Do it yourself

Thursday, August 28, 2025

Refinement of the monetary policy framework in India

The Reserve Bank of India adopted its current monetary policy framework in August 2016, under the governorship of Dr. Raghuram Rajan. This marked a major shift in the monetary policy formulation process in India.

In the pre-independence era, the function of monetary policy was mainly to maintain the sterling parity, with the exchange rate being the nominal anchor of monetary policy. Liquidity was regulated through open market operations (OMOs), bank rate and cash reserve ratio (CRR). After independence, India adopted the planning model of development, loosely based on the USSR model. The role of RBI monetary policy in this model was mostly to regulate credit availability, employing OMOs, set bank rate and reserve requirement in congruence with the planning objectives and development needs of the country.

The monetary policy framework witnessed a major shift between from mid 1980s to late 1990s. In 1985, on the recommendation of the (Dr. Sukhamoy) Chakravarty Committee, a new monetary policy framework was implemented. This framework was primarily based on targeting with feedback models. This framework was termed “Monetary Targeting with Feedback” as it was flexible enough to accommodate changes in output growth. The RBI was mandated to control inflation within acceptable levels with desired output growth. Further, instead of following a fixed target for money supply growth, a range was followed which was subject to mid-year adjustments.

Developments like deregulation of interest rates, integration of the Indian economy with the global economy, liberalization of the exchange rate system, etc. in the mid 1990s, warranted a change in the monetary policy approach. The RBI began to deemphasize the role of monetary aggregates and implemented a multiple indicator approach (MIA) to monetary policy in 1998 encompassing all economic and financial variables that influence the major objectives outlined in the Preamble of the RBI Act. This was done in two phases—initially MIA and later augmented MIA (AMIA) which included forward looking variables and time series models.

The current monetary policy framework of the RBI was adopted in 2016. This framework was based on the recommendations of the (Dr. Urjit) Patel Committee report. The Committee recommended a monetary policy framework that was largely based on the US FOMC model – flexible inflation targeting by RBI and a six-member statutory Monetary Policy Committee (MPC) for setting the policy repo rate. The key tools of monetary policy implementation under this framework have been the repo rate as the primary policy rate, supported by liquidity management tools like open market operations, standing deposit facility, and marginal standing facility.

The Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the RBI in February 2015 to formally adopt the flexible inflation targeting (FIT) framework. This was followed up with the amendment to the RBI Act, 1934 in May 2016 to provide a statutory basis for the implementation of the FIT framework. The Central Government notified in the Official Gazette dated August 5, 2016, that the Consumer Price Index (CPI) inflation target would be 4% with ± 2% tolerance band for the period from August 5, 2016 to March 31, 2021. The same tolerance band has however continued even after the March 2021 deadline.

The framework has, so far, helped anchor inflation expectations, reduce inflation volatility (from 7.5% pre-2016 to ~5% post-2016), and support growth, though challenges remain due to supply-side shocks (e.g., food and fuel prices) and external spillovers.

The RBI has now released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. The goal is to maintain price stability while supporting economic growth and financial stability in a dynamic global and domestic environment.

Proposed refinements

Inflation target and tolerance band: Retain the 4% CPI inflation target but review the ±2% tolerance band. RBI proposes (i) narrow the band (e.g., ±1.5%) for stricter inflation control; or (ii) maintain the current band but clarify its use to avoid misinterpretation as a range for persistent deviation; or (iii) Introduce asymmetric bands (e.g., tighter upper bound to prioritize high inflation control). RBI also suggests considering core inflation (excluding volatile food and fuel prices) as a secondary guide to better reflect demand-driven pressures. Public comments are invited by September 30, 2025, on key questions: Should the 4% target or ±2% band be revised?

Scope of inflation targeting: Continue using headline CPI as the primary metric due to its broad coverage and public relevance. Explore supplementary indicators (e.g., core inflation, inflation expectations, or sectoral indices) to address supply shocks like food price spikes, which are less responsive to monetary policy.

Monetary policy committee (MPC) processes: Enhance transparency through more detailed MPC minutes and forward guidance on policy intentions. Propose increasing the frequency of MPC meetings (e.g., monthly instead of bimonthly) to respond more swiftly to economic developments. Consider expanding external member expertise to include climate economics and global trade specialists.

