Is India’s economic slowdown temporary or sign of deeper shift?

Over the last few months, there has been rising debate on whether monetary policy focus should shift towards growth or maintain a laser focus on inflation. This debate has been triggered by the loss of growth momentum in H1FY25. At the same time, comfort on inflation has reduced with headline CPI breaching the upper threshold of 6% in October. Globally, too, conditions have turned more volatile with persistent FPI outflows and dollar strength maintaining depreciation pressures on the INR.

Against this backdrop, the RBI has two policy paths before it: either to remain on pause or initiate a gradual rate cut. If the RBI remains on pause, its assessment of the loss of growth momentum in H1 FY25 would need to be temporary. If it decides to initiate a gradual rate-cut cycle, the upward inflation pressure will need to be temporary.

So where does the truth reside — is growth transient or is it inflation? As always, the truth lies somewhere in the middle. Some aspects of moderation in growth are transient such as weakness in government expenditure and rural demand. Some aspects are likely to persist, such as moderate urban demand and tentative private corporate capex.

Government capital expenditure, which was a key support to the capex cycle last year, has declined in H1 FY25. The central government capital expenditure has contracted by 15% in H1 FY25 v/s 43% jump in H1 FY24. State government capital expenditure also contracted in H1 FY25 by 13% YoY v/s a 55% jump in H1 FY23. This drastic change in expenditure pattern was likely caused by the shift in focus towards the election. The good news is that capital expenditure is expected to pick up pace in H2 FY25, both for the Centre and state governments.

Indeed, signs are already visible of a pick-up in government expenditure momentum with the sharp reduction in government cash surplus. Overall, the government cash balance has become negative at -Rs 40,450 crore as of November 15, 2024, from a peak surplus of Rs 5.1 lakh crore as of May 24, 2024.

Revival in private corporate capex has remained elusive. Fundamentals remain supportive of healthier banks and corporate balance sheets and rising capacity utilisation in the manufacturing sector. However, uncertainty about consumption demand has kept companies tentative. This is reflected in listed companies' fixed assets declining on a quarter-on-quarter basis in Q2FY25 (RBI monthly bulletin).

Export growth has improved somewhat in FY25 after a very weak FY24. However, the prospects of a revival of tariff wars globally next year, under the new US government clouds the outlook for external demand.

The domestic consumption story was supported by urban demand last year, while rural consumption remained weak. In FY25, the support from urban consumption began to wane, as urban wage growth began to slow from the second half of FY24. The impact of this is visible with consumer goods production growth at just 1.3% in Q2FY25 and a 1.9% decline in passenger vehicle sales. Non-financial listed companies' profit growth declined in H1FY25, with moderation in revenue and input costs holding up. This is likely to keep urban wage growth subdued in the remainder of FY25 and turn urban demand.

The silver lining of the consumption story is expected to be rural demand which was lackluster last year. The relatively better-distributed monsoon this year is expected to result in strong output for both kharif and rabi crops. Some signs of improvement in rural demand are visible with a decline in demand for work under NREGA. FMCG rural sales volume growth has exceeded urban sales for the last three quarters (Q4FY24 to Q2FY25). The pick-up in rural demand is expected to gain momentum in H2FY25, post the harvest.

Taking into consideration the mix of transient and more persistent factors, GDP growth in FY25 is estimated at 6.6% v/s 8.2% in FY24. Growth momentum is expected to pick up in H2FY25, supported by rural demand and a rise in government expenditure.

The relatively better outlook for growth in H2 FY25 provides the RBI with some policy space to assess the durability of inflation pressures. The near-term outlook for headline inflation remains unfavourable due to elevated food inflation. However, in the medium-term food inflation pressures are expected to ease supported by kharif and rabi crop output. Against this combination of growth-inflation outlook, the RBI is likely to take its time to assess the durability of growth and inflation, before taking policy action. We expect a shallow rate cut cycle to start from February 2025 onwards.

(The author is the Chief Economist at IDFC FIRST Bank)