Economy
Growth, inflation, financial stability: It’s a season of major trade-offs for India’s policymakers
Summary
- The uncertain external environment and little luxury of leeway on all fronts puts India’s fiscal and monetary policy makers in an unenviable tight spot.
For India, the January-March quarter is a critical period marked by major data releases (such as revised and advance GDP estimates), key policy decisions (the Union Budget and the last monetary policy review of the year), and significant documents (the Economic Survey). However, given an uncertain global environment and limited policy flexibility, the current quarter will also bring difficult trade-offs as policymakers strive to balance competing priorities. Here are some of the key dilemmas they face:
1. Growth or inflation?
The shockingly low GDP growth of 5.4% for July-September 2024 has raised concerns about a potential cyclical downturn, primarily driven by weakening consumption demand. A mix of slowing wages, high inflation, and inadequate job creation has dampened urban consumer sentiment. The Reserve Bank of India’s (RBI) consumer confidence survey indicates that sentiment remains fragile and has yet to return to pre-pandemic levels, with households hesitant to spend on non-essentials.
Slower growth typically calls for expansionary fiscal and monetary policies. The upcoming Union Budget is expected to stimulate demand, either by increasing disposable incomes (through tax relief or targeted transfers) or reducing costs (such as tariff cuts). However, the government’s commitment to fiscal discipline limits its ability to provide significant stimulus—especially with economic growth already falling short of budgetary projections.
Monetary expansion faces similar constraints. While a year of interest rate hikes followed by a prolonged pause has helped contain inflation, it remains above the 4% target. Persistent food inflation is the primary culprit, which has become deeply entrenched in recent months. With food expenses comprising 40-47% of household budgets, they play a critical role in shaping inflation expectations.
Additionally, food inflation has strong ripple effects, quickly pushing up prices of processed foods and domestic services. An RBI study (August 2024 monthly bulletin) warned that persistently high food prices could unanchor inflation expectations unless countered by monetary policy measures.
By that logic, monetary tightening would be a better idea than expansion. But therein lies the dilemma: tightening monetary policy could help control inflation expectations but at the cost of slowing an already fragile economy. On the other hand, easing rates might boost growth but risks fuelling inflation further.
2. Credit or deposits?
Bank credit growth slowed sharply from 20.1% (year-on-year) in January 2024 to 11.1% by December, largely due to tighter regulations on unsecured loans and lending to non-banking financial companies (NBFCs) imposed in November 2023. These restrictions, combined with high interest rates, have further dampened credit expansion.
Read this | Banks added over ₹2 trillion more in deposits than loans in 2024
A key concern is the decline in credit impulse—the change in bank credit as a share of GDP, often considered a leading indicator of economic activity. It turned negative after the new regulations took effect and remained so throughout 2024, signalling weaker consumption and investment.
Worse still, deposit growth has been even slower than credit growth, creating a funding gap for banks. To bridge this shortfall, banks have increasingly relied on costly wholesale deposits (such as certificates of deposit, or CDs). A senior RBI official recently noted that outstanding CDs have exceeded levels last seen in 2012, when households were diverting their savings into gold. This time, retail investors are shifting their funds into the stock market.
This dynamic presents another policy challenge. A tighter monetary stance could help attract deposits but would further suppress credit growth. Conversely, easing rates might stimulate credit expansion but make bank deposits even less attractive.
3. Managed float or free fall?
Since October 2024, the RBI has been selling dollars to manage the exchange rate. The stated aim of intervention is to reduce volatility rather than defend a specific rupee-dollar rate. That’s why RBI often intervenes to smoothen demand-supply fluctuations caused by foreign portfolio investment (FPI) flows (January 2025 RBI bulletin). When FPIs take out dollars, the RBI steps in by selling dollars and when FPIs bring in dollars, the RBI buys them.
Sustained dollar sales, however, deplete forex reserves and drain rupee liquidity. By the end of January 2025, the average liquidity deficit in the banking system had exceeded ₹3 trillion. In response, the RBI had announce injecting about ₹1.5 trillion through open market operations, repo auctions, and forex swaps to ease the liquidity crunch.
Yet, stepping back from intervention poses its own risks. If the rupee is left to float freely, it could face sharp depreciation—especially if the new US administration raises tariffs on imports.
Given India’s reliance on crude oil imports and its current account deficit, a weakening rupee would be inflationary and could destabilize external balances. At the same time, a depreciated currency could help offset the impact of tariffs by making Indian exports more competitive.
Also read | Rupee tantrums: The risk and cost of RBI's approach
Each of these trade-offs carries significant consequences. Policymakers must navigate a delicate balancing act, weighing growth against inflation, credit expansion against financial stability, and currency management against market forces. With limited room for manoeuvre, success will require not just skilful policy choices, but also a measure of luck.
