India’s economy is the sixth largest in the world based on GDP at constant prices in 2015 US dollars. The IMF projects it will grow around 6% per annum over the next five years, a faster pace than other BRIC nations.
Given the strength of the services sector and the high level of consumer optimism in India, private consumption appears well placed to drive growth again in fiscal year 23-24.
Furthermore, the Reserve Bank of India (RBI) believes banks and private companies have healthy balance sheets, while supply chain normalisation, business optimism and robust government capital expenditures are additional factors supportive of a renewal of the capex cycle.
A further tailwind to growth comes from the government’s Production-Linked Incentives (PLI) scheme which was introduced in 2020. This scheme proposes financial incentives over five years to boost domestic manufacturing across 14 key sectors. Since the PLI’s introduction, fixed capital formation in India accelerated beyond its 2011-2018 trend implied level. Further acceleration is possible in 2024 as protectionist policies, such as the impending import restriction on laptops and tablets, are implemented to encourage domestic production.
However, while protectionist policies can raise demand for domestic products in the short run, in the longer run they are more likely to reduce aggregate demand due to market inefficiencies which increase costs for consumers. The result could be a slower pace of GDP growth due to weaker aggregate demand.
Turning to monetary policy, India adopted a flexible inflation targeting framework in 2016, formalising price stability as the primary policy objective. The RBI targets CPI inflation at 4% with a 2% tolerance band either side of the target.
Food accounts for around 46% of the CPI basket in India, making it an important determinant of inflation. Since food prices are more vulnerable to supply shocks than other goods and services, having a credible inflation target to anchor both inflation and inflation expectations is important.
Without such a target, long-run inflation expectations can drift due to supply shocks, on which monetary policy has little impact. If long-run inflation expectations are stable, supply shocks are less likely to lead to second-round effects and more likely to manifest themselves as one-off changes to the rate of inflation, i.e. they become transitory.
The RBI expects price increases to peak in the second quarter of the fiscal year at 6.2% before falling towards the midpoint of the inflation target over the next year. Monetary policy is therefore likely to remain restrictive for the remainder of 2023 to maintain the credibility of the inflation target. Interest rate cuts are possible in 2024 in the absence of further shocks.