India's economy: Extended tight monetary policy may curb growth further

India witnessed three years of heady growth, with average real gross domestic product (GDP) growth of around 8 per cent. Financial markets responded exuberantly to this world-leading performance. Recently, the growth momentum has moderated, which we view as a process of normalisation, returning to a more steady rate of expansion. This phase of strong growth was accompanied by concerning spillovers in some sectors, which macroprudential measures are now aiming to contain.

 

We address three aspects here. One, the factors driving this cyclical moderation in growth. Two, the “heady vs steady” argument extends to the consumer credit cycle. Three, whether an extended period of tight monetary policy will lead to a greater growth sacrifice.

 

Firstly, tight financing conditions and the lagged impact of idiosyncratic factors — such as general elections, a slowdown in construction activity, delays in project outlays, and adverse weather conditions (ranging from heat waves to heavy unseasonal rainfall) —have emerged as cyclical speed bumps. Our proprietary GDP Nowcast model, along with sub-indices for key growth drivers on both the demand and supply sides, provides insights into the direction of the economy.

 

Industrial activity and net exports (goods and services) have held up, whilst investments (machinery  and equipment) and consumption have lagged at the halfway mark of the fiscal year. Factors such as the regulatory action-driven slowdown in unsecured loan growth, and the inflation fight that has pitched consumers against producers have entailed some economic cost. Lastly, clear signs of a pick-up in private sector capex are still absent. Our previous study established that forward-looking growth expectations and corporate profitability typically convince firms to step up capex commitments. Diversification in the export basket, towards a higher share of manufactured goods and well-faring service trade (professional services in particular), has lowered the cyclicality in its contribution.

 

Public investments are gaining ground, with the states’ capex expected to get a hand from the next round of concessional loans provided by the Centre. Recent state election results underscore that political stability is also essential in maintaining the momentum of infrastructure spending. The Centre’s capex disbursements need to rise by 52 per cent year-on-year between October 2024 and March 2025 to recover lost ground, making it an uphill task to fully meet the budgeted targets. As discussed below, consumption is likely to continue punching below its weight. A modest pick-up in the momentum in the second half, driven by easing inflation, less restrictive policies, and increased public capex, are behind our 6.7 per cent growth forecast.

 

We expect medium-term growth to stabilise at 6.5-6.6 per cent, stronger than the FY19-20 pace but moderating from the post-pandemic years. Combined with nominal GDP growth of 9-9.5 per cent, and foreign exchange (FX) reserve assumptions, we see room for India’s nominal GDP (in US dollar terms) to become the third-largest in the world within this decade.

 

Secondly, the heady vs steady argument also extends to the consumer credit cycle. Banks’ retail lending grew at a high double-digit rate in FY23-24, prompting tighter vigilance from the authorities, particularly regarding the unsecured portion of the portfolio. The Reserve Bank of India (RBI) identified several areas of concern, including the delinquency rate in the credit card portfolio, which was higher than that of all other consumer credit sub-categories as of March 2024. The RBI also highlighted the exposure of non-banking financial companies-fintech lenders and small finance banks to this segment.

 

Easing consumer credit and slowing consumption are occurring at a time when employment trends remain positive, suggesting that the underlying concern is more about leverage levels.

 

On an aggregate basis, household debt as a percentage of GDP has been inching up in the past eight quarters. Household balance sheets have benefited from the reflationary boost from wealth effects, but defences of the higher income brackets are stronger. The cumulative increase in the cost of living continues to weigh on purchasing power. The GDP deflator is up a cumulative 25 per cent since the pandemic (indexed=2019). The intention to de-lever further might tend to cap consumption in the near term. Stabilising the cost of living, along with ensuring job security, will be key near- and medium-term prerogatives for the administration.

 

Third, the monetary policy committee continues to maintain a cautious posture, highlighting limited room for rate cuts in the face of above-target inflation. With food prices, particularly volatile vegetable prices, driving inflation in recent months, there is ongoing debate on whether policymakers should tap ex-food headline inflation as a gauge for policy. There is some merit in this argument. The arrival of kharif crops is expected to temper prices, along with only a third of the inflation basket growing above 4 per cent at this juncture. Our trimmed mean measures are also running below the headline.

 

Concerns over second-round effects have yet to materialise, as inflation expectations, rural/urban wage growth, and business cost expectations remain contained. Therefore, an extended period of tight monetary policy might entail a bigger growth sacrifice. The only risk in this argument is the currency, which has come under pressure from a bid dollar and portfolio outflows. The record weekly drop in foreign reserves highlights the scale of intervention that was required to keep the currency from breaking through fresh successive lows. Nonetheless, one could argue that the strong build up in the reserves was precisely for such a “rainy day”. The forward-looking policy bias might create room to lower rates in early 2025.

 

The author is senior economist & executive director, DBS Bank