Q2 GDP growth at 5.4%: Growth slowdown cyclical or policy-driven?

India’s real GDP growth stood at a 7-quarter low of 5.4% in Q2FY25, well below India’s potential GDP growth of 7-7.5%. The drastic slowdown was contributed by mining and quarrying (-0.1%), manufacturing (2.2%), and electricity group (3.2%). Is this slowdown cyclical or policy-driven? Going by the recent growth rates, which sequentially declined from 8.6% in Q3FY24 to 7.6% in Q4FY24 and further to 6.7% and 5.4% in the first two quarters of FY25 respectively, a cyclical slowdown seems to have set in. On the contrary, if one considers RBI’s latest assessment of India’s ‘State of the Economy’ (RBI Bulletin, November 2024), growth momentum remains fairly promising in the second half of FY25.

 

According to the RBI's assessment, the slow growth in H1FY25 was temporary, attributed to inadequate public spending in Q1FY25 due to the general election and excess rainfall in Q2FY25. Hence in its October monetary policy, the RBI retained the growth and inflation projections at 7.2% and 4.5% respectively for FY25. As India’s growth momentum was perceived to be resilient, MPC was not in a hurry to cut the repo rate, until retail inflation was durably secured at 4%.  

 

The credibility of India’s inflation measurement is partly eroded due to the remote base year (2012). The average inflation projection would have been at least 50 basis points less had there been a change in the base year with relatively less weight assigned to the ‘food and beverage’ group based on the 2022-23 Consumer Expenditure Survey.

 

Sectoral analysis of GDP shows a dismal performance of the manufacturing sector in Q2FY25. This was unlikely to be very much affected by the excess rainfall in Q2FY25. The much-awaited virtuous cycle of the manufacturing sector is yet to gather momentum due to prevailing high borrowing costs. The recent inventory build-up, particularly in the FMCG sector indicates weak urban demand. Microfinance and MSME sectors have shown a rise in NPAs. Credit growth moderation in H1FY25 was partly policy-driven due to tight monetary policy and restrictive regulatory policy against unsecured loans.

 

Agricultural growth is expected to accelerate in Q3FY25 due to a bumper kharif harvest anticipated this year. Agriculture growth alone is unlikely to revive overall GDP growth significantly above 7% in Q3FY25 unless the manufacturing and services sectors perform better. Moreover, GDP growing above 7% in Q3FY25 on top of a high base (8.6% in Q3FY24) may be difficult due to external headwinds.

 

If the slowdown is cyclical, countercyclical public policy is warranted to push India’s growth above 7%. Policy-driven growth slowdown is anyway not desirable. Can fiscal policy bailout? The central government is committed to fiscal consolidation in the post-COVID period. The process is still incomplete as the debt-GDP ratio remains elevated. However, this year’s fiscal deficit target may be achieved following a large transfer of RBI profit to the government. Fiscal dominance is not advisable in an inflation-targeting country like India.

 

The MPC missed an opportunity for an early rate cut in October 2024 as the CPI inflation was below 4% in July-August 2024. The rise in headline CPI inflation in September-October 2024 has been largely limited to food inflation caused by disruption due to heavy rains. As a bumper kharif harvest is predicted in 2024, food prices will soften in Q3FY25. Moreover, if the inflation forecast remains well below the upper tolerance band, the MPC should tolerate it under the flexibility clause embedded in the inflation mandate.

 

In October 2024, the RBI changed its monetary policy stance from ‘withdrawal of accommodation’ to neutral. As the liquidity condition was comfortable, the weighted average call money rate, the operating target of monetary policy, mostly remained below the repo rate since October 2024. If the MPC ignores the government’s expectation of an early rate cut, there is a high probability that India will miss the growth target of 7% in 2024.

 

The writer is currently the RBI Chair Professor at Utkal University and former Head of the Monetary Policy Department of RBI. Views are personal.