Incorporating new challenges: RBI proposes to incorporate certain contemporary challenges in the process of setting monetary policy. These new challenges include - (i) Climate Risks: Integrate climate-related risks (e.g., weather-induced food price shocks) into the framework, potentially through adjusted forecasting models or stress-testing scenarios. (ii) Digitalization and Fintech: Account for the impact of digital currencies and fintech on money supply and monetary transmission. (iii) Global Spillovers: Strengthen coordination with global central banks to mitigate the impact of external shocks (e.g., U.S. Federal Reserve rate hikes, commodity price volatility).

Monetary policy transmission: Address lags and inefficiencies in policy transmission (e.g., slow pass-through of rate changes to lending rates) by improving banking sector competition and liquidity management. The RBI proposed exploring alternative tools, such as forward guidance or yield curve control, to enhance transmission in volatile markets.

Growth and financial stability: Balance inflation control with growth objectives, especially in the context of India’s post-pandemic recovery and structural reforms. Strengthen coordination between monetary and fiscal policies to avoid conflicting signals (e.g., high fiscal deficits undermining inflation control).

Rationale for Review

Changing economic landscape: Rising supply-side shocks (e.g., food and energy prices, climate disruptions) and global uncertainties (e.g., geopolitical tensions, monetary tightening in advanced economies) require a more adaptive framework.

Inflation dynamics: Persistent food inflation and volatile global commodity prices challenge the FIT framework’s effectiveness.

Stakeholder feedback: Public and expert consultations highlight the need for greater clarity on the tolerance band and flexibility in addressing non-monetary inflation drivers.

Expected Impact

Price Stability: A refined framework could better anchor inflation expectations, reducing volatility.

Economic Growth: Enhanced flexibility may support growth without compromising inflation control.

Resilience: Addressing climate and global risks could make the framework more robust to shocks.

Challenges: Narrowing the tolerance band or increasing meeting frequency may strain RBI resources and require careful calibration to avoid over-tightening.

Tuesday, August 26, 2025

Chairman Powell stopped just short of committing a cut

Federal Reserve Chair Jerome Powell delivered his final keynote address at the Jackson Hole Economic Symposium on August 22, 2025, hosted by the Federal Reserve Bank of Kansas City. The speech focused on the U.S. economic outlook and the Federal Reserve’s monetary policy framework review, addressing the Fed’s dual mandate of price stability and maximum employment.

In his speech, Powell noted the U.S. economy’s resilience despite challenges from President Donald Trump’s tariffs and immigration policies. Inflation remains above the Fed’s 2% target (PCE index at 2.6% in June 2025), driven partly by tariff-related price increases, while the labor market shows signs of weakening, with July’s job growth at 73,000, well below expectations, and downward revisions of 258,000 jobs for May and June.

Monetary Policy Outlook: Powell signaled openness to interest rate cuts at the September 16-17, 2025, FOMC meeting, admitting that monetary policy is in restrictive territory, and the baseline outlook and the shifting balance of risks may warrant adjusting the policy stance. However, he avoided committing to a specific timeline or size of cuts, citing mixed signals from rising inflation and a cooling job market.

The CME FedWatch tool showed a 74% probability of a September rate cut, down from near certainty earlier in August, reflecting uncertainty about the size and timing.

Powell also spoke about Fed’s revised “Statement on Longer-Run Goals and Monetary Policy Strategy”, emphasizing adjustments to address evolving economic conditions, such as demographic shifts and productivity changes affecting labor markets.

Political Pressures: While Powell did not directly address political pressures, the speech occurred amid President Trump’s criticisms of the Fed’s independence, including calls for Fed Governor Lisa Cook’s resignation and Powell’s own potential replacement, as his term ends in May 2026.

How experts read Powell lips

Market experts, participants, and media provided varied interpretations of Powell’s speech, reflecting its cautious tone and the complex economic environment:

Analysts at Barclays and BNP Paribas revised their forecasts to predict a September rate cut, interpreting Powell’s remarks as dovish, though he avoided endorsing large cuts (e.g., 50 basis points) sought by some Republicans.

Experts highlighted Powell’s acknowledgment of a “challenging dichotomy” between tariff-driven inflation and a weakening labor market. Deutsche Bank analysts noted that a hawkish stance could unsettle markets, particularly for rate-sensitive sectors like homebuilders and small caps. Conversely, a dovish tilt was seen as supportive of equities.

