External risks: Trade and capital flows to impact economic growth

There is hope one day and confusion the next. As the July 9 deadline approaches, it is difficult to say with certainty whether India and the United States (US) will be able to reach a mutually beneficial bilateral-trade agreement in time. The policy approach adopted by the US has not only disrupted the global trade order, but there has also been a significant upheaval in global financial markets. The dollar, for instance, has lost over 10 per cent against a basket of currencies in the first half of 2025. Besides US trade policies, geopolitical tensions have increased external risks. The increased level of risk and uncertainty was also reflected in the analysis of the latest bi-annual Financial Stability Report (FSR) of the Reserve Bank of India (RBI), released on Monday. As the FSR noted, increasing trade disruption and intensifying geopolitical hostilities can negatively affect the domestic growth outlook. It can also result in increased risk aversion among investors and further corrections in domestic equity markets. 

 

The developments in the US can affect the Indian economy through different channels. It will not only be critical to watch the kind of trade deal offered to India, but a lot will also depend on the arrangements the US would have with its other trading partners and India’s competitors. All this will affect the tradable sectors of the Indian economy with implications for the medium-term growth outlook. India will also be affected through the investment channel. Besides trade, the US fiscal position and other policies would affect global capital flows. It is worth noting that India ran a modest current account deficit (CAD) of 0.6 per cent of gross domestic product (GDP) in 2024-25. However, overall net capital flows were insufficient to finance the CAD, resulting in depletion of foreign-exchange reserves. Although India reported a current account surplus in the last quarter of 2024-25, a rise in global risk aversion could make it difficult to finance even a moderate CAD. The updated framework of the RBI shows that under extreme adverse shocks, foreign portfolio outflow could be worth 6 per cent of GDP. While the extreme situation may not play out, the external position will need careful monitoring. 

Nevertheless, in this adverse global scenario, domestic economic and financial conditions are likely to provide comfort to Indian policymakers. Inflation, for example, is expected to remain close to the target, which has allowed the RBI to frontload policy-rate cuts. A monsoon that is above normal is likely to boost agricultural production, supporting overall growth. On the fiscal front, the ongoing consolidation is likely to continue. The corporate and bank balance sheets are in good shape. As the FSR highlighted, the debt-to-equity ratio of non-financial corporations has been declining, and India’s corporate debt-to-GDP ratio, at 51.1 per cent, is much lower than in many emerging and advanced economies. Although household debt has increased, it remains much lower than in other emerging markets. In the banking sector, gross non-performing assets (NPAs) among scheduled commercial banks have declined from a high of 9.6 per cent in March 2017 to 2.3 per cent in March 2025. Net NPAs have also declined, while the return on assets has improved. Notably, fundraising from the capital market increased 32.9 per cent in 2024-25. Thus, while corporate balance-sheet and domestic financial-market conditions are favourable, investment revival, which is necessary to increase potential growth, may remain constrained by heightened external uncertainty.