What GDP data doesn't show: Structural weakness and real living standards

Business Standard March 18, 2025

The latest GDP data shows India’s economy is recovering, with growth rising from 5.6 percent in July-September to 6.2 percent in October-December, and an estimated 7.6 percent in January-March. At this pace, India is set to become the world’s fourth-largest economy. However, before we start celebrating, we need to examine the economic situation more carefully. Upon doing so, we’ll find significant weaknesses, indicating that substantial policy work remains.

For a start, investment remains too weak to drive rapid growth. In 2024-25, real investment is expected to rise by a mere 6 percent, trailing economic expansion. In contrast, investment during the 2004-2007 boom grew by 15 percent annually, accounting for 40 percent of GDP. Now, it stands at just 33 percent.

Even more concerning, the supposed growth acceleration disappears when considering long-term trends. For 2024-25, growth is expected to be 6.5 percent, significantly lower than the 8.8 percent average post-Covid. This is corroborated by high-frequency indicators, including slower retail sales, declining credit growth, weak corporate earnings, poor goods exports, a drop in net foreign direct investment, and a sharp fall in core inflation.

To understand the current state of the economy, we must look back a few years. Before Covid, growth had fallen below 4 percent, with the economy in poor shape. The unorganized sector struggled due to Demonetisation and poor GST implementation, while the organized sector was still recovering from excessive borrowing during the boom. Many of these issues remain unresolved. However, after Covid, they were less visible because the economy was boosted by several temporary factors.

One such factor was the normalization of activity as people returned to work and households resumed spending after the lockdown. The consumption revival was fuelled by a surge in retail credit, which grew at an annual rate of around 20 percent for several years.

A second factor was the government’s infrastructure push, with spending growing at an average rate of 30 percent between 2021-22 and 2023-24, further boosting the economy.

The most important factor, however, was the rise of a "New Economy." The growth of Global Capability Centres (GCCs) set up by multinational companies led to a remarkable 65 percent increase in service exports over the three years ending in 2023-24. The windfall income of nearly 2 million GCC workers was spent on SUVs and luxury real estate, sparking booms in the auto and construction sectors, with the latter growing in double digits in real terms in the three years ending 2023-24.

Table: Ranking of select countries based on real GDP per capita

Over the past year, these temporary factors have faded. The boost from the economy’s reopening disappeared, and as fiscal constraints tightened and diminishing returns set in (e.g., from building airports in smaller cities), the government reduced infrastructure spending. Service export growth also slowed to under 10 percent between April-June 2023 and April-June 2024 as the GCC expansion levelled off.

In other words, conventional wisdom is mistaken. The post-Covid boom was the anomaly, while the recent slowdown represents a return to normal—a reversion to the economy’s long-term growth rate, which has averaged around 6 percent since 1991.

We need to ask: would a long-term growth rate of 6 percent be enough to meet the country’s needs? It’s hard to believe it would. Even recent above-trend growth hasn't created enough jobs. There are deeper, structural issues that may suppress demand longer than expected. According to the Centre for Monitoring the Indian Economy, only 420-430 million of India's 1.1 billion working-age people are in the labor force, either employed or seeking work. While the working-age population has grown, the labor force has not, causing the participation rate to drop from 46 percent in 2017-18 to 40 percent in 2023-24. Only a small portion of those in the labor force have formal sector jobs, highlighting a serious jobs crisis. Middle-class Indians have also faced stagnant nominal wage growth, with average inflation of 5 percent often leading to declining real wages, which weakens demand.

India has also not made enough progress in improving living standards. While the country has climbed international rankings, the progress remains slow. In 1980, India ranked 142nd in real GDP per capita out of 167 countries. Twenty years later, it moved up to 124th, and another 20 years later, it reached 109th. However, this still places India far behind most other economies.

Ultimately, the size of the economy as given by GDP and its post-Covid growth rate are misleading. What truly matters is the long-term growth rate as it will determine how quickly per capita incomes reach comfortable levels. The urgent need now is a strategy to accelerate growth—a plan that tackles the country’s deep structural issues, enabling the economy to take off sustainably and for good.