Media outlets, including The Guardian and Reuters, emphasized the political backdrop, with Trump’s attacks on Fed independence overshadowing the speech. Trump’s comment, “He should have cut them a year ago. He’s too late,” underscored tensions, with some analysts concerned about the Fed’s autonomy.

Overall, experts and media saw Powell’s speech as a balancing act, addressing economic challenges while navigating political pressures and maintaining Fed credibility. The lack of a clear commitment to rate cuts left room for interpretation, with some viewing it as pragmatic and others as overly cautious.

Global Perspective

The presence of other central bankers, such as ECB President Christine Lagarde and Bank of England Governor Andrew Bailey, at the symposium, highlighted global monetary policy coordination challenges. Media noted the symposium’s focus on labor market transitions and data quality issues, with declining survey participation affecting economic projections.

Market Reaction

Financial markets responded positively to Powell’s dovish tilt, interpreting his openness to rate cuts as supportive of growth.

The S&P 500 rose approximately 1.5–1.6%, the Nasdaq Composite climbed nearly 2%, and the Dow Jones Industrial Average surged 1.9–2%, reaching a record intraday high. The rally reflected relief at the prospect of looser monetary policy, particularly for growth-oriented and rate-sensitive stocks.

U.S. Treasury yields fell, with the two-year Treasury yield dropping nearly 10 basis points to 3.69% and the 10-year yield declining 6 basis points to 4.27%. The yield curve steepened, with the spread between 5- and 30-year rates hitting a cycle high, reflecting mixed expectations for inflation and growth.

The U.S. dollar weakened against a basket of currencies, including the euro and yen, with the Bloomberg Dollar Spot Index falling about 0.4%. This reflected expectations of lower rates reducing the dollar’s appeal.

Options pricing indicated an expected S&P 500 move of about 0.8% in either direction, nearly twice the average daily move over the past month, underscoring the speech’s anticipated impact.

The market’s upbeat response contrasted with pre-speech jitters, as Wall Street had been on edge, with the S&P 500 declining for five consecutive days prior to August 22 due to uncertainty over Powell’s stance and disappointing retail earnings.

Conclusion

Powell’s Jackson Hole speech last week, signaled a potential shift toward rate cuts in September, driven by labor market concerns, but stopped short of a firm commitment due to persistent inflation risks from tariffs. Market experts and media viewed the speech as cautiously dovish, navigating a complex economic and political landscape. Markets reacted positively, with equities rallying, bond yields falling, and the dollar weakening, reflecting optimism about potential monetary easing. However, the lack of definitive guidance and ongoing political pressures left some uncertainty, with analysts bracing for volatility depending on future economic data and Fed actions.

I however do not see a significant impact of the US market reaction on the Indian markets in the near term. Any enthusiastic response to the elevated rate cut hopes might be met with some aggressive selling.

Back home, the Reserve Bank of India (RBI) has recently released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. More on this in my next post.

Wish the readers A Happy Ganesh Utsav. May the Lord of Intellect and Conscience, remove all our obstacles created by our greed, ignorance, ego, intolerance, lust, material attachment, etc., and bless us with wisdom, contentment and peace.

Thursday, August 21, 2025

A visit to the street

2025 is proving to be an interesting year for traders in the Indian stocks. The traders have faced multiple challenges in the past eight months; and had some good opportunities to make extraordinary profit. More notably—

What made traders’ life tough

· The external environment has been volatile. Geopolitical conflicts in the Middle East had escalated materially. The war between Russia and Ukraine continued and developed a new trade/tariff angle for the Indian economy. India engaged with Pakistan in a small but intense war that could have serious long-term repercussions for regional geopolitics. These events caused sharp volatility in the market, causing exacerbated margin calls and losses to the traders.

· The US imposed reciprocal (25%) and penal (25%) tariffs on imports of merchandise from India, making Indian exports to the US significantly uncompetitive in comparison to the traditional competitors like Vietnam, Bangladesh, Sri Lanka, Turkey, Indonesia, Ecuador, etc. This led to a sharp correction in the stocks of companies drawing material export revenues from the US.

· Economic growth of India has been stable but no acceleration is seen. The demand (both consumption and investment) has remained subdued, impacting consumer companies that were over owned by traders and investors alike.

