India’s main macro and financial pitfalls

India’s economic future looks promising. However, the road to this future is a minefield littered with financial and macroeconomic risks. The tremendous importance of food in the average CPI basket of goods means the balance between government intervention and the free market is precarious, and add to that the country’s high reliance on imports of oil and other commodities that expose it to external geopolitical and price shocks. The huge need for investment to attract external companies and achieve the climate transition makes drawing up a balanced budget a constant challenge. Investors should therefore be aware of these and other risks. However, India has already learned a lot from its financial past.

India is one of the most vulnerable countries to climate risks, with food inflation and major fluctuations in food prices due to unsuccessful harvests closely linked to changing weather patterns. Because food accounts for 46 percent of the average Indian CPI basket, this greatly increases the risk of inflation. Core inflation, the less volatile element, accounts for just 45 per cent of total inflation compared to 60 to 80 per cent in other emerging countries.

Potato and onion prices

The prices of perishable food in particular fluctuate enormously at times. In December 2019, the price of onions surged 327 percent due to unexpected heavy rainfall after the monsoon season; potato prices more than doubled in  November 2020 for the same reason; and tomato prices rose 158 percent in June 2022 due to heatwaves and cyclones. Despite the limited share of these three vegetables (2.2 per cent), they accounted for one third to half of the volatility of headline inflation.

The dynamics of Indian inflation are therefore different from those in other countries. The Reserve Bank of India (RBI) cannot ignore the temporary hikes in food (and fuel) prices. Its inflation target therefore relates to headline inflation. “Food price increases could spill over into higher core inflation mediated by rapidly rising household inflation expectations,” explains the IMF in its country report[1]. Moreover, it is easier to communicate monetary policy when based on headline inflation rather than core inflation. “Food is a very politically sensitive commodity,” says Amitabh Dubey of GlobalData.TSLombard . "If food prices are too low, the farmers are dissatisfied. When they are too high, consumers become disgruntled."

Flexible inflation target

Officially it applies a 4% target to headline inflation. In practice, the RBI is trying to stabilise core inflation – where interest rate policy has the most impact – at 4%, and in addition, it applies an inflation tolerance range of a 2 percentage point increase or decrease. This can be used to absorb any price shocks. “Better control of supply, such as selling buffer stocks at subsidised prices, can help,” says Shumita Deveshwar of GlobalData.TSLombard. In 2021, India imposed export prohibitions on cereals, sugar and certain types of rice, removed import duties on lentils, and reversed previous increases in excise duties on petrol and diesel. As a result, Indian inflation stabilised in the following quarters whereas it increased in the other emerging countries due to supply issues related to the pandemic. Food inflation in India therefore does not closely follow the trend of global food inflation. “CPI inflation should average 4.5% in FY25, despite the continued strong growth momentum,” says Deveshwar. “This will boost confidence among global investors that the RBI can effectively contain inflation.”

According to academic research, the introduction by the RBI of a flexible inflation target in 2016 already led to better anchoring of inflation expectations and a more predictable monetary policy. The credibility of the monetary policy was further enhanced by the appointment of 3 external (non-RBI) members to the 6-member Monetary Policy Committee. The result? India is one of the few low and middle-income countries where the frequency of monetary policy surprises has decreased in recent years, which undoubtedly benefits the country's financial stability.

According to academic research, the introduction by the RBI of a flexible inflation target in 2016 already led to better anchoring of inflation expectations and a more predictable monetary policy. The credibility of the monetary policy was further enhanced by the appointment of 3 external (non-RBI) members to the 6-member Monetary Policy Committee. The result? India is one of the few low and middle-income countries where the frequency of monetary policy surprises has decreased in recent years, which undoubtedly benefits the country's financial stability.

A war chest of forex reserves

This financial stability is also boosted by a large war chest of foreign exchange reserves. According to the Guidotti-Greenspan rule, countries must hold sufficient foreign currency reserves to cover their foreign liabilities maturing within twelve months and all of the current account deficit. While India's external debt is low, it does have a current account deficit (and a substantial budget gap, but more on this later). By holding a buffer of currency reserves, India ensures that it can continue to pay for imports of essential goods and services. At the end of 2023, India's forex reserves covered more than 11 months of imports. A figure above 8 months is considered comfortable.

Forex reserves are also used to stabilise the currency against the currencies of major trading partners such as the US dollar. If the rupee weakens too quickly, this increases the risk of inflation and undermines trust in the currency, which can lead to a negative spiral. Financing of private sector investments in dollars – often due to lower US interest rates – is detrimental to Indian or foreign companies in India because of the reimbursement in a currency that is suddenly worth less. Between December 2019 and November 2022, the Indian rupee weakened from 70 to 82 rupees per dollar. Since then, the rupee has hovered at this level, thanks to regular interventions by the RBI. The IMF has labelled this a 'stabilised arrangement' exchange rate regime instead of a 'floating currency'. Obviously, the recent peak in global interest rates has also helped. A US long-term interest rate of 5% for one year or 5 years: this also makes a world of difference.

