Cautious optimism

In its meeting earlier this month, the Monetary Policy Committee (MPC) decided to keep the policy repo rate steady at 6.50%. This decision marks a shift to a ‘neutral’ monetary policy stance, indicating that the committee is neither inclined to tighten nor ease monetary conditions in the near term. The rates for the standing deposit facility (SDF) and the marginal standing facility (MSF) remain unchanged at 6.25% and 6.75%, respectively. The neutral stance is primarily driven by the potential rise in inflation due to external pressures, especially the possible escalation of war in the Middle East and its impact on crude oil prices.

The Reserve Bank of India also released the Monetary Policy Report. According to it, India’s economic trajectory in 2024 has demonstrated resilience, with Q2 GDP growth moderating to 6.7%, down from 8.6% in Q4 2023. This deceleration is partly driven by external pressures such as slowing global demand, geopolitical tensions, and softening manufacturing momentum in key export markets. India’s reliance on the robust performance of its services sector has cushioned the impact. However, the manufacturing sector, which has experienced sluggish export growth due to weaker demand from advanced economies, remains vulnerable to global headwinds. According to the IMF’s projections, while India’s growth prospects remain strong compared to other emerging markets, the external sector could face increasing challenges if geopolitical tensions escalate or if there is a sharper-than-expected slowdown in global trade.

In the first half of 2024-25, rural demand exhibited a notable pickup, with key indicators reflecting improving conditions. Tractor sales expanded by 8.1% in June-July 2024, marking a strong recovery. Motorcycle sales, a proxy for rural discretionary spending, grew by 19.6% in April-August 2024. Fast-moving consumer goods (FMCG) sales in rural areas also saw a significant boost, driven by better agricultural performance. The demand for work under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) declined by 16.6% in Q2, 2024-25, indicating reduced reliance on rural employment schemes due to improved farm sector employment. Above-normal southwest monsoon rainfall and higher kharif sowing contributed to the positive outlook, with kharif acreage up by 1.9% year-on-year, supporting further revival in rural demand.

Urban demand remained robust, supported by several high-frequency indicators. Domestic air passenger traffic increased by 5.6% year-on-year in Q1, 2024-25 and maintained momentum in July-August 2024. The Index of Industrial Production (IIP) for consumer durables rose by 10.6% in Q1, 2024-25, followed by 8.2% growth in July 2024, reflecting sustained expansion in urban discretionary spending. Bank credit to households grew in double digits, registering a 14.4% year-on-year increase as of September 20, 2024, despite some slowdown in unsecured personal loans. Urban consumer confidence, as measured by the Reserve Bank’s Consumer Confidence Survey, improved in September 2024, with optimism about future economic conditions rising.

Government consumption contracted by 0.2% year-on-year in Q1, 2024-25, pulling down overall GDP growth. Revenue expenditure, excluding interest payments and major subsidies, grew by a modest 3.1% year-on-year during April-August 2024, while capital expenditure fell sharply by 19.5% during the same period. The revenue expenditure to capital outlay (RECO) ratio deteriorated to 5.2 from 4.1 a year ago, indicating a decline in the quality of government spending. However, tax revenue growth remained strong, with gross tax revenues rising by 12.1% year-on-year in April-August 2024, driven by income tax collections, which grew by 25.5%, and indirect tax collections, which expanded by 10.0%.

External demand saw mixed performance, with merchandise exports growing by just 1.1% year-on-year during April-August 2024, while imports rose by 7.1%. The merchandise trade deficit widened to USD 116.7 billion, compared to USD 99.2 billion in the same period the previous year. Export growth was driven by sectors such as electronic goods (8.7%), engineering goods, and pharmaceuticals, while petroleum products and gems dragged overall exports. On the services side, exports remained buoyant, growing by 9.8% in Q1, 2024-25 and 10.9% in July-August 2024, led by strong demand for software and business services. As a result, the current account deficit widened marginally to 1.1% of GDP in Q1, 2024-25 from 1.0% in the same quarter of the previous year.

On the inflation front, headline inflation in India eased to 3.6% in August 2024 from 6.4% in Q3 2023, primarily due to a decline in energy prices and stable food costs. However, core inflation remains a concern, reflecting sticky service prices, which continue to put upward pressure on inflation expectations. With global inflation remaining high, particularly in services, India faces the risk of imported inflationary pressures, especially in energy and commodities, should geopolitical disruptions escalate further. This is precisely why the RBI has adopted a cautious stance, refraining from aggressive rate cuts to ensure inflation stays within its target range, while external vulnerabilities like higher oil prices and currency volatility loom as potential risks.

The rise in global crude oil prices could also significantly impact India’s inflation trajectory. Currently, Brent crude prices are hovering around $76 per barrel, and any further escalation due to geopolitical tensions or supply disruptions could push prices higher. Given that India imports around 85% of its crude oil, this would directly increase input costs across sectors, particularly transportation and manufacturing.

A USD 10 increase in crude oil prices could add about 30-35 basis points to headline inflation, exacerbating existing pressures. Additionally, India’s current account deficit, which was at -1.2% of GDP in 2023, could widen further as higher oil prices increase the import bill. This could put downward pressure on the rupee, making imports even more expensive and amplifying inflationary risks. With core inflation also sticky around 5%, the RBI may have to tighten monetary policy further, potentially stalling economic growth.

India’s financial markets have experienced volatility in response to global shifts in monetary policy. Sovereign bond yields have softened in line with global trends; however, any sudden tightening by the U.S. Federal Reserve or other advanced economy central banks could reverse this trend, increasing India’s borrowing costs and putting pressure on its fiscal balance. India’s forex reserves, which rose to $704.9 billion in 2024, provide a buffer against external shocks. Still, sustained capital outflows due to risk-off sentiment in global markets or stronger-than-expected dollar strength could weaken the rupee and exacerbate external vulnerabilities.

During H1, 2024-25, Indian financial markets exhibited stability, contrasting with global volatility. Money market rates aligned with liquidity conditions, with the weighted average call rate (WACR) remaining five basis points above the repo rate on average, down from 21 basis points in H2, 2023-24. Surplus liquidity after July 2024 led to softening overnight rates, while long-term government bond yields eased due to favourable domestic developments and global cues. Mutual funds dominated the lending side of the tri-party repo market, with a slight decrease in their market share from 66% in H2:2023-24 to 65% in H1:2024-25. Bank credit growth outpaced deposits, rising by 14.4% year-on-year as of September 2024, primarily driven by personal loans and the services sector. Meanwhile, non-banking financial companies (NBFCs) increased their resource mobilisation from the market, with a 32% share in commercial paper issuances in H1, 2024-25, up from 29% the previous year.

Given the external risks, particularly the uncertain geopolitical environment and the potential for rising crude oil prices, the RBI is unlikely to reduce rates rapidly. While inflation has eased, core inflation remains stubborn, and any significant increase in oil prices could push inflation higher, necessitating caution. The next MPC meeting in December will likely focus on assessing the impact of global developments, especially energy prices, and their transmission to domestic inflation. The RBI’s priority will remain to balance growth with inflation management, ensuring external vulnerabilities, such as oil price shocks and currency volatility, are effectively mitigated before considering any policy rate changes.

The writer is Officer on Special Duty, Research, Economic Advisory Council to the Prime Minister. Views expressed are personal