· Earning momentum has stalled for the past few quarters, with earnings growing in single or low double digits. The valuations of several popular and fancied sectors and stocks have witnessed some de-rating, but still continue to be in the realm of “questionable” for a large majority of stocks.

· While the implied volatility (VIX) has remained low, the realized volatility experienced by the traders has been elevated. Also, sector rotation has been swift and painful. Stocks from sectors like IT services, Pharma, FMCG, Realty and smallcap that were doing well couple of years ago and were over owned have noticeably underperformed YTD2025. While sectors like Auto, Metals and financial services that were under owned and performed poorly have outperformed.

What worked for the traders

International equities, precious metals and crypto assets have done exceedingly well YTD2025. Traders who had invested enthusiastically in Asian equities (especially greater China) a few years ago and were suffering losses have managed to recoup most of their losses. Crypto assets have provided phenomenal return, while gold and silver have also fared very well.

· Internationally, the worst performing markets in the Post Covid period, especially, China, Hongkong, and Japan, have been top performing markets in the past one year. While India has been one of the most notable underperformers. In USD terms, India has yielded a negative return of ~5% in the past twelve months.

· Precious metal and crypto assets have done exceedingly well for Indian investors and traders in the past twelve months.

Wednesday, August 20, 2025

Should the market be celebrating low inflation?

In July 2025, India’s consumer price inflation (CPI) hit an eight year low of 1.55% (yoy). Several factors contributed to the fall in inflation, including, a favorable base effect, lower fuel inflation, and decline in beverages and food prices. Since the inflation is much below the RBI tolerance range of 4% to 6%, it has excited the market participants about another rate cut at the RBI’s October 2025 Monetary Policy Committee (MPC) meeting. The prospect of lower Goods and Services Tax (GST) rates from November 2025, which could keep inflation subdued further, has added fuel to the speculations.

However, notwithstanding what RBI does at its next meeting, we need to answer a fundamental question - Is this low inflation—or even disinflation—a desirable thing for a growing economy like India?

Positive side of low inflation

Boost to Consumer Spending: Lower prices for essentials like vegetables and pulses mean more disposable income, which could spur consumption in a country where private spending drives nearly 60% of GDP.

Room for RBI Rate Cuts: Low inflation gives the RBI wiggle room to cut rates further, potentially by 25 basis points in October, reducing borrowing costs for businesses and homebuyers. Cheaper loans could ignite investment and housing demand, key pillars of India’s growth story.

GST relief on the horizon: Hopes of lower GST rates from November 2025 could be a game-changer. A reduction in GST, especially on essentials (which make up ~46% of the CPI basket), could keep inflation in check, further boosting purchasing power. This could amplify the RBI’s efforts to stimulate growth without stoking price pressures.

For a growing economy like India, projected to grow at 6.5-7% in FY26, low inflation creates a stable environment for businesses to plan investments and for consumers to spend confidently. No wonder markets are abuzz with optimism.

Why low inflation might be a problem

Low inflation, or worse, disinflation (a slowing rate of inflation), isn’t always a sign of economic health. For a dynamic economy like India, aiming to scale manufacturing and infrastructure, persistently low inflation could spell trouble.

Dampening capex enthusiasm: Low inflation often signals weak demand or excess supply. If prices stay too low, businesses may hesitate to invest in new factories, machinery, or tech upgrades—key drivers of capacity addition (capex). Why expand when profit margins are squeezed, and demand looks shaky? India’s GDP growth is already lacking triggers for acceleration, and a prolonged low-inflation environment could further sap corporate confidence.

Savings take a hit: Low inflation often leads to lower interest rates, as seen with the RBI’s recent cuts. While this is great for borrowers, it’s a blow to savers. Fixed deposits and small savings schemes, mainstay of Indian households’ savings, yield less in a low-rate regime. With real returns (adjusted for inflation) shrinking, households might cut back on savings, which fund bank lending and, ultimately, investment. India’s gross domestic savings rate, already down to 30.2% of GDP in FY24, could face further pressure.

Deflationary risks: If inflation dips too low—say, into disinflation or outright deflation—consumers might delay purchases, expecting prices to fall further. This could trigger a demand slump, hitting sectors like consumer durables and retail hard. Japan’s “lost decades” serve as a cautionary tale of how deflation can choke growth.

