India's economic growth faces two major risks and two key challenges

Having successfully tackled internal economic instability, it now faces external threats to growth

The finance ministry’s latest Review of the economy, which came out on September 26, exuded confidence about the Indian economy being able to meet the Economic Survey’s growth forecast of 6.5-7 per cent in FY25. Some two weeks later, the prospect of the forecast being upended by global events is very real.

Oil prices are hovering around $80 a barrel for Brent crude, an increase of 16 per cent from the September low.  The Indian economy can take the increase in its stride. However, if events in the world at large were to push the price of oil beyond $100, we will have to start worrying.

“Nothing new there,” optimists would argue. “The world has shrugged off worries about oil prices for over 30 months since February 2022, when Russia commenced its military operations in Ukraine.” In June 2022, the price of oil went up to around $120 a barrel. From July 2022 onwards, oil prices have stayed below $100, with prices staying below $80 for the most part. 

Two factors contributed to this remarkable outcome. One, the North Atlantic Treaty Organization (Nato) and the European Union (EU) imposed a price cap of $60 on oil purchased from Russia while also reducing dependence on oil supplies from Russia. The cap turned out to be quite effective.

Two, the doctrine of “managed escalation” has played out well. According to this doctrine, Nato would progressively equip Ukraine to effectively fight Russia. Each step on the escalatory ladder would be managed so that Nato itself was not drawn into a direct conflict with Russia. Escalation has been managed, the war in Ukraine has not derailed the world economy.

The same doctrine has been applied to the conflict between Israel and the Axis of Resistance (comprising Iran and its proxies, such as Hezbollah, Hamas, and the Houthis). For over a year now, Israel has been trading fire with Hezbollah on its northern border with Lebanon. These exchanges have been confined to a narrow strip on either side of the border, with casualties on both sides staying within  limits. Iran and Israel have engaged in tit-for-tat missile exchanges, inflicting damage that both sides find acceptable.

“Managed escalation” always carries the risk of miscalculation or error — at some point, one party or both parties can cross tolerable limits. The issue now — and this is where optimists would be mistaken — is not so much miscalculation as cold calculation on Israel’s part. With the successes Israel has had against Hezbollah in recent weeks, Prime Minister Benjamin Netanyahu believes the time has come to “change the Middle East.” There is the prospect  not only of escalation but of a prolonged campaign. 

A probable Trump victory in November heightens the implied risk. Following Iran’s missile attack on Israel, Mr Trump wants Israel to go after Iran’s nuclear facilities.  While Mr Trump may well be posturing in the run-up to the polls in early November, his known hawkishness on Iran poses clear risks for West Asia and the world economy.

There is another risk that a Trump victory poses, one about which there seems to be less ambiguity. Mr Trump promises sweeping cuts in taxes for corporations as well as individuals, higher tariffs and substantial deregulation. He sees the tax cuts as paying for themselves by boosting growth, but many economists are sceptical. They think the tax cuts will result in wider deficits, an increase in public debt, and slower US growth down the road. 

Mr Trump has promised a tariff of 20 per cent on all imports and a tariff of 60 per cent on Chinese goods. He sees higher tariffs not just as protecting US manufacturing but as paying for the tax cuts he has in mind. Economists have raised a howl but many American business leaders think Mr Trump has got it right. Whatever the long-term impact, there is little doubt that Mr Trump’s policies will be disruptive for the world economy in the short term.

The two risks apply to the world economy as a whole. Apart from these, there are two challenges that are specific to India. One relates to foreign direct investment (FDI). Net FDI (item 1 in the accompanying table), which is the FDI inflows minus FDI outflows, fell by over $28 billion in 2023-24, compared to 2021-22. The Review says that this is because repatriation of profits (item 4) surged considerably in 2023-24. It says this is not a bad thing because it assures foreign investors of an exit route for profits made in the country.

However, repatriation of profits is not the only factor dragging down net FDI flows. Gross inflows of FDI (item 3) have fallen steeply from $85 billion in 2021-22 to $71 billion in 2023-24.  The Review argues that FDI flows to emerging markets as a whole have fallen by 15 per cent in 2023 and India is likewise affected. But if India is positioning itself as an alternative to China for FDI, this should not be happening.

Some analysts contend that the fall in gross FDI has to do with India’s scrapping of bilateral investment treaties that allowed for third-party arbitration of disputes. The change, they say, has made foreign investors nervous. Maybe. Or it may well be that FDI has fallen for the same reasons that private domestic investment has not picked up in recent years. If gross FDI does not rebound strongly in FY25, we would need to be concerned.  

The second challenge, which is relatively short-term in nature, is with respect to foreign institutional investment (FII) flows. FIIs invested $44 billion in India in 2023-24. FII inflows in the April-July quarter of FY25 have fallen to $6.3 billion, from $20.5 billion in the same period of FY24. Analysts say this is to be expected as Indian stocks are overvalued. There has also been a huge switch of funds to Chinese stocks, given the low valuations in that market. This shift is said to have increased in recent weeks following the stimulus to the Chinese economy.

A fall in capital flows, combined with oil prices exceeding over $100, is not the best place for the Indian economy to be in. Happily, India’s external position today is strong enough to cope with such a scenario. However, higher oil prices and disruptions in the world economy could undermine growth projections. 

India has had considerable success over the years in dealing with the sources of instability within the economy. The threats to growth and stability now emanate from outside — geopolitical risks, rising protectionism, and banking instability in the West.

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