Monetary Policy Can’t Take Up The Government’s Slack To Boost Economic Growth

The Union Budget for 2025-26 comes at a strange time for the Indian economy. While there is, undeniably, pressure on the government to revive growth, it can also be argued that it may not have been as much if not for the second quarter GDP data, which showed growth slid to a seven-quarter low of 5.4%.

Until the GDP data was released at the end of November, the growth picture, while patchy, was largely fair--or as former Reserve Bank of India Governor Shaktikanta Das used to say, the positives outweighed the negatives. However, the narrative decidedly has taken a turn for the worse since then, with the first advance estimate of GDP for 2024-25 as a whole pegging the full-year growth figure at a four-year low of 6.4%.

Das’ assessment of growth, of course, must be seen in the context of the central bank’s primary objective, which is inflation. And price rises have not been kind to the RBI in recent years, forcing the Monetary Policy Committee to leave the repo rate unchanged at 6.50% for two full years now after it raised it rapidly by a huge 250 basis points in 2022-23. In fact, if one discounts the CPI prints for July and August 2024--when a favourable base effect dragged down inflation below 4%--headline retail inflation has been above the Indian central bank’s medium-term target since September 2019.

Coincidentally, September 2019 was also the month when the central government’s last serious economic reform occurred, when it reduced corporate tax rates. Prior to that came the rollout of the Goods and Services Tax regime in July 2017. And while some would like to count demonetisation of late 2016 as an economic reform, it would not be serious to attach such a label to that scheme.

The narrative of reforms in India over the past five years has largely remained just that—a narrative. While the coronavirus pandemic disrupted corporate plans, the country’s private investment cycle had been showing only tentative greenshoots for years. Companies have long been sitting on large cash reserves, with earnings growth now expected to slow to around 5% in 2024-25 after four to five years of over 20% expansion. The situation has become so pressing that key ministers have repeatedly called on businesses to step up investments over the past couple of years.

In September 2022, Finance Minister Nirmala Sitharaman questioned industry leaders on what was holding back investments. More recently, in November 2023, Commerce Minister Piyush Goyal urged companies to prioritise long-term growth over short-term margins, suggesting they lower prices to stimulate demand.  He dismissed concerns over weakening middle-class consumption, arguing that businesses should focus on expanding market share and sustaining profitability rather than reacting to quarterly fluctuations.

Nomura, in its 2025 outlook for India released earlier this month, noted that demand in the mass segment remains subdued due to sluggish real income growth. It also highlighted a recent slowdown in wage growth within the formal sector.

The Indian economy is stuck in a vicious cycle of sorts: with income growth weak, consumption for non-premium goods and services can’t really grow, with high food inflation making matters worse and reducing discretionary demand further. And as companies notice weak demand for their products, there is little incentive to invest in expanding capacities. It is little surprise then that the sectors which have seen heavy private investment are the ones where public capital expenditure has been the heaviest: infrastructure.

With the reform process seemingly shuddering to a halt five years ago, growth seems to be cooling too, but structurally, with corporate confidence taking a further hit from rising global uncertainty. What policymakers need to avoid is a quick-fix in the form of an interest rate cuts by the central bank. While lower interest rates may spark some firm-level investment activity, from a macroeconomic perspective it is the real interest rate that determines investment, as per an RBI study from August 2013. And for real interest rates to be durably low, inflation must be so too.

The Monetary Policy Committee will meet less than a week after the 2025-26 Budget is presented in Parliament. While it may finally lower the repo rate then, we should be under no illusion that a 25-basis-point rate cut will somehow spark a growth revival; that hinges on what the government announces on February 1.