Dare to be different? Budget FY26 must prioritise growth and employment

It’s that time of the year. India’s 2025-26 (FY26) Budget will be presented on February 1, followed closely by the Reserve Bank of India’s policy meeting on February 7. Policymakers are facing a particularly complex environment. It’s no small ask to restart the public capex cycle, boost consumer demand, and press ahead with fiscal consolidation, all while domestic growth is soft, tax revenue growth is slowing, and the overseas environment is uncertain.

 

Let’s start with the global backdrop. Sure, US yields may soften if the Fed cuts in 2025, but the dollar could remain strong as it typically benefits not just from American exceptionalism but also economic uncertainty, like the evolving tariff policies in the US, and unpredictable geopolitics. This is already pressuring emerging market currencies, like the rupee, and could continue to do so.

 

Back home, growth has fallen to below potential levels of 6.5 per cent. Policy stimulus could help get it back up to 6.5 per cent. But what form should that take: A higher fiscal impulse, or looser monetary policy?

 

Let’s first assess the fiscal environment. In good news, the government will likely outperform on its FY25 fiscal consolidation target, closing the year at 4.8 per cent of gross domestic product (GDP) versus the 4.9 per cent budgeted, led by weaker-than-budgeted public capex due to slower approvals in an election year.

 

FY26, however, will likely be harder. Weak equity markets in recent months may lower capital gains tax revenue growth. But capex may pick back up as election-led delays are behind us. And this is a good idea because Central capex tends to crowd in state capex. And the capex process not only creates immediate jobs but also capacity to grow faster in the medium term.

 

Lowering the fiscal deficit to “below 4.5 per cent of GDP,” in line with the finance ministry’s promise, will then have to come from cuts in current expenditure. Cutting spending on subsidies and centrally sponsored schemes may be hard, but not impossible. After all, the latter did fall a while back when the priority was “cleaning up” expenditures, but it has since shot back up in recent years. Time for another spring clean, perhaps.

 

The silver lining in the Budget math is that because we expect a recovery in high-quality capex, the fiscal stimulus in FY26 may remain neutral, despite fiscal consolidation.

 

And assuming the fiscal stimulus, at best, is neutral, then stimulus must come from monetary policy. Indeed, things are falling into place there. January’s consumer prices are expected to rise just 4.2 per cent from 6.2 per cent in October, helped by a good crop of vegetables. If the wheat harvest is as good as sowing suggests, disinflation could then continue into FY26. True, a weaker rupee will add to inflation, but estimates suggest that average inflation will remain around the 4 per cent target in FY26.

 

So, what roles can monetary policy play? Several, in our view. We think rate cuts should happen sooner rather than later. We don’t expect foreign exchange (FX) weakness as a result, given that many other emerging markets, like Indonesia and South Korea, have eased rates and this hasn’t added to FX pressure. The trick is just not to get carried away and ease too much.

 

Then there is liquidity. Many easing instruments are being put to work already, such as OMO purchases, FX swaps, long-tenor variable-rate-repos, and a previous cash reserve ratio (CRR) cut. The trick would be to keep using a bit of all instruments, rather than depend too much on any one. And create ample amount of reserve money growth needed to fuel the economy.

 

And, finally, and most importantly, there’s the rupee. A flexible exchange rate and rupee weakness can do wonders. One, it can reignite growth by making India’s exports (especially services exports) competitive. Two, less FX intervention can ease domestic liquidity stress. Three, it frees up rate and liquidity policy to address growth, instead of being used to defend the currency. Four, it can offset the harmful impact of potential import tariffs that could be levied in a protectionist global backdrop. Five, by helping exports remain competitive, it positions India as an attractive candidate to plug into global supply chains as they are rejigged.

 

The latter is important. Fears of global tariffs could be an opportunity for India, which up to now has not benefited much from US trade tensions. One can see this through the lens of foreign direct investment (FDI) as India has, so far, not received much FDI in mid-tech sectors like textiles and furniture. Attracting more investment from overseas could be an important way to create the jobs needed to uphold growth.

 

However, India ultimately needs to work hard on several fronts to seize the opportunity by keeping the exchange rate flexible, containing domestic import tariffs to keep the cost of production low, being welcoming to FDI from across the world, and expanding its free trade agreements. In particular, bilateral trade agreements with advanced economies like the US could benefit India by reducing tariffs levied on labour-intensive Indian exports.

 

So, can India dare to be different? Meet the tough fiscal consolidation path it has promised, despite weaker growth? Focus on capex, even with demands for a consumption stimulus? Cut policy rates sooner rather than later? Not worry about a weaker rupee? Not impose blanket tariffs and non-tariff barriers, even if the rest of the world seems to be doing so? Finally, sign bilateral trade agreements and be open to FDI from countries like China?

 

Because, if India wants more growth and jobs, business-as-usual won’t do the trick.

 

The author is chief India and Indonesia economist and managing director (global research), HSBC