RBI’s warning bell: The RBI’s latest monetary policy review projects inflation rising to 4.6% in Q1 FY26, driven by potential food price spikes and global pressures like US tariff hikes (impacting 10.3% of the CPI basket). If businesses and consumers bank on low inflation now, only to face a sudden uptick, it could disrupt planning and erode confidence.

The GST wildcard

The anticipated GST rate cut from November 2025 could tilt the scales. Lower GST on essentials could keep inflation below the RBI’s projections, supporting consumer spending and giving the RBI more room to ease rates.

For instance, a 1% reduction in GST on food items could shave 0.1-0.2% off headline inflation, based on historical studies. This would be a boon for growth, especially in rural areas where food dominates household budgets.

But there’s a catch. Lower GST could reduce government revenue, limiting fiscal space for infrastructure spending—a key driver of India’s capex cycle. Plus, if global commodity prices or US tariffs spike, imported inflation could offset GST’s deflationary impact, forcing the RBI to rethink rate cuts.

Conclusion

Low inflation could be an opportunity as well as a challenge for India. In the short-term, it’s a tailwind—cheaper goods, lower borrowing costs, and potential GST relief could juice up consumption and growth. But sustained low inflation risks stifling capex and savings, which India can’t afford. The RBI’s cautious outlook for FY26, coupled with external risks, suggests it will tread carefully, likely opting for a modest 25-basis-point cut in October rather than aggressive easing.

Investors should watch the October MPC meeting closely and track GST reform updates. Sectors like consumer goods and banking could benefit from lower rates and higher spending, but keep an eye on capex-heavy industries like infrastructure and manufacturing for signs of slowdown. For now, enjoy the calm—but don’t bet the farm on it lasting.

Tuesday, August 19, 2025

It’s sunny outside, but better to carry umbrella

In his Independence Day speech, the prime minister announced that his government has proposed comprehensive reforms to the extant Goods and Services Tax (GST) structure. The proposals have been reportedly sent to the Group of Ministers (GoM). Two Groups of Ministers (comprising representatives of the State governments) — one on rate rationalization and another on compensation cess — will have to approve the proposals before they go to the GST Council for approval. The central government is quite confident that the GST Council members shall approve the proposals promptly, and it could be implemented before the forthcoming festival season. The stated objectives of the proposed GST reforms, focus on simplifying the tax system, reducing the tax burden, and promoting economic growth.

Based on the publicly available information, the key highlights of the proposed GST reforms are as follows:

Structural Reforms

Correct inverted duty structures to align input and output tax rates, reduce input tax credit accumulation and support domestic value addition.

Resolve classification disputes by streamlining rate structures to minimize disputes, simplify compliance, and ensure equity and consistency across sectors.

Provide long-term clarity on rates and policy direction to enhance industry confidence and support better business planning.

Rate Rationalization

Simplify the GST structure by reducing the current four slabs (5%, 12%, 18%, 28%) to a two-slab system (5% and 18%), with a special 40% rate for luxury and sin goods like tobacco and online gaming.

Lower taxes on essential and aspirational goods (e.g., refrigerators, air conditioners, packaged food, medical items) to enhance affordability, boost consumption, and make these goods more accessible, particularly for the common man, middle class, women, students, and farmers.

Maintain current tax incidence on sin goods (e.g., tobacco at 88%) by subsuming compensation cess into a uniform 40% rate after its expiration.

Ease of Living

Simplify compliance processes, particularly for small businesses and startups, through seamless, technology-driven, and time-bound registration.

Introduce pre-filled returns to reduce manual intervention and mismatches.

Ensure faster, automated refund processes for exporters and those affected by inverted duty structures to cut delays and build trust in the system.

Markets welcome the proposals

The Indian equity markets reacted to the proposal with enthusiasm. Despite lingering uncertainties over implementation of penal tariffs from 27^th August 2025, benchmark indices gained ~1.5%. The sectors expected to be directly benefiting from the lower incidence of GST, e.g., automobile, white goods, FMCG, insurance, cement, retail trade etc. witnessed strong buying. After almost seven weeks of sideways to weak market movement, it was a pleasant scene to witness.

