After a period of higher-than-potential growth, the Indian economy has slowed in the past six months. High food inflation has eaten into consumer spending, while public capital expenditure has slowed.
Falling food inflation should allow the Reserve Bank of India (RBI) to start its rate cut cycle in February. While we expect the 2025/26 budget to stay on the fiscal consolidation path, the negative impulse should be smaller than in 2024/25.
Weaker growth momentum and high valuations will likely put downward pressure on equities in the near term but monetary easing should support local rates and sequential growth in the second half of 2025. We expect the RBI to allow some more depreciation of the rupee this year.
Slowing economy in the past six months
India’s third-quarter GDP growth at 5.4% year-on-year came in significantly below market expectations and second-quarter growth (6.7%). Since then, industrial production has rebounded somewhat, while consumption indicators have been mixed.
Rural consumption indicators such as motorcycle and scooter sales have improved in the past couple of months but passenger vehicle sales have not fared as well, suggesting that urban consumption remains weak. Rural consumption has been supported by improved agricultural conditions, while the manufacturing sector has been relatively weak.
On the investment side, slower public capital spending has been one of the main factors behind weaker growth. Private investment has not picked up either as credit growth already peaked in the first half of 2024.
High food inflation has contributed to weaker urban consumption and has driven the headline CPI inflation to the upper end of the RBI's target range (4% plus or minus 1.5%). Severe weather patterns have pushed up vegetable prices and food price inflation peaked in October at 9.7%.
Given that the share of food in India’s CPI basket is relatively high at around 50%, the RBI has kept its policy rate on hold even if core inflation was quite low for the whole of last year. While core inflation was at 3.6% in November (and averaged 3.4% for 2024), food inflation remained high at 8.2%.
RBI to start its rate cut cycle in February
We expect food price inflation to continue its decline as harvests normalise and base effects kick in. Falling food inflation should allow the RBI to start its rate cut cycle.
In the last meeting of the RBI’s Monetary Policy Committee (MPC), two members out of six already voted for a cut of 25bp. These two members were the new external members that were appointed in October. The MPC also decided to reduce the cash reserve ratio (CRR) by 50 basis points, indicating its dovish bias. We expect the MPC to start its rate cut cycle in the next meeting in February.
A strong US dollar since the elections in November has put pressure on emerging market currencies in general. After managing the rupee tightly for the past two years, the RBI has allowed a slight depreciation but has also spent significant international reserves in defending the rupee. With only a small nominal depreciation, the rupee is now on a strong side in real effective terms. With continued strength in the US dollar akin to the 2022 episode, we expect the RBI to allow some more depreciation this year.
On the fiscal front, the 2025/26 budget will be released on 1 February. We expect the budget to stay on a fiscal consolidation path, but with a deficit reduction that is smaller than in 2024/25. Public capital expenditure will likely remain front and centre, but more programs for job creation would be welcome. Pro-growth monetary and fiscal policy should support a sequential improvement in the second half of this year.
What do these mean for India’s financial markets?
Policy rate cuts should support local rates. Weaker near-term growth momentum will likely put downward pressure on earnings and equities, although the market should continue to benefit from the structural shift of household savings.
The local investor base expanded substantially in 2024. We were cautious on Indian equities last June as we expected regulatory actions to curb the market frenzy especially in options trading.
The regulatory crackdown that started in September, a slowing economy and high valuations (the 12-month forward price-to-earnings ratio of the MSCI India is at 25x) have led the index to correct by 10% from its peak last September. Foreign investors have become more cautious and pulled out from the market in recent months.
However, we expect a pro-growth policy to support a sequential improvement in the second half of 2025 as monetary easing supports local rates, despite weaker growth momentum putting downward pressure on equities.
Mali Chivakul is an emerging markets economist at J. Safra Sarasin Sustainable Asset Management. The views expressed above should not be taken as investment advice.