Domestic fundamentals strong but global headwinds remain a concern

Domestic fundamentals, public capex, and robust growth in the services sector ensured real gross domestic product (GDP) growth of 7.8 per cent in the first quarter of 2025-26 (Q1FY26). These numbers indicate not just an annual growth spurt but are also evidence of strong sequential momentum. Though a favourable base has played its part, sectoral performance too contributed. A growth rate of close to 8 per cent in Q1 should help the fiscal end with a decent growth print. However, challenges posed by global headwinds will commence from the second quarter. Growth has been fairly broad-based across all sectors, barring a few like mining and electricity, but the trajectory for the rest of FY26 depends on the extent to which policy initiatives mitigate external shocks. 

Sectoral growth trends convey an overall growth momentum. At 3.7 per cent agri & allied sectors more than doubled their pace over the previous year. This is attributable to good monsoons and technology initiatives. If monsoon does not play truant, we must expect 4.5-5 per cent to be the ‘new normal’ in our agri growth story. The industrial sector posted fairly modest growth, which was not surprising as corporate earnings and the index of industrial production numbers gave subtle hints. The lack of momentum in private capex can be attributed to slow industrial growth. However, manufacturing grew 7.7 per cent, exhibiting significant sequential strength over Q4FY25, while mining and electricity sectors de-grew, the latter apparently being pulled down by bountiful monsoons. Services sector, so far immune to tariff headwinds, grew 9.3 per cent, an annual and sequential growth of 200 and 250 basis points (bps) respectively, scripting the Q1 growth story with its 57 per cent weight in GDP. 

On the expenditure side, private consumption continues to contribute more than 60 per cent to GDP. It is pertinent to note that rural demand shows green shoots after long spells in the slow growth lane. The upswing in FMCG sales volumes explains this better. Urban demand, however, is yet to revive to its potential as slow wage growth and leveraged households remain a drag. GST rationalisation is expected to provide further impetus as consumer durables and ‘white goods’ turn more affordable. A full pass-through is estimated to improve GDP growth by 55 bps for 6 months, assuming marginal propensity to consume (MPC) of 0.7 and an annual revenue loss of ~1.2 trillion. Meanwhile, public capex continues to do the heavy lifting. Exports grew 21 per cent at current prices, aided by frontloaded outbound shipments. 

This brings us to the question of further repo rate cuts. Global shocks would impact from Q2. Textiles, gems & diamonds, leather & footwear, handicrafts, marine products, furniture, to name a few, will bear the brunt of tariffs. But rate cuts are unlikely to be seen as a panacea. More plausible measures include special liquidity windows, a moratorium on loan repayments, or special dispensation on NPA classification, as limitations of monetary policy to growth have been fairly acknowledged. 

Nominal GDP will likely grow 8 per cent, accounting for muted inflation, exerting upward pressure on fiscal and debt metrics. Likely fiscal support to help tariff-hit sectors could act as a drag. However, cushioned by the Reserve Bank of India dividend and negligible revenue loss from GST tweaks, the central fiscal deficit is not expected to breach 4.4 per cent. The fiscal situation of states is likely to come under some strain, which is mirrored in rising state development loan (SDL) yields. 

How does the growth outlook pan out for the rest of FY26 and beyond? Tariffs are expected to shave around 50 bps off GDP growth for the rest of the financial year. A full pass-through of GST cuts could just about mitigate this, which possibly explains the MPC retaining the FY26 growth forecast at 6.5 per cent. However, firms might hesitate to pass on full benefits, notwithstanding anti-profiteering clauses. Assuming a 50 per cent pass-through growth boost from consumption could fall short by 25 bps to mitigate the tariff shock impact. However, even if growth averages just 6 per cent for the rest of the FY, the full year growth will be 6.5 per cent, riding on 7.8 per cent in Q1, which would be the most likely scenario. 

The softness in growth momentum that we might observe in subsequent quarters is attributable to global headwinds. Domestic fundamentals remain resilient, which will propel us towards potential growth rates once external headwinds subside.

 

The author is chief economist at Canara Bank