Economic and market scenarios have been changing very fast during the last six years. During the pandemic, India did well. We led from the front to combat COVID, and IT and telecom services, which were in huge demand during the lockdown and Work From Home (WFH). The stock market rallied from the Nifty pandemic low of 7511 in April 2020 to 26216 in September 2024, attracting millions of new investors to the stock market.
Even at the beginning of this year, the Indian economy was in a sweet spot with decent growth, low inflation and macro stability with declining fiscal and current account deficits. Things took a big turn for the worse with the US-Israel attack on Iran and the closure of the Strait of Hormuz, which triggered a totally unexpected energy crisis. This global energy shock impacted big energy importers like India hugely. Fiscal and current account deficits are rising; bond yields are headed north; rupee is depreciating; and inflation is on an uptrend. The macro headwinds are strong. The relevant questions are:
Will this become a perfect storm?
What are the implications for inflation, growth and markets?
Inflation is on the rise globally. This has triggered a bond market sell-off, spiking bond yields. The US 10-year bond yield rose to 4.66 percent recently and the 30-year yield jumped to 5.19 percent, which is a 22-year high. The message from the bond market is that it will be difficult for central banks to contain inflation. Therefore, markets expect interest rates to rise. In India, the 10-year yield rose to 7.15 percent. This will raise the cost of borrowing for the government and the private sector. This will have implications for GDP growth in FY27.
An inevitable fallout of this energy crisis is that India’s fiscal deficit will shoot up in FY27, far beyond the target of 4.3 percent. The cumulative impact of the cut in excise duty on petrol and diesel by Rs. 10 a liter, the rise in fertilizer subsidy, and the expected dip in corporate tax from oil marketing companies has the potential to push the fiscal deficit to about 5 percent of the GDP. This will impair the fiscal consolidation program, which the government has been implementing successfully after the COVID shock. The rise in fiscal deficit will crowd out private investment with negative implications for growth.
Rupee depreciation is an auto correct policy tool
The big talking point in economic and market circles has been the continuous depreciation of the rupee. Rupee which was around 90 to the dollar at the beginning of this year, touched a low of 96.96 on 20th May, making it one of the worst-performing EM currencies. Rupee depreciation will lead to imported inflation and further depreciation expectations can trigger more foreign portfolio capital flight. But it is important to understand that rupee depreciation is not a problem alone; it is part of the solution, too. More expensive dollar will automatically curtail expenditure on imported goods and services like foreign travel. This will be more effective than austerity appeals. Equally important is that currency depreciation will boost exports, thereby helping reduce the trade deficit, the root cause of the problem. Therefore, there is no harm in allowing the rupee to depreciate so long as it doesn’t trigger speculative capital flights, endangering financial stability.
The market has been resilient
Despite the strong macro headwinds, the stock market has been reasonably stable, supported mainly by domestic investment. An important positive trend is visible in the Q4 results, which have turned out to be better-than-expected. Since the market valuations are fair now, a sharp correction appears unlikely. The situation will change if the West Asia crisis aggravates and crude spikes above $140. On the other hand, if the West Asia crisis gets resolved and crude prices drop, it will turn out to be positive for the market.
India can manage this threat, but at a cost
India can withstand these macro headwinds; but there will be a cost in the form of lower growth and higher inflation. India’s success in fiscal consolidation – bringing the deficit down from 9.2 percent in FY21 to 4.4 percent in FY26 – has enabled the economy to largely absorb this shock. But the macro headwinds will depress GDP growth and increase inflation. If crude price remains elevated for an extended period, the hit will be hard. But even then, the crisis can be managed preventing it from developing into a perfect storm. In the worst-case scenario, FY27 GDP growth may decline to 6 percent and CPI inflation may rise to 5.5 percent. The situation calls for debt management from the RBI and the government.
This, too, shall pass
India has weathered many a crisis. The Balance of Payments crisis of 1991 turned out to be an opportunity, which paved the way for ushering in economic reforms. Since then, we weathered the recession triggered by the tech bubble burst of 2000, the Global Financial Crisis of 2008, the taper tantrum of 2013 and the pandemic catastrophe of 2020. Indian economy has the strength to overcome the ongoing energy crisis, too. We will emerge from this crisis and grow stronger.
