Indian Growth Conundrum, Navigating the Gap Between Resilience and Potential

Indian Growth Conundrum, Navigating the Gap Between Resilience and Potential

The global economic landscape in late 2025 is characterized by cautious pessimism. With a weak growth outlook and persistent geopolitical and trade uncertainties, central banks across major economies are leaning towards accommodative monetary policies to stimulate activity. Against this backdrop, India’s economy stands out for its remarkable resilience, posting a robust real GDP growth of 7.8% in the first quarter of FY26. However, beneath this impressive headline figure lies a more complex and nuanced reality. A deeper analysis reveals lurking concerns—from subdued nominal growth and weak monetary transmission to one of the highest real interest rates among peer economies. This creates a critical policy conundrum: is India settling for growth below its true potential, and what must be done to ensure that hard-won structural reforms translate into sustained, high-powered expansion?

This article delves into the dual narrative of India’s economic performance, exploring the sources of its resilience, the hidden vulnerabilities, and the imperative for a coordinated policy response to bridge the gap between current growth and potential output.

The Global Context: A Shift Towards Accommodation

The international economic environment is softening. In response, central banks are cutting rates. The US Federal Reserve, despite retail inflation hovering at 2.9% in August (above its 2% target), reduced its policy rate by 25 basis points (bps) in September, bringing it to a range of 4.0-4.25%. This decision signaled a heightened concern for emerging weaknesses in the labor market over transient inflationary pressures. Market expectations point towards two more rate cuts in the US before the end of 2025, with the easing cycle potentially extending into 2026.

This global pivot towards accommodation provides a favorable external context for India. Lower interest rates in developed markets can ease pressure on the Indian rupee and potentially attract foreign investment. However, this same global softening also implies a potential setback for India’s external demand, as key export markets like the US and Europe experience slower growth.

India’s Resilience: Strong Fundamentals and Timely Stimuli

Despite these global headwinds, India’s domestic economic momentum has remained sturdy. The Q1 FY26 GDP growth of 7.8% has instilled confidence, with agencies like Fitch Ratings upgrading India’s FY26 growth forecast to 6.9%. This resilience is underpinned by several key factors:

1. Strong Agricultural Outlook: The first advance estimates project a record foodgrain production of 362.5 million tonnes for the 2025-26 crop year, a 3.4% increase over the previous year’s high. This bumper harvest, fueled by an above-average southwest monsoon, ensures rural demand remains stable, keeps food inflation in check, and boosts farmer incomes.

2. GST Rationalization as a Demand Catalyst: The significant rationalization of the Goods and Services Tax (GST) structure, effective September 22, 2025, acts as a powerful stimulus. By reducing tax rates on a wide range of goods, the government has effectively put more disposable income in the hands of consumers and lowered costs for businesses. This injection of demand, timed just before the festive season, is expected to largely offset any weakness in external demand.

3. Structural Reform Legacy: As argued by the author, the economy’s resilience is not accidental but has been “assiduously built over the last decade by pursuing several structural reforms,” including the insolvency code, GST itself, and a focus on digital infrastructure.

The Lurking Concerns: Behind the Spectacular Headline

However, a closer examination of the data reveals several areas of concern that threaten to cap growth below its estimated potential of 7.75%.

1. The Nominal vs. Real Growth Paradox:
The most significant red flag is the stark divergence between real and nominal GDP growth. While real GDP grew at a spectacular 7.8% in Q1 FY26, nominal GDP growth was a meager 8.8%—one of the lowest rates since the COVID-19 crisis. This discrepancy is largely attributed to an unusually low GDP deflator growth of just 1%. The GDP deflator, a broad measure of inflation across the economy, is composed roughly of 25% Consumer Price Index (CPI) inflation and 75% Wholesale Price Index (WPI) inflation. With WPI inflation having entered positive territory (0.52% in August) after a period of being low or negative, it suggests that the disinflationary trend may have bottomed out. If the GDP deflator rises towards more normal levels, the spectacular real GDP growth will mathematically decelerate, even if the underlying economic activity remains strong.

2. Fiscal and Corporate Sector Implications of Low Nominal Growth:
Low nominal GDP growth has serious consequences. It adversely affects the government’s fiscal arithmetic, as tax revenues are linked to nominal, not real, growth. Furthermore, the corporate sector’s sales growth was subdued in Q1 FY26. The eye-catching Gross Value Added (GVA) growth of 7.7% may be subject to downward revision due to large statistical discrepancies, particularly in manufacturing growth.

3. The Problem of Weak Monetary Policy Transmission:
The Reserve Bank of India (RBI) has cut the repo rate by 100 bps in the current cycle, yet the benefits have not fully percolated to borrowers. Transmission to lending rates has slowed, especially after the RBI shifted to a neutral policy stance in June 2025. Some banks have even raised lending rates in certain segments. Large corporations continue to prefer cheaper external commercial borrowings (ECBs), and the yield on the 10-year government security has been trending upwards since May 2025, making government borrowing more expensive. This weak transmission negates the stimulative intent of rate cuts.