In my view, the proposed GST reforms, in conjunction with the lower incidence of income-tax, expected pay commission benefits from the current fiscal year, good monsoon leading to improved rural income, stable prices, lower rates and adequate liquidity in the system shall support the Indian equity markets, especially the consumption (also see here), a sector which has been struggling for some time. Nonetheless, it would be in order to exercise some caution and not get overexcited by the GST proposals.

In particular, the traders might want to suitably factor in the following considerations in their expectations:

· GST restructuring may be overall revenue neutral, implying that net impact of the GST rate rationalization may not be significant. For example, some 5% items can go to a higher slab of18% and some 28% items may go to 40%. Besides, the compensation cess that was to end by March 2026, may get subsumed in the 40% rate for many items and become permanent.

· In the past few years passenger vehicles with higher engine capacity (SUVs and large cars) have witnessed the highest growth rate. The effective GST rates on these vehicles may not come down (or even go higher).

· The prime minister has repeatedly mentioned the urgency to control obesity. Several consumption items (e.g., aerated beverages, confectionary, fried snacks, sweets etc.) are popularly believed to be contributing to the rise of obesity amongst common people, especially youth. These goods could potentially get classified as “sin" items and qualify for the highest tax rate.

· To neutralize the fiscal impact of lower GST collection, the government may choose to cut subsidies on food and EV/solar. The pay commission award might also be rationalized to factor in the benefits of lower income tax, GST and inflation; resulting in lower rise in income than presently estimated.

· Some of the lower GST benefits may be used to set-off losses on account of higher US tariff (for businesses which are not 100% export oriented) and not passed on to the consumers.

· A major destocking exercise could happen before new GST rates come into effect. Buyers of discretionary items like cars and white goods may postpone buying till lower GST rates come into effect. 2QFY26 results may be impacted by lower sales and destocking. Though, Nov Dec may see accelerated demand and overall FY26 impact may be positive.

· Petroleum products and alcohol continue to stay out of the GST ambit.

· Not likely (but also not improbable), but the GST Council may not immediately approve the proposed changes in the GST rate structure, delaying the implementation. It will disappoint the traders and cause heightened volatility in the markets.

Thursday, August 14, 2025

Strategy review in light of the US tariffs - 3

…continuing from yesterday.

In my view, assimilating the impact of a sustained Indo-US trade standoff in a personal investment strategy is an extremely complicated task, for three reasons – (i) Indo-US relations are very deep and wide; (ii) Indo-US trade relations go much beyond import and export of goods and service; (iii) Indo-US trade relations are intricately intertwined with strategic, geopolitical and social relations.

Hence, the impact of a prolonged standoff in the trade relations may not be confined merely to a couple of thousand Indian exporters, having a material exposure to US markets. In my view, a noticeable impact could be felt at economic, political, geopolitical, and financial levels.

As of this morning, we do not know about the progress in back-channel negotiations. But visibly both the sides appear to have hardened their stance. India has outrightly rejected the reasons cited by the US administration for imposing penal tariffs, viz., purchase of crude oil from Russia, as unreasonable and completely untenable. The US President has extended the tariff moratorium for China (the largest buyer of Russian oil) by another 90 days. He is attending a meeting with the Russian president tomorrow. In my view, this is indicative of a different design behind these tariffs, rather than the stated one (also read Tariff Tantrums).

I hope that a sense will prevail and the Indo-US relations get normalized soon. Would be even better if this normalization of relations is part of a larger global resolution, in which the US and other major trade partners like China, Russia, Japan, and EU also come to a sustainable agreement. This could usher a new phase of global economic growth, in which India could be a meaningful partner.

However, if parochialism, hyper nationalism and/or vested business interests override the spirit of cooperation and globalization, and a broad-based resolution is denied, India faces economic and geopolitical challenges that would require material policy changes, including foreign, trade, fiscal and monetary policies.

If I were to imagine a worst-case scenario in Indo-US relations, I would draw a picture using the following colors and shapes.

· The US maintains penal tariffs, or even increases it further. The US businesses find it unviable to import from the Indian vendors. For generic goods and commodities, they shift to alternative sources (partially or fully) in the next 6-9 months. For specialized goods like specialty chemicals, auto components, pharmaceuticals, polished precious stone and jewelry, etc. the US importers may adopt a India+1 strategy. They may focus on developing alternative suppliers over the next 1-2 years and shift a part of their sourcing to such alternative vendors.

