India's Economic Challenge: Unraveling the Inflation Puzzle
The Paradox of Low Inflation: A Growing Concern
As India approaches Budget 2026, a once-celebrated phenomenon has now become a cause for concern. For years, low inflation and robust tax collections were seen as a boon, but now, economists are raising the alarm. The focus has shifted from real GDP to nominal GDP, and this transition could shape India's economic landscape and market outcomes in FY27.
From Disinflation Celebration to Fear
India's recent growth years were marked by a unique fiscal comfort. Despite significant deficits, markets remained calm due to strong tax collections. However, with inflation at historic lows, a critical issue has emerged.
The Broken Assumption
With CPI near 2% and WPI flirting with zero, the GDP deflator has plummeted to around 0.5%, the lowest in decades. This has resulted in a disconnect: strong real GDP growth has not translated into increased revenues or corporate earnings. Six consecutive quarters of single-digit Nifty earnings growth, despite an 8% GDP expansion, highlight the challenges of a low-nominal-growth environment.
Nominal GDP: The New Centerpiece
JP Morgan's Sajjid Chinoy predicts a moderation in real GDP growth from around 7.5% this year to a more conservative 6.5% as various cyclical factors subside. Chinoy argues that this year's nominal GDP growth may have been an anomaly driven by exceptionally low inflation. While a mean reversion is expected, a return to high inflation is unlikely.
China's Impact: The Elephant in the Room
One key reason for subdued inflation is China's massive excess manufacturing capacity. Chinoy highlights this as a significant constraint, as China continues to export deflation to the world, particularly Asia. Even geopolitical risks have failed to boost inflation meaningfully, keeping oil markets well-supplied and prices low.
For India, this means WPI could remain depressed, limiting companies' pricing power and capping nominal GDP growth.
Optimism and the Credit Cycle
Neelkanth Mishra of Axis Bank offers a more optimistic outlook. While acknowledging the importance of nominal GDP, he believes real growth in FY27 could surpass expectations. Mishra's argument centers around the credit cycle. He believes that monetary easing, including rate cuts and liquidity injections, will have a delayed impact, and we are now witnessing the real effects as credit growth accelerates.
"What was once a vicious cycle is now becoming a virtuous one," Mishra states, suggesting that rising credit demand could boost both real growth and earnings momentum. Mishra predicts a nominal GDP growth of around 10.5%, with real growth at 7.5% and a deflator of 3.5%.
The Inflation Puzzle and Commodity Markets
China's influence extends to commodity markets. Mishra expects ferrous metals and iron ore prices to soften, while aluminum prices may remain high due to falling energy costs. Low food and vegetable prices have also contributed to disinflationary pressures, complicating fiscal planning and earnings expectations.
Earnings Revival: The Market's Dilemma
For markets, the question is whether earnings growth will normalize or accelerate significantly. UBS's Gautam Chhaochharia believes an earnings pickup is imminent as nominal GDP improves. The debate lies in whether growth will settle at 10-12% or reach mid-teens levels.
Markets seem to be pricing in a more optimistic scenario, assuming a sustained credit upswing. Chhaochharia emphasizes that this assumption hinges on banks' risk appetite, as India's banking system is well-capitalized and lenders are showing signs of loosening credit standards.
Budget 2026: Navigating a Complex Macro Environment
Budget 2026 presents a unique challenge for the government. The era of fiscal comfort is giving way to revenue concerns, and the margin for error is narrowing. The task is to balance fiscal consolidation with policies that stimulate nominal growth, without relying on past high inflation rates.
As economists warn, India's next growth phase may require a shift in mindset, learning to thrive in an environment of low inflation.