The Core Challenge: Excessively High Real Interest Rates

The central thesis of the analysis is that India’s real policy rate is too high. The real interest rate is the policy rate minus the current inflation rate. As the provided table illustrates, India’s real policy rate stands at 3.4% (5.5% repo rate – 2.1% CPI inflation). This is significantly higher than that of major economies:

• USA: 1.10-1.35%

• United Kingdom: 0.2%

• European Union: 0.15%

• Japan: -2.2%

Even compared to emerging market peers like Malaysia (1.5%), India’s cost of capital is substantially higher. With inflation “extremely benign” and expected to remain so due to the bumper harvest and GST cuts, the RBI has a clear window of opportunity to support growth more aggressively. The author argues that unlike the Fed or the Bank of England, which are still balancing growth with above-target inflation, the RBI is “unequivocally positioned to support growth.”

Policy Imperatives: A Call for Action

Settling for growth between 6.5% and 6.75% in FY26 would represent a “lost opportunity” for an economy with a potential of 7.75%. The fiscal stimulus provided by income tax breaks and GST rationalization risks being wasted if the manufacturing sector refrains from making capital investments due to high real interest rates. For a sustained investment cycle to take hold, the cost of capital must be conducive.

Therefore, the policy prescriptions are clear:

1. An Immediate Rate Cut: The Monetary Policy Committee (MPC) should consider a 25 bps repo rate cut in its upcoming October meeting. This would signal a renewed focus on growth.

2. Dovish Forward Guidance: The RBI should provide clear communication that further rate cuts are on the table if inflation forecasts remain comfortably below the 4% medium-term target.

3. Ensure System Liquidity: To accelerate the transmission of rate cuts to actual lending and yield rates, the RBI must maintain ample liquidity in the banking system. A liquidity deficit can impede the flow of cheaper credit.

Conclusion: Seizing the Moment

India stands at a pivotal moment. It has navigated global turbulence with impressive fortitude, supported by strong fundamentals and timely fiscal measures. However, macroeconomic management cannot be complacent. The hidden vulnerabilities of low nominal growth and weak transmission, compounded by one of the highest real interest rates among comparable economies, threaten to keep the economy performing below its potential.

The onus is now on policymakers to be proactive. A coordinated effort, combining continued fiscal prudence with a more assertive growth-supportive monetary policy, is essential. By cutting rates and ensuring liquidity, the RBI can empower businesses to invest, ensuring that the demand stimulus from GST reforms translates into a virtuous cycle of investment, job creation, and sustainable high growth. The resilience has been built; it is now time to leverage it fully and seize the opportunity to unlock India’s true economic potential.

Q&A Section

Q1: What is the key difference between India’s real GDP growth and nominal GDP growth in Q1 FY26, and why is it significant?
A: In Q1 FY26, India’s real GDP growth was a strong 7.8%, but the nominal GDP growth was only 8.8%. The significance lies in the reason for this gap: an unusually low GDP deflator (a measure of economy-wide inflation) of just 1%. This is concerning because nominal growth, not real growth, is the base for tax revenues and corporate earnings. If the GDP deflator rises to a more normal level, the high real GDP growth rate will automatically decelerate, potentially revealing weaker underlying momentum.

Q2: Why has the RBI’s 100 bps rate cut not fully benefited borrowers in India?
A: This is due to weak monetary policy transmission. The process of banks passing on rate cuts to lending rates has slowed down, particularly after the RBI adopted a “neutral” stance in June 2025. Factors contributing to this include banks potentially raising rates in some segments, large corporations opting for cheaper foreign borrowing (ECBs), and rising government bond yields, which make overall borrowing more expensive.

Q3: What is the “real interest rate,” and why does the article argue that India’s is too high?
A: The real interest rate is the policy interest rate (repo rate) minus the current inflation rate. It represents the true cost of borrowing. India’s real policy rate is 3.4% (5.5% repo rate – 2.1% inflation). The article argues this is too high because it is significantly above the rates in major economies (like the US and UK) and peer emerging markets (like Malaysia). A high real rate discourages investment by making borrowing costly, which can stifle economic growth.

Q4: What specific action does the author recommend for the RBI’s upcoming policy review?
A: The author recommends that the RBI’s Monetary Policy Committee (MPC) cut the repo rate by 25 basis points in October. The justification is that with inflation “extremely benign” and expected to remain low due to a bumper harvest and GST cuts, the central bank is unequivocally positioned to prioritize supporting growth over controlling inflation.

Q5: How does the article view India’s projected growth of 6.5-6.75% for FY26?
A: The article views this projected growth as a “lost opportunity.” While respectable in a global context, it is considered below India’s estimated potential growth rate of 7.75%. The author argues that with the right policy mix, particularly a more accommodative monetary policy, India should not settle for growth below its potential, especially after a decade of structural reforms that have built a resilient economic foundation.