India's economic challenges in 2025: Reforms key to sustained growth

To achieve Viksit Bharat, India must tackle slowing growth and global headwinds

India starts 2025 on a sombre note with the passing of Dr Manmohan Singh, whose bold first-generation reforms in 1991 set the country on the path to faster growth. The economy is also slowing, with Q2 FY25 growth dropping to 5.4 per cent. Over the past three years, it performed well above expectations, growing at 8.7 per cent in FY22, 7.2 per cent in FY23, and 8.2 per cent in FY24, driven by public capital expenditure, substantial investments in global capability centres (GCCs), and surging service exports.

 

Government experts and analysts think the dip in last quarter’s growth is temporary. That will be known soon but, nevertheless, with no widespread revival in domestic private investment and GCC investment having peaked, India’s growth will decline, unless it undertakes much delayed second-generation reforms.

 

What is also worrisome are the rising global uncertainties. In its latest World Economic Outlook update, the International Monetary Fund (IMF) projects baseline annual global growth at a much lower 3.1 per cent for 2024–2029, compared to 3.7 per cent in the 20-year period from 2000–2019, which included the Global Financial Crisis, and warns it is subject to huge downside risks.

 

It highlights four risks: Conflict escalation; tariff and trade policy uncertainty; lower migration; and tightening global financial conditions, which combined could be lower by 1.5 percentage points. The first two risks, conflicts and trade policy, could each reduce global growth by 0.5 percentage points, while the last two, lower migration and financial tightening, could each lower growth by 0.25 percentage points. While the first risk, conflict escalation may not materialise, the second, tariffs, and the third, lower migration, are certainties and could collectively reduce global growth by 1 percentage point. With rising trade and fiscal uncertainty, the US Fed has signalled that it will slow down interest rate declines, thereby already tightening financial conditions.

 

If a China-US trade war does materialise, some experts believe India could attract more foreign direct investment under a China+1 strategy. However, India has not seen significant investment relocating from China so far, except for iPhones. Despite production-linked incentive (PLI) subsidies, India’s red tape, labour and land laws, and its approach to bilateral investment treaties make it challenging to attract investment. Additionally, India’s dependence on Chinese intermediates for iPhones and pharmaceuticals could hinder its position in a US-China trade war.

 

Some experts suggest India should join the Regional Comprehensive Economic Partnership (RCEP) or the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), but with a huge trade deficit with China even with tariffs on Chinese imports, joining RCEP would likely exacerbate these deficits in the near term. And China has also applied for CPTPP membership. A trade agreement with the UK remains pending, while negotiations with the much larger EU market are even more complex, further hindered by the EU’s proposed Climate Border Adjustment Mechanism.

 

India will undoubtedly be in Donald Trump’s tariff crosshairs. He has labelled India the “tariff king” and threatened reciprocal tariffs. Instead of engaging in a tariff slugfest, as during Mr Trump’s previous term, a smarter approach would be to proactively negotiate a trade and investment deal with the US, India’s largest export market. The goal should be to reduce the bilateral trade deficit while expanding overall US-India trade, which is projected to reach $500–$600 billion by 2030. This could be achieved by opening Indian markets to selected US imports, such as petroleum, oil products, LNG, nuclear and energy equipment, and defence.

 

On migration, Mr Trump appears to favour increased legal migration through H1-B visas and Green Cards. However, with nearly 800,000 undocumented Indians in the US, a mass deportation drive, if unleashed in full force, will affect India significantly.

 

Slowing growth is not the only concern. Despite a low current account deficit, the rupee is coming under pressure as funds exit India, particularly with the Fed expected to slow down interest rate cuts in 2025. The rupee is depreciating in a familiar step function to around Rs 86 per dollar, which will improve competitiveness but also increase prices and put unhedged borrowing at risk.

 

Fiscal policy faces tough choices, with public debt at 83 per cent of gross domestic product (GDP) and the FY25 fiscal deficit projected at 4.9 per cent of GDP for the Union government. A straight-line glide path for fiscal consolidation should reduce the FY26 fiscal deficit to 4.2 per cent of GDP, still higher than any year since the National Democratic Alliance came to power in 2014 (see figure).

 

The mid-year review, however, only promises it will be less than 4.5 per cent of GDP. The key to faster fiscal consolidation, while maintaining public capital expenditure, is aggressive privatisation, which has been inexplicably slow. State-level finances also require consolidation and quality improvement, as noted by the Reserve Bank of India.

 

The puzzle remains weak private investment. In the beginning of 2024, the excuse was election uncertainty, but now it can only be attributed to weak demand due to a K-shaped recovery. Capacity utilisation remains around 75 per cent, and surging imports make new investments less worthwhile.

 

India needs a more inclusive growth model and what economists call second-generation reforms. Encouraging greater investment in labour-intensive manufacturing by collaborating with state governments to ease labour and land acquisition laws and reduce red tape is both necessary and achievable. India requires “cooperative federalism” for initiatives like goods and services tax, but “competitive federalism” for areas such as labour and land reforms and cutting red tape, where progressive states can lead the way. Tourism, capable of creating millions of jobs and attracting investment, needs a significant push. With the elections behind us, the upcoming Budget presents an opportunity to move boldly in these directions.

 

The RBI has revised its FY25 growth forecast to 6.7 per cent and the IMF projects India’s 2025 growth at 6.5 per cent. Even with impressive growth in the last three fiscal years, averaging over 8 per cent, India’s GDP remains below the level it would have reached if the pandemic had not occurred. A reversion to average 6-6.5 per cent growth with global conditions worsening and a looming Trump trade and migration shock is not inevitable but will require immediate focus. And if India aims to return to more inclusive 7.5-8 per cent GDP growth, much-delayed second-generation reforms are essential. Will India grasp this nettle in 2025 and stay on the path to a Viksit Bharat, initiated by Manmohan Singh’s bold liberalisation in 1991? 

 

 

The author is distinguished visiting scholar, Institute for International Economic Policy, George Washington University, USA, and distinguished fellow, Isaac Center for Public Policy, Ashoka University, India