Inflation vs Exchange Rate: RBI’s conflicting objectives

Business Standard February 18, 2025

Since November 2024, the Reserve Bank of India (RBI) has allowed the rupee to weaken against the US dollar, ending the effective peg that it had maintained for nearly two years. However, it has continued to intervene in the foreign exchange (FX) market to limit the rupee’s decline, keeping it the least volatile major currency in Emerging Asia with a modest 3 percent depreciation. This has, however, strained monetary policy and tightened liquidity at a time when the economy is weak and needs support.

To understand how this has happened, we must examine the link between monetary policy, currency management, and liquidity. The rupee weakens (or the dollar strengthens) when dollar supply in the FX market falls short of demand, such as when India's diminishing growth prospects discourage capital inflows. To counter this, the RBI can sell dollars from its FX reserves, preventing or even limiting rupee depreciation. However, it does not give dollars for free; it sells them for rupees. This absorbs rupees from the system, thereby tightening monetary conditions.

The RBI conducts this transaction with banks. When a person asks a bank to exchange Rs 1 lakh for dollars, the bank typically goes to the FX market, finds a seller, and matches the buyer with the seller. In this case, the bank acts as an intermediary, profiting from the spread between the buying and selling rates.

However, when a bank gets dollars from the RBI, the process changes. The bank must provide Rs 1 lakh to pay for the dollars, but its assets mostly consist of loans and government securities. Only a small portion of bank deposits is held at the central bank due to the CRR (cash reserve ratio) mandate. This is what the bank uses to pay the RBI when the latter sells dollars. This means when banks buy dollars from the RBI on a large scale, their balance at the RBI can fall short of requirements, causing their liquidity to tighten.

This is exactly what has been happening. For most of the past few years, the banking system had a healthy liquidity surplus. However, over the past few months, the RBI has sold large amounts of dollars, causing its FX reserves to drop sharply from USD 704 billion in September 2024 to USD 630 billion in January 2025. As a result, domestic banking system liquidity has shrunk, and the system is now in a large deficit, around Rs 1-2 lakh crores.

To address this, the RBI has taken two approaches. On a daily basis, it has been lending funds to the banks. It has also repeatedly engaged in open market purchase operations, buying government securities from banks to replenish their deposits at the RBI. These actions have ensured that banks have the necessary funds to conduct their business. However, this does not mean the RBI’s FX intervention has been without consequences.

This is evident in the graph below, which shows the difference between the weighted average call rate (WACR) and the RBI’s policy repo rate. The WACR reflects banks' borrowing costs in the overnight interbank market. When banks have a liquidity surplus, the WACR goes below the repo rate, resulting in a negative spread. However, as liquidity has tightened, particularly since November 2024, the spread has become positive, indicating that banks facing a cash shortfall have struggled to secure the necessary funds.

Figure 1: Spread between weighted average call rate (WACR) and repo rate (Source: RBI)

This matters because the RBI has now signalled its intention to ease monetary conditions. On February 7, the central bank lowered the repo rate, citing weaker inflationary pressures and slowing growth. However, just days after the cut, the RBI conducted a massive FX intervention to prevent the rupee’s depreciation. Though FX intervention data is released with a lag, anecdotal evidence suggests the RBI sold between USD 7 to 11 billion in only two days. This action tightened monetary conditions and raised the WACR.

In effect, the central bank has been sending mixed signals. Is the RBI truly committed to ease monetary conditions – or not? It is difficult to decipher from its actions.

For banks, the message is clear: as long as the RBI keeps liquidity tight and interbank lending conditions remain strained, they will be hesitant to lower their own interest rates. This reluctance means the RBI's repo rate cut will not get transmitted to the rest of the economy, and the monetary stimulus will fail to materialize. In short, the RBI's exchange rate management strategy is undermining the effectiveness of its monetary policy.

The law mandates that the RBI's primary objective is maintaining price stability, keeping an eye on growth. It does not mention managing the exchange rate. It is time for the central bank to focus on managing inflation and growth, allowing the exchange rate to adjust based on fundamental factors.

Union Budget 2025-26: Many small measures but lacks big ideas

Union Budget 2025-26: Many small measures but lacks big ideas, Ideas for India, Feb 5, 2025.