But going back to the current account: in the early 90s, this increasing deficit was one of the drops that made the already full bucket – which already included high external debt and budget gap – overflow. In 2023, this current account deficit fluctuated around 1.2 per cent. The IMF estimates the CA deficit will be 2.3 per cent of GDP by 2029. A current account deficit indicates that a country is importing more than it is exporting, meaning more is paid to other countries than it is receiving. “The doubling of service exports has structurally improved this deficit,” says Anubhuti Sahay, chief economist for South Asia economic research at Standard Chartered Bank. "Before the pandemic, service exports stood at 6 to 7 billion dollars per month. Today, this figure fluctuates between 12 and 14 billion. Despite the sharp rise in oil prices, the CA deficit therefore remained under to 2 per cent. This rose to over 4 per cent when oil prices previously increased in 2013."

Lower oil import costs... thanks to Russia

“An oil price that hovers above 100 dollars per barrel for 3 to 4 years remains one of the greatest risks for India,” says Sahay. Oil imports are a very important component of net import flows. “India’s growing dependence on imported energy can be explained by the country's strong growth and its large and growing population,” adds Deveshwar. “India's import dependence of crude oil soared to 87%, making it very vulnerable to external shocks.”

India currently is the third largest consumer of oil in the world and is therefore doing everything it can to reduce this cost. Even if this means trading with the Russians. According to data from Kpler and Vortexa, two data platforms for commodity traders, India has benefited significantly from the sharp discounts on Russian oil and is buying at prices below the cap of 60 dollars per barrel imposed by the West. The share of Indian oil imports from Russia rose from 1 per cent in 2021 to more than 40 per cent in mid-2023. Currently India is the second largest importer of Russian oil after China. According to The Economist, the discount on Russian oil fell in 2023 from 20% at the start of the year to 5% in December. With India’s oil imports worth $181 billion and accounting for more than a quarter of the country's total imports, even those savings are significant.

Increasing oil dependency

The Indian government ordered domestic oil processors to leave the price of diesel and naphtha unchanged in 2022 despite the rising international oil prices caused by the Russian invasion of Ukraine. As a result, it escaped fuel inflation, which caused disaster in neighbouring Pakistan and Sri Lanka. In the run-up to the elections, retailers reduced fuel prices for the first time. Less expensive oil also provides more budgetary margin for the BJP due to the shrinkage of fuel subsidies, allowing it to extend a popular subsidy for LPG by one year.

India is currently benefiting from the fall in oil prices, but its oil dependency will only continue to increase. According to the International Energy Agency, growth and urbanisation will push up oil consumption by 20% by 2030. The majority of this oil, which is processed in India and then increasingly re-exported (including to the West), continues to be primarily sourced from Russia and the Middle East. These are both geopolitically sensitive regions. Investment in renewable energy is one way to reduce this dependency, and India has earmarked 2.6 billion dollars for this in its budget. But this is a pittance compared to the 200 billion dollars per year that the CEEW think tank estimates India needs to deliver on the net-zero promise by 2070.

Interest expense has an impact on Indias budget

The oil price also influences the budget gap through energy subsidies. This – combined with the relatively high government debt – is a parameter that is closely monitored abroad especially in view of interest rates which rose from 4% to 6.5% between early 2022 and early 2023. A sharp peak in food prices in August 2023 – yet again – means that interest rates remain high even today. “The RBI’s concern that these high food prices will translate into higher wages means that it is not yet immediately inclined to cut interest rates,” says Deveshwar. “On the other hand, this shores up the RBI's credibility.”

Mint, an Indian business and financial daily, recently compared the new budget to that of 1947, just after India’s independence. Defence expenditures accounted for the largest share at the time, at 47%, followed by subsidies for imported food (11%) and refugees (11%). Today, interest payments (20%) are the single biggest item of the government’s expenditure, followed by defence (8%) and subsidies (7%).

Financing the climate transition

India’s debt-to-GDP ratio peaked at 88.5% in 2020/2021. However, India is aiming for a debt-to-GDP ratio of 60% (40% for the central government and 20% for the states). The pandemic put a spanner in the works, with government debt rising by 13 percentage points in just 1 year. From 2014 until 2019, government debt was already on the increase, from 64% to 75%. The Indian government managed to shrink the budget gap to 9% of GDP. However, the significant loans that states and the government have guaranteed to state-owned companies, or, as in the past, bailouts of state-owned electricity companies require vigilance. The electricity tariffs that electricity companies charge are not reflective of the market as a result. “If these risks are realised, this would raise gross financing needs to more than 20% of GDP and debt ratio would rise to 88% of GDP,” warns the IMF. Currently, India's government debt stands at 81%, one of the highest debt ratios of all emerging countries.

