External risks: US trade policy may affect economic growth in FY26

The financial year 2024-25 (FY25), which is ending this week, has arguably seen economic growth return to normal levels. According to the National Statistics Office’s second advance estimates, the Indian economy is estimated to have grown 6.5 per cent in FY25 as against 9.2 per cent in the previous financial year. The average growth rate between FY22 and FY24 was 8.8 per cent, partly driven by the low base of the pandemic year. The average growth rate between FY13 and FY20 was 6.6 per cent. Thus, it is no surprise that several forecasters expect the growth rate to be around 6.5 per cent in FY26. The Reserve Bank of India (RBI) has projected 6.7 per cent. 

While the growth rate in FY26 is expected to be around the longer-term average, the year begins with considerable uncertainties on the external front. India and the United States (US) last week concluded a four-day discussion and have come to an understanding over the next steps for the proposed bilateral-trade agreement. Sector-level engagement is expected to start in the coming weeks. Although this is a positive development, it remains unclear whether it will be sufficient to prevent the proposed reciprocal tariffs by the US, starting April 2. Since it is extremely complex to implement the idea of reciprocal tariffs, it could possibly be implemented in select sectors to begin with. Nevertheless, US trade policy remains a big source of uncertainty. The protectionist shift in US trade policy and potential responses from its trading partners will not only affect trade flows but also influence investment and consumption demand globally, dragging down overall global growth. 

Aside from potential country-specific tariffs, global trade tensions and their impact on economic activities will influence economic outcomes in India. However, in the given uncertain environment, Indian policymakers will draw comfort from the fact that there aren’t too many risks to macro stability at the moment. The government is expected to remain on the fiscal-consolidation path and contain the fiscal deficit at 4.4 per cent of gross domestic product in FY26. The retail inflation rate is expected to come down and open up space for further monetary-policy easing by the monetary policy committee. On the external front, while the current-account deficit is likely to remain modest, investment-related uncertainties could affect both direct and portfolio flows, with implications for the rupee. A potentially higher inflation rate in the US can affect the trajectory of its policy interest rate, with implications for global capital flows. Foreign portfolio investors bought stocks and bonds worth only about $2.7 billion in FY25 as against over $41 billion in the previous financial year. 

Thus, the biggest downside risk for FY26 is US trade policy-related uncertainty. Once clarity emerges, the policy focus in India should shift to increasing the trend growth. The latest Economic Survey underscored the need to accelerate the growth rate close to 8 per cent to achieve the development goal set for 2047. The required increase in the growth rate is unlikely to come in a business-as-usual scenario, particularly given the global environment. One approach could be to accelerate economic reforms. Will FY26 mark the beginning of the next generation of economic and governance reforms? The answer to this question will shape the growth trajectory for the year and beyond.