India's economy faces slower growth in 2025, macro risks intensify

In 2025, macro policies will need to support domestic demand, but without compromising on macrofinancial stability risks

The year 2024 can be characterised as a “strong start, weaker finish” for India’s economy. It started with Goldilocks-like settings, with real gross domestic product (GDP) growth closer to 8 per cent and gradually easing inflation. In the last few months, however, policy tradeoffs have worsened, due to a sharper-than-expected slump in GDP growth, higher food inflation, and currency depreciation pressures. As we turn the page, what does 2025 hold in store?

 

The global backdrop appears challenging: Uncertainty remains high due to Trump 2.0 policies. We expect President-elect Donald Trump to strike fast and hard on imposing tariffs, leading to a pickup in US inflation and just one Fed cut, in March, followed by a pause for the remainder of 2025. China is likely to announce more fiscal stimulus, but this is unlikely to drive a sustainable recovery, given the economy is not in a normal downcycle. These factors could slow global GDP growth to 2.9 per cent year-on-year in 2025, down from 3.2 per cent in 2024. For India, this implies reduced dependence on exports as a growth engine and increased reliance on domestic demand.

 

Cycling down on growth: Many believe the surprise slump in GDP growth to 5.4 per cent in Q2 FY25 was a one-off, and the economy will bounce back to 6.5-7.0 per cent over coming quarters, supported by higher government spending and a rural recovery. This looks difficult.

 

India’s strong post-pandemic rebound was driven by a mix of pent-up demand, a surge in retail credit, an aggressive focus on public capital expenditure, and strong exports performance. However, several of these factors are now reversing.

 

Urban consumption is likely to moderate as post-pandemic pent-up demand fades, monetary policy remains tight, and nominal income growth slows. The Reserve Bank of India’s (RBI’s) macroprudential tightening has sharply contracted credit growth, and loan defaults have risen for credit card and personal loans. As delinquencies tick up, banks are likely to become more risk averse, moderating demand for credit-driven small-ticket consumer goods. In the case of microfinance, this clampdown means borrowers will no longer be able to roll over multiple loans. Overall, credit conditions are tight, and the household credit cycle is likely to weigh on consumption demand in 2025.

 

India also faces a threat from China’s overcapacity. In response to Western tariffs, China will likely redirect exports into newer markets, including India. Already, India’s economic challenge from imports from China spans low-tech (low-priced consumer goods, metals and chemicals), intermediate and high-tech (specifically green-tech) products. This is having several economic implications, including a worsening trade imbalance, pressure on firms’ profit margins and lower domestic production. An uncertain global environment, softer domestic demand, higher credit costs and rising imports from China are likely to weigh on private capex.

 

There are some positive offsets. Rural demand is expected to benefit from robust monsoons, the government is likely to fast-track capital expenditure plans, services exports are increasing, and India could also gain from trade diversion.  Overall, however, we believe India’s economy has entered a cyclical growth slowdown. We expect GDP growth to decelerate to 5.8 per cent y-o-y in 2025, down from 6.5 per cent in 2024, with sub-6 per cent readings likely in the coming quarters.

 

Inflation is less of a challenge: The global and domestic backdrop means less demand-side or commodities-driven inflation. Food price inflation should moderate, due to bumper crop output, while a negative output gap and moderating wage growth should ensure benign core inflation. The main risks to inflation stem from currency depreciation and unforeseen weather-related food price spikes. The RBI estimates that every 5 per cent depreciation of the rupee adds 0.35 percentage points to headline consumer price index (CPI) inflation. However, with inflation expectations anchored, second-round effects are unlikely.

 

Currency depreciation remains a risk: Merchandise exports are likely to face headwinds from a slowing global economy, but a strong services trade surplus, healthy remittances, and stable oil prices should keep the current account deficit manageable at around 1.5 per cent of GDP. However, a hawkish Fed and global policy uncertainty are likely to keep foreign capital flows under pressure.

 

What does this macro backdrop mean for policy? First, below-trend growth argues for activating countercyclical policies to stabilise domestic demand, but macrofinancial stability warrants that we adopt the appropriate policy mix.

 

Second, a credible path towards fiscal consolidation will send a reassuring signal to investors. With plans afoot to move from deficit- to debt-targeting starting from FY27, policymakers should communicate that this will still mean sticking to fiscal discipline. At the same time, with private capital expenditure unlikely to increase in the near term, public capex must be maintained while addressing state capacity constraints to enable faster execution.

 

Third, the RBI should finetune its currency policy. So far, the RBI has heavily intervened to cap rupee depreciation. However, this is tightening banking liquidity and is counterproductive when the trade deficit is widening. We believe the RBI should allow the rupee to weaken somewhat, as this can act as an automatic stabiliser to cool imports. While this could lead to some imported inflation, the alternative is even weaker growth.

 

Fourth, many believe rate cuts will exacerbate currency weakness. However, India largely attracts growth capital, and without signs of growth stability, pressure on the external sector can continue. The balanced response to the tradeoff between sub-trend growth and macrofinancial risks is lowering policy rates from their current restrictive zone towards more neutral settings. Also, the RBI should be more proactive on liquidity injection. With the banking system in a liquidity deficit, policy transmission would be impaired otherwise.

 

Fifth, the implementation of new regulatory guidelines, such as the draft liquidity coverage ratio norms, should be more gradual. With credit growth moderating, macroprudential policies should not be procyclical.

 

Sixth, from a medium-term perspective, supply chain relocation will continue under Trump 2.0, and if the US decides to clamp down on trade diversion via third countries, such as Vietnam and Mexico, this could be another opportunity for India. At the same time, India needs to gradually lower its dependence on imported intermediate goods and increase its domestic value addition by developing a local supply chain ecosystem.

 

The road ahead may be turbulent, but smooth seas never made skilled sailors.

 

The author is chief economist (India and Asia ex-Japan) at Nomura