The target budget gap for FY2025/2026 is 7.5%. This should ensure that government debt eases gradually to more comfortable levels. The IMF forecasts a government debt of 77.5% for 2029. Slow and steady, but then India's financial needs – capital investments, subsidies, climate transition, etc. - are huge. India’s public and private spending to meet the Sustainable Development Goals in the areas of health, education, water and sanitation, electricity and roads alone is estimated at 6.2 per cent of yearly GDP per annum[1]. The investments required to achieve net zero by 2070 are estimated to be in the range of 4 to 8% of GDP[2]. “If India would finance climate investment with the current blend of financial instruments, debt would rise to more than 130 per cent of GDP and annual finance needs to be 27 per cent of GDP per annum,” according to the IMF's sobering analysis . This once again underscores the message of the previous episode: India urgently needs help for its climate transition.

Increasing revenue through formalisation

However, as India's economy becomes more formalised, the budgetary risk decreases. India's gross tax revenue surged 19.2% year-on-year during the first 8 months of FY24. “The impressive 24.8% increase in corporate and personal income taxes stands out in particular,” according to my colleagues from BNP Paribas, "which means that 81% of the full-year target has already been achieved. The strong increase in tax revenues reflects the strong macroeconomic momentum and the administrative measures to increase compliance, especially through digitalisation and improvements to the Goods & Services Tax (GST)."

Monthly GST revenues are now around 500 billion Rupees higher than before the pandemic. The government has ensured that there are virtually no charges for digital payments. Even the smallest street merchants have embraced them, ensuring this payment flow is now also traceable. “Micro-enterprises are now registering for the GST, the tax base is broadening, and formalisation continuing.” This is necessary, because to date just 65 million Indians paid taxes.

Inflows from international financial markets

Not only are tax revenues rising, capital inflows are also increasing. After decades of shielding itself from the global bond market, the improved macroeconomic conditions, the need to attract funds for public capital investment [infrastructure works], and a record amount of loans, have finally prompted the Indian government to seek more financing in the international financial markets. The trauma due to high foreign debt – 30% of GDP in 1991 – just before the country’s near-bankruptcy took time to heal.

“This requires a very cautious approach,” explains Sahay. "It’s not something that the government and the RBI are keen to dive straight into. In the past, the government and the RBI mulled slowly opening up the Indian capital account to foreign investors, which always coincided with black swan events in the financial markets (eg. Global Financial Crisis, the taper tantrum with rising interest rates in the US due to tapering of its quantitative easing policy). The intention is for the Indian economy to have a solid foundation before going down this path in a big way."

Inclusion in global bond indices

This foundation is now in place. “The RBI has finally allowed foreign investors to buy unlimited amounts of specific government bonds since March 2020,” says Deveshwar. “This means that these bonds can now be included in global bond indices and India now has a weightage in them.” Inclusion in the indices will follow in June.

In anticipation of this, foreign capital inflows reached a multi-year peak in January and February. “The flip side of the coin is that the inclusion of Indian government bonds in the major institutional bond indices and benchmarks means investors will be monitoring fiscal and monetary policy even closer,” says Deveshwar. “India does not have much margin for error with its BBB- rating, the lowest creditworthiness just above 'junk'.” The government will have to engineer a further gradual improvement in macroeconomic and financial fundamentals, allowing the international inflow of money to become a large and stable source of financing."

Job creation

Despite all these threats, job creation remains the greatest challenge to India’s future. However, the industrial approach that can guarantee a good future does not always match the short-term needs of the country's rural population. The next government must succeed in making progress, even if the road is bumpy, by giving and taking. If it fails in this endeavour, unemployment will increase and many young people risk remaining disillusioned and frustrated. This is a breeding ground for extremism.

The huge opportunity that awaits India in the next 25 years is unique. The active population of 20-64-year-olds will peak in 2050. The dependency ratio – the number of under 25s and people aged 65 and over in relation to this working population – will start to increase from 2040. By then, India will have to have taken a tremendous leap forward with the development of a robust social security system. Otherwise, India will turn into an ageing society by 2050 before becoming a rich country. 

This is the doomsday scenario. The ideal path, however, is paved with well-paid industrial jobs for the nearly 200 million additional workers in the next 25 years and the 100 million workers who want to leave the agricultural sector. This guarantees a rapidly rising middle class, a rise in consumption and shrinking inequality. International companies need to be drawn in. For now, they are still adopting a wait-and-see attitude due to sizeable challenges in India's logistics and some important 'big bang' reforms that absolutely still need to be implemented. The latter in particular, the changes to agricultural, land and labour laws, are the keys that will unlock and throw open the door for Western investors. After the pause in the reform agenda in recent years, it is up to the next government to revive this momentum, paving the way for the creation of prosperity for current and future generations.

[1] Garcia-Escribano and others, 2021

[2] Ghosh et al., 2023.

[1] India 2023 Article IV Consultation, IMF Country Report No. 23/426 December 2023