India's trade deals are a win, but fiscal vulnerabilities are also growing

India weathered the Trump tariff shock better than expected, but high public debt and slower fiscal consolidation pose risks even as trade deals lift growth and investor sentiment

India weathered the Trump tariff shock remarkably better than expected. Gross domestic product (GDP) growth is likely to exceed 7 per cent in 2025, and external balances remained positive during the period. Front-loading of goods exports to the United States, access to cheaper Russian oil, strong service exports, and higher remittances helped. The rupee depreciated sharply, at one point breaching 92 to the dollar as net foreign portfolio outflows reached $18 billion, but a weaker rupee perversely kept India’s exports more competitive. 

What kept global growth in 2025 much better than projected by the International Monetary Fund and the World Bank was artificial intelligence (AI) and spending on related infrastructure like data centres. The fact that most countries chose not to retaliate to US unilateral tariffs, which could have triggered a global trade war, was another factor. Nevertheless, US President Donald Trump’s continuing threats to take over Greenland, attack Iran, and his unpredictable behaviour on tariffs have kept the global uncertainty index and the price of gold close to $5,000 an ounce. 

Even in this fractured, more protectionist world, India’s growth momentum for a Viksit Bharat remains dependent on exports and attracting more foreign direct investment (FDI). The win-win European Union (EU) trade deal negotiated in record time will help attract more FDI from the EU once bilateral investment agreements are signed, boost India’s labour-intensive export sectors, and signal to the rest of the world that India is ready to lower tariffs and is open to trade. 

It was also, as we now see, a signal to Mr Trump that India cannot be bullied and was instrumental in his sudden approval of a US-India trade deal, slashing tariffs from 50 per cent to 18 per cent, lower than what Bangladesh, Vietnam and other Asian competitors are paying. The US realised it would need to move quickly to forestall India from aligning its rules and regulations in line with the EU. 

The details of the India-US trade deal are not yet available but the overall positive sentiment around it will pull back some of the short-term portfolio capital that left in 2025. The rupee and Indian equities have already seen a bump-up. Whether India’s China+1 strategy, which Mr Trump’s 50 per cent tariffs had derailed, will get back on track remains to be seen. Mr Trump’s unpredictability, and on-and-off signals may give long-term investors pause. 

The 2026-27 Budget has allocated funds to build resilience and manage risks. It has reduced import duties on intermediate inputs for labour-intensive exports and for critical products India needs to reduce dependence on China and build more resilient supply chains. Continuing the push for public capital expenditure — which people expected would now pause — is welcome, especially as recovery in private investment and FDI may await completion of the EU trade deal and greater certainty on US intentions towards India.

 

AI could be a big boon or bane for India. The increased but targeted outlay for AI to support India’s AI National Mission, along with the support for semiconductors, in the Budget is, therefore, welcome. However, in this new world order, where allies or alliances do not count and everyone is rearming, India’s defence expenditure as a share of GDP was low at under 2 per cent of GDP. With worsening relations in its neighbourhood and no dependable allies, the increase in defence outlay for modernisation to 2 per cent was overdue and necessary.

 

But the slowdown in the glide path for fiscal consolidation, with the fiscal deficit set at 4.3 per cent of GDP for FY27, is worrisome. India’s debt dynamics — especially with rising public debt at the state level and increased spending after the Eighth Pay Commission kicks in — will require faster fiscal consolidation. As Sajjid Chinoy has shown, even with 11 per cent nominal GDP growth — higher than the 10 per cent projected in the Budget — India’s overall public debt remains close to 80 per cent of GDP by 2030 because state public debt exceeds 30 per cent of GDP.

 

This means faster fiscal consolidation at both the Union and state levels is necessary to create the fiscal space India must have to deal with bigger shocks. One way to achieve this in the Union Budget would have been to forgo increases in allocations for internal security, which are already high. Another would be faster privatisation, projected at a modest 0.2 per cent of GDP in this year’s Budget.

 

The Trump shock also pushed India into a more accelerated reform mode in 2025 — cleaning up goods and services tax, encoding labour reforms, opening insurance and defence production to 100 per cent FDI, and signalling the intent to deregulate. But keep the promised Reform Express going on the so-called factor market by removing obstacles to land acquisition and zoning, increasing labour flexibility further to firms over 300 workers, and reducing the cost of energy, while also fixing its creaky and highly corrupt legal and administrative system.

 

The Budget has announced yet another committee to look at banking reforms for Viksit Bharat. It will look at ways to increase India’s credit-to-GDP ratio, phase out the statutory liquidity ratio (SLR), and develop the bond market — issues discussed in my January Column. But any of these financial sector reforms will depend on reducing the public-sector borrowing requirements, which at their highest-ever level of ₹17.2 trillion (about $190 billion), up 16 per cent from the previous year, will test the RBI, as debt manager of the government, to keep G-Sec yields in check while operating within the guidelines of the inflation-targeting regime.

 

If new and bigger shocks laid out in the Economic Survey hit, such as a major correction in the US equity markets, India has limited fiscal space to respond. Leaving itself vulnerable with exceedingly high public debt ratios is not a sound strategy in today’s uncertain and jittery world. Let me end by offering big congratulations to the Narendra Modi government for navigating two big trade deals, which could be game changers and will lift India’s growth prospects, improve FDI flows, and make India a more open and competitive economy. Let us hope the EU deal is ratified this year, and that Mr Trump sticks to the US deal.

 

The author is a distinguished visiting scholar at the Institute for International Economic Policy, George Washington University. His book Unshackling India was declared the best new book in economics by the Financial Times in 2022