ensuring its timely delivery, particularly to micro, small and medium enterprises to not only revive growth but also drive employment.
Will the economy turn around on its own as the cycle changes, or will it need a policy impetus?
Let us turn to inflation. Beginning 2016, the RBI followed the Flexible Inflation Targeting (FIT) framework which requires it to maintain inflation at an average of 4% and within a band of 2% to 6%. This system works in essence with three targets: the operating target, the intermediate target and the outcome target. The operating target is the Weighted Average Call Rate (WACR), the intermediate target is inflation forecasting and the outcome target is the FIT band. It must be noted that the RBI has been fairly successful in its liquidity management, keeping WACR in sync with the policy repo rate by using its monetary policy instruments such as Term Repo, Variable Reverse Repo and Standing Deposit Facility (SDF).
However, the inflation forecasting of the RBI leading to the end outcome has not been satisfactory. This is because food inflation remained at a higher level. For example, the headline CPI inflation at 6.2% was above the upper tolerance level of 6% in October 2024 from 5.5% in September, and below 4% in July and August by a significant increase in food inflation and core (CPI excluding food and fuel) inflation.
We will further need fiscal empowerment through tax buoyancy, a healthy competitive environment, more nurturing of micro and small businesses further and a commitment to good governance
The November 2024 inflation print was 5.48% with food inflation of 8.2%. Thus, going forward, the MPC’s projection of bringing down the inflation rate to 4.0% in Q2 of 2024-25 is rather optimistic. This is because of uncertainly and unpredictability of energy prices (which are at a lower end right now), pressure from input costs, further pressures from risks to weather events emanating from climate change, risks to food inflation and an expected rise in international commodity prices.
In the anatomy of economic structures, the fiscal sector is the heart while the fiscal deficit and associated debt to GDP ratio symbolises obesity. If the latter swells, it puts pressure on the heart and the economy can collapse. Recognising this, the Indian authorities have adhered to the FRBM Act, the latest version of which enacted in 2018 mandates that the fiscal deficit of the Centre should be no more than 3% of the GDP and the debt to GDP ratio should be capped at 40%. As against this, the medium-term fiscal rolling target as set out in the Union Budget 2024-25, fiscal deficit has been placed at 4.9% and debt to GDP ratio at 56.8%.
India being a federal set up, with a unitary bias, the Central government should set examples for the State governments in prudent fiscal management. This was also highlighted in the RBI Annual Report of 1991-92, when the economic reforms were first rolled out. But with the Centre’s targets itself showing slippage, expect that the States will only do worse. This in effect means that the RBI advice in its recent study of State Budgets (State Finances: A Study of Budgets of 2024-25) with the theme ““Fiscal Reforms by States” is meaningless.
The fiscal deficit of the Centre should be no more than 3% of the GDP and the debt to GDP ratio should be capped at 40%
Furthermore, the criticality of the adverse implication of enduing revenue deficit to GDP ratio both at the Centre and States level has been relegated to the background in the Fiscal Responsibility and Budget Management (FRBM) Act, 2018. In this context, it is important that the 16th Finance Commission should recommend the elimination of revenue deficit as a mandatory target as it originally was in the FRBM Act, 2003. This will ensure fiscal discipline and prudence.
The numbers tell us of a decline in investment on the one hand and industrial output on the other. Is this decline transitory, durable, cyclical or structural?
India is a fairly open economy. Therefore, the resilience of the external sector is critical. In this context, the current account sustainability along with hierarchy of capital flows, with a priority for FDI flows, is important. The latest data released by the RBI for Q2 of 2024-25, the CAD remained at 1.2% of GDP as against 1.3% of GDP in Q2 of 2023-24. The lower CAD was mainly on account of higher “computer services” and remittances by Indians employed overseas, despite higher merchandise trade deficit. Both of these contributing to lowering the CAD will likely not stay in a world marked by growing AI offerings and protectionist forces contributed by geopolitical tensions.
According to India’s international Investment Position (IIP) for Sep. 2024, the share of debt liabilities accounted for 52.7% (up from 51% for Sep. 2023) and the balance 47.3% are non-debt liabilities, which include FDI. Debt liability is a cause of concern in terms of repayment and interest.
With the Centre’s targets itself showing slippage, expect that the States will only do worse
In sum, reviving non-inflationary and sustainable growth will remain a challenge till some of the underlying issues are addressed. We will further need fiscal empowerment through tax buoyancy, a healthy competitive environment, more nurturing of micro and small businesses further and a commitment to good governance. The slippage in capital expenditure and continuation of revenue deficit carries adverse effect for growth. Overall, reviving growth remains a tall order.