We now forecast USD/INR to rise steadily towards 86.00 levels by 4Q2025 (calendar year). INR should still outperform Asian FX in 1H2025 in an environment of swift tariff increases by Trump 2.0 as per our base case expectations, and especially against the likes of CNY, KRW, THB, MYR and SGD. Nonetheless, this outperformance could reverse as Dollar strength moderates in 2H2025.
Part of the driver behind our FX forecast change is a less benign domestic growth environment for India, which could weigh further on portfolio inflows.
We lower our India GDP forecast to 6.1% for FY2024/25 and 6.3% for FY2025/26, down from 6.9% and 6.7% previously. We have been flagging the likelihood of a moderation in growth but these numbers came in much lower than we had anticipated (see IndiaPulse – Bringing forward the 1st RBI rate cut). The good news on India’s growth is that the July-Sep quarter should mark the trough of economic activity, with several high frequency indicators rebounding in October/November, helped by a rural economy recovery and faster disbursement of the government’s operational spending. The bad news is that with food inflation still elevated, RBI is likely to only have policy space to cut rates from the February meeting. RBI’s bevy of macroprudential measures on consumer loans could continue to weigh on economic activity, while government capex seems to be facing some operational hurdles to ramping up to target.
We now expect RBI to cut rates by 75bps this cycle starting from the February meeting for a terminal rate of 5.75%, from 6.50% currently. Our previous expectation was for 50bps of cuts this cycle. RBI’s upcoming December policy meeting decision this week is admittedly an extremely close call. We expect to see increasing dissent from the MPC’s three external members, with the decision potentially resting on RBI Governor Das. As a first move, we think RBI will announce a 50bps Cash Reserve Ratio cut in its December meeting to help boost banking system liquidity, which has been depleting with the RBI’s aggressive FX intervention operations.
We think USD/INR risk reversal longs or call spreads may make sense, and we also expect USD/INR forward points to rise at a slower pace. IGB 10-year yields should continue heading lower and IGB bonds FX-hedged may be attractive.
India’s GDP growth likely to improve but remain below potential
India’s GDP growth for the July-Sep quarter came in materially weaker than expected at 5.4%yoy. This was far softer than RBI’s own forecast of 7%yoy in the Oct 2024 monetary policy statement, and also below the weakest estimate of 6% in the Bloomberg survey of economists. The details showed the miss was driven by weaker manufacturing activity, together with softer private consumption and investment (see Appendix Charts 22 to 27). The bright spots for the economy include an improvement in agriculture activity, helped by a decent Southwest monsoon and Kharif crop sowing, with government spending also seeing nascent signs of picking up.
Moving forward, the key question for INR FX and rates markets is whether this growth slowdown proves to be short-lived or something more pernicious.
Our best sense is that growth should improve from here in what is likely a cyclical slowdown, but should remain below India’s growth potential of around 6.5%. The July-Sep quarter should mark the trough of economic activity.
For one, our domestic activity index which tracks a whole range of high frequency indicators across private consumption and investment shows some improvement in growth in October and November (see Chart 3 below and also Appendix for more details). The improvement was more evident in rural consumption, with indicators such as two wheeler and tractor sales and registrations rising 10-20%yoy (see Chart 4 below). Agriculture exports also picked up by >30%yoy, helped in part by the government’s relaxation of rice export curbs. We also saw some improvement in urban consumption although at a slower pace with domestic passenger vehicle sales growth moving back into positive territory while domestic air passenger traffic rose more than 10%yoy for instance. Meanwhile, investment activity was comparatively more moderate, with power demand, finished steel production, goods vehicle registrations, railway freight, and capital goods imports for instance generally growing below 5%yoy (see Chart 4 below).
Beyond the near-term, we see four key factors supporting growth into FY2025/26 – improvement in government revenue spending, good Kharif and Rabi harvests helping the rural economy, strong corporate sentiment, and still strong pipeline of private capex projects (see Chart 5 and 6 below): We think part (but not all) of the driver behind India’s economic slowdown was due to weakness in government spending disbursement in the lead-up to the Lok Sabha Elections, due to the Election model code of conduct. After the Lok Sabha Elections, government spending was generally slow to ramp up, but have recently started to do so from an operational spending perspective driven by increasing transfers to states and also rollout of the government’s social welfare programmes. In addition, the best leading indicators of India’s economic activity including on business expectations of services and infrastructure firms shows continued strong corporate sentiment, indicating that companies are still reasonably bullish on prospects for the country (at least based on latest surveys). Meanwhile, private capex projects sanctioned by banks and financial institutions remain strong, even if the levels have come off slightly from the peak seen over the past two years (see Chart 7 below).
Several factors continue to weigh on growth – delayed moderation in inflation, slower RBI rate cuts, and RBI’s continued moves to tighten macroprudential measures including on unsecured credit: Nonetheless, we think India’s growth slowdown is likely to have been driven also by restrictive monetary policy and the RBI’s moves to tighten macrorudential measures including raising risk weights on unsecured consumer loans and increase monitoring of NBFC business practices (see Chart 8 below). Meanwhile, the recent spikes in food prices driven by volatile vegetable components together with edible oil price increases due to import duty hikes have reduced the policy space in the near-term for the RBI to cut rates to support growth. Our expectation is for food inflation to moderate moving forward as the impact of heatwaves fade and the positive impact of higher Kharif and Rabi crop harvests start to feed through, including in supporting rural activity.
If we are right about the above, we expect RBI to start its rate cut cycle from its February meeting, bringing the repo rate to 5.75% by 3Q2025 (calendar year) for 75bps cuts in total. Meanwhile, we expect RBI to as a first step cut its Cash Reserve Ratio by 50bps in the December meeting to help boost banking system liquidity, which has been depleting to some extent given the RBI’s aggressive actions to intervene in the FX market to cap INR weakness. With our expectation that the Fed will likely slow the pace of rate cuts into 2025, RBI’s rate cuts should also help to slow the pace of upward rise in USD/INR FX Forward points, while also allowing a gradual grind lower in IGB 10-year bond yields towards 6.30% by 4Q2025.
We forecast spot USD/INR to rise gradually towards the 86.00 levels by end-2025, with RBI intervention continuing to cap realised FX vol. We think RBI will intervene less aggressively over time and allow USD/INR to move higher in an orderly fashion. We nonetheless stress that we are not overly bearish INR. From a global perspective, we expect INR should have some space to outperform Asian FX crosses especially CNY, KRW, THB, MYR and SGD in an environment of sharp tariff increases in 1H2025, but conversely should underperform if and when the worst fears on Trump’s tariffs do not materialise. From a local perspective, the possibility of Indian Government Bonds being added to the Bloomberg Global Agg Index could add around US$10-15bn of incremental flows, although timing remains admittedly uncertain.
Appendix