· The US administration brings services and remittances also within the ambit of tariff/taxation. More non-tariff restrictions are (VISA, qualifications, numbers, minimum pay etc.) also imposed on Indian workers and students. This might force more Indian companies to establish onshore entities in the US and increase local hiring. Alternatively, some Indian companies may choose to establish entities in the foreign jurisdictions with favorable terms of trade with the US.

· The US may restrict technology transfer to India by the US entities, hampering the growth of the manufacturing sector and R&D initiatives.

· The US may increase strategic engagement with the neighbors of India, especially the hostile neighbors like Pakistan and Bangladesh, to put geopolitical pressures and keep the borders insecure.

· The US may also incentivize/pressurize its close allies to review their relationships with India.

· The US administration may sanction certain Indian entities on the pretext of criminal activities, supporting war, unethical business practices etc., particularly impacting their global business and financing deals.

· The global economy also suffers, as the Political instability and unpredictable economic policies in the U.S., erodes confidence in the US economy and financial system. The foreign capital begins to move out of the US, causing sharp volatility and decline in the US asset prices, pressing the USD lower and bond yields higher, and a potential stagflationary condition.

· Several Indian MSME's face severe financial stress as they lose their US business. Some of them fail to survive as they are unable to develop alternative markets in time. Many downsize their operations. Several medium and large businesses establish overseas entities with a local employee base. Unemployment rises. There is some incremental stress on the financial system. Consumption suffers. Realty demand falls. Government faces fiscal pressures as growth declines and the deflationary trend strengthens.

If I close my eyes and visualize this picture, it frightens me to the core. If I try to assimilate even a part of this to my investment strategy, I would end up holding almost zero risk asset (equity). I would therefore refrain from any such exercise.

If you ask me “whether this worst-case scenario is possible?”, I would say “yes”. If you ask me what is the probability of this occurring, I would say “very low” but not “zero”.

I would like to believe that a broader global trade agreement may happen in the next 3-5 months, and Indo-US trade relations normalized to pre 2025 level, at least. In the meantime, I would, however, rationalize my portfolio to reduce the weightage of smallcap companies having over 20% revenue exposure to the US. In the mid and large cap space, I would only review the companies with over 20% revenue exposure to the US, provided they have significant debt on their books and are trading at a premium valuation (more than 20% premium to their long-term average valuation).

Wednesday, August 13, 2025

Strategy review in light of the US tariffs - 2

…continuing from yesterday.

To assess the impact of the latest changes in tariffs on the Indian exports to the US, on investment strategy and make suitable changes to minimize the adverse impact on investment portfolios, it is important to understand the dimensions of the Indo-US trade, its elasticity to tariffs, and sustainability of tariffs on various merchandise. Given the southward sloping trajectory of the Indo-US strategic relations since 2018, it may also be relevant to speculate a worst-case scenario; and find ways to assimilate that into investment strategy.

Dimensions of Indo-US trade

(Important note: The figures given in the following discussions have been taken from various sources, including the WTO, US trade department and India’s department of commerce. At various places these are reported either for calendar year or financial year. In some cases, these are provisional numbers. There could be some mismatch in terms of CIF and FoB reporting. Besides, I have rounded off numbers for convenience at many places. So please consider these data and pointers just for assessing a broader trend and not for doing any precise analysis. I would also not completely rule out any error in the figures. Readers may want to cross check where numbers appear incongruent.)

The US accounts for one fourth of India’s total exports

The US has been a key trading partner of India in the past three decades. Exports to the US account for more than one fourth of the India’s total

· In 2024, India exported goods worth US$87.3bn to the US; and it imported goods worth US$41.5bn from the US.

· India exported services worth US$41.6bn to the US, and imported services worth US$41.8bn from the US.

· India had an annual trade surplus with the US of appx US$45bn.

· Overall, in FY25, India exported goods and services worth US$821bn, and exported goods and services worth US$915.2bn. In this merchandise export were US$437.4bn, and merchandise imports were US$720.2bn

· The exports to the US constituted ~26% of India’s total exports. However, merchandise exports were slightly less at 20% of the total merchandise exports.

Pharma a key export for India, not so for the US

· Pharmaceuticals are a major part (US$11bn or ~12% of the total merchandise export to the US in FY24) of the Indian exports to the US.

