India’s GDP grew by 7.8% YoY in Q2 2023, surpassing expectations and marking the highest growth rate in a year. This growth was largely driven by consumption, which contributed to almost half of the overall growth. Additionally, the strong demand has also led to an increase in industrial production, with India’s manufacturing PMI expanding for 25 consecutive months and reaching a high of 58.5 in August. These numbers far surpass those of other Asian countries.
However, there are some concerns related to external factors and inflation. The Indian economy’s external vulnerability, which has been a problem in the past, is growing as the current account deficit decreased to 4.6% of GDP in the second quarter. Furthermore, the heatwave and drought caused by this year’s El Nino climate have severely impacted certain sectors such as agriculture and construction. In particular, the adverse weather conditions have led to higher food prices and a significant increase in headline inflation, reaching 7.4% YoY in July, compared to 4.9% in June. This has resulted in negative real interest rates, which in turn has led to capital outflows and pressure on the Indian Rupee, especially in light of the strong USD.
The Reserve Bank of India (RBI) is faced with a dilemma due to the rebounding inflation. On one hand, the negative real interest rates are affecting capital flows and the currency. On the other hand, there is mounting fiscal pressure after India’s fiscal revenue decelerated sharply in Q2. Consequently, the government has increased its borrowing from the market, pushing up the yield curve. If the RBI decides to hike interest rates, it will further increase the government’s financing cost and debt service, which could potentially impact consumption just before India’s general election in April 2024.
Considering these factors, our baseline scenario is that the RBI will maintain the current interest rates until the next fiscal year, which is Q2 2024. However, it is worth noting that the Federal Reserve should have already begun easing by then. Overall, India’s economy remains strong in comparison to other emerging markets in Asia, largely due to resilient domestic demand. However, challenges may arise from the growing current account deficit and rising inflation, which could put pressure on capital flows and the rupee. Given these circumstances, we do not expect the RBI to react swiftly to the inflationary pressure, particularly considering the weakening currency.