Budget 2025: Balancing reforms and fiscal consolidation to revive growth

Business Standard January 21, 2025

In less than two weeks, the Finance Minister will present the Union Budget for 2025-26. The budget will be presented against the backdrop of a slowing economy characterised by high levels of fiscal deficit and debt. That means the FM will have to find a way to announce policy initiatives to revive growth while also achieving fiscal discipline. While calls for tax cuts and increased infrastructure spending are loud, this Budget must do a lot more to drive sustained growth.

The two key questions are: What is the diagnosis of the economic slowdown? And what can the Budget do to address it?

Let's tackle the question of slowdown first. The consensus is that the slowdown is temporary, but data suggests otherwise. Barring one quarter, the economy has been slowing steadily since mid-2023, with real GDP growth rate falling from more than 8 percent to under 6 percent in just a year. High-frequency indicators also show that the post-Covid growth momentum is fading, possibly signalling a deeper, structural slowdown.

Before Covid, the economy was already struggling, growing at less than 4 percent in Q4 2019. Post-Covid, many high frequency indicators pointed to the emergence of two different economies within one: an "Old economy" in middle and rural India, and a "New economy" driven by a boom in service exports. The latter was fuelled by the rise of global capability centres (GCCs), mainly US-based, employing high-skilled Indian workers in sectors like Research and Development. The New economy boosted luxury consumption, like SUVs, and sparked a mini-boom in construction. In comparison, the Old economy has been weaker from even before the pandemic, the result of low private sector investment and weak goods exports. Workers in the Old economy have also been getting battered by high food inflation and falling real wages. And now, the New economy is slowing down too, normalizing to a more moderate growth pace. Together, these dynamics are creating a serious demand problem.

How should the Budget address this, while also reducing fiscal deficit? Two things are worth considering.

The Budget should focus on rationalizing expenditure to achieve fiscal consolidation. In February 2023, the FM had set a target to reduce the fiscal deficit to less than 4.5 percent by 2025-26, but this will be challenging in a slowing economy with nominal GDP growth under 10 percent. However, lowering the fiscal deficit is essential for macroeconomic stability, which is key for growth. To achieve fiscal consolidation, the government should reduce revenue expenditure, which includes schemes and transfers, and accounts for nearly 77 percent of total spending. For example, why is it important to provide free food grains to 800 million people annually when there is no pandemic emergency any more?

On the issue of growth, there is a lot of clamour for more government spending on infrastructure. While some infrastructure is needed, it is unclear if this alone will boost GDP growth. For sustained economic growth, a revival in private sector investment is crucial, but public infrastructure spending does not seem to encourage this. Moreover, with much infrastructure already built, the marginal benefits of new roads or highways are diminishing. In short, government infrastructure spending might be a blunt tool for stimulating growth when private sector confidence remains low.

Likewise, tax cuts can boost consumption, but given the limited fiscal space, there is little room for widespread cuts. Moreover, large segments of the Old economy, where falling wages and poor job prospects are hurting demand, aren't even in the tax base. As a result, some tweaks here and there with the tax structure are unlikely to make a significant impact.

To facilitate high, sustained growth, the Budget must revive a key element missing from India’s economic agenda: Reforms. Since the rollout of Goods and Services Tax (GST) in 2017, no major reforms have been introduced. Many say that no new reforms are needed since all the key policy initiatives have already been adopted. But this is not true. There is in fact much that needs to be done.

Given the current economic climate, the Budget could propose liberalizing import tariffs, removing non-tariff barriers where import-dumping is not a concern, scrapping Quality Control Orders that restrict the imports of vital supplies to the manufacturing sector, overhauling the tax system (including residence-based taxation to attract foreign investment), further simplifying the GST, eliminating cesses and surcharges, curbing excessive industrial policy so as to create a level playing field for all firms and incentivising states to do land and labour reforms. Long-overdue regulatory reforms should also be prioritized. The conversation around reforms has faded, but now is the time to bring it back.

This Budget must serve as a blueprint for the government’s long-term economic vision, laying out a comprehensive medium-term strategy to restore private sector confidence. Incremental changes to taxes or spending will not be enough to turn the tide, and the economy will continue to struggle. The time is ideal for a "dream budget" akin to the 1991 reforms that sparked high growth and unlocked significant gains in productivity.