· The US accounts for almost one third of India’s total pharmaceutical exports (FY24-US$31bn). Overall, the US imports pharmaceutical products worth US$180bn annually. Imports from India are thus ~6% of the total pharmaceutical imports. Ireland (28%) and Germany (21%) are major sources of pharmaceutical imports into the US.

· Pharmaceutical products are presently not subject to the reciprocal and penal tariffs announced by the US administration, effective from 07^th August and 27^th August 2025 respectively.

Precious metals, Engineering goods and Petroleum products are top exports

· In 2024, India exported US$9.2bn worth of precious stones & metals (~10% of total goods exported to the US), US$12.3bn worth of electrical machinery & equipment (~14%), US$11bn worth of petroleum products (~13%) and US$6.7bn worth of nuclear reactors, boiler, and machinery (~7.5%; exempt from the latest tariffs presently).

· Export of Textile, Apparels, etc. was appx US$5.2bn (6%).

· Telecom instruments/electrical parts worth US$2.2bn (2.5%) were exported.

Important to note that a lot of export from India to the US is done using imported raw material. A significant part of gems, precious metal, petroleum products, telecom equipment etc. is re-export of imported inputs after some value addition. Total value addition in these goods is much less as compared to textiles, carpets, pharmaceuticals etc. So, the net economic effect of slowdown in low value addition exports (almost 30% of the total exports to the US) may be much less.

The following is a summary of assessment study on India’s key exports.

High risk of loss in competitive edge

Electrical machinery & equipment — Highly price-sensitive, intense competition from China, Vietnam, Mexico; Indian exporters would lose market share quickly.

Apparel & textiles — Margins are thin, heavy competition from Bangladesh, Vietnam; high tariff would wipe out price competitiveness.

Articles of iron or steel — US can source from South Korea, Mexico, Turkey; India would see sharp volume declines.

Organic chemicals — Competitive global supply from China & Germany; would lose share unless specialized grades.

Medium risk — partial substitution possible

Machinery & mechanical appliances — Some niche segments less replaceable, but mainstream machinery will shift to other suppliers.

Optical/medical instruments — US has domestic production and EU/Japan suppliers; tariffs would hurt Indian share.

Low risk — possible tariff pass-through

Pharmaceuticals — US dependent on India for generics & APIs; short-term volumes unlikely to fall sharply, though margins may compress.

Precious stones/metals — Price elasticity lower; India could pass part of tariffs to US buyers due to skill-based competitive edge.

Mineral fuels — Mostly re-exports/refining trade; US can diversify but switching costs high for certain grades.

Items where US is significantly dependent on India

(High potential to pass on tariffs without major volume loss)

Generic pharmaceuticals & bulk drugs — India supplies 30–40% of US generic prescriptions.

Cut & polished diamonds — India processes ~90% of the world’s diamonds by volume.

Certain specialty chemicals & dyes — Limited alternative suppliers at scale.

Scenario analysis

For many Indian MSMEs — particularly in textiles, leather goods, handicrafts, small engineering components, jewelry, and carpets — the US is not just a large market; it’s often the largest, sometimes contributing 30–70% of annual revenues.

Until now, Indian exporters benefited from relatively low MFN tariffs, often 2–6% lower than competitors. The new tariff wipes out this edge, pushing landed prices above those from Vietnam, Bangladesh, or Mexico — in some cases by 10–15%.

For price-sensitive segments, that is an existential threat.

…to continue tomorrow

Tuesday, August 12, 2025

Strategy review in light of the US tariffs

The US administration has announced imposition of 50% additional tariffs (25% reciprocal and 25% penal), over and above the regular/MFN tariffs that were already in place, on merchandise imports from India. Certain items, like pharmaceuticals, that are part of separate trade negotiations, and services are presently not part of the new tariff rates and continue to be charged at the extant rates.

This level of tariff is indubitably concerning, as it makes numerous Indian MSME businesses, especially those exporting textile, leather goods, small components, jewelry, carpets etc., incompetitive; and in many cases poses an existential threat to the exporting entities. For several MSME the US market contributes a substantial part of their revenue; and these entities were enjoying some advantage over competitors due to lower MFN tariffs. They not only lose this advantage, but become materially incompetitive due to these tariffs.

These reciprocal and penal tariffs, in my view, tantamount to covert economic sanctions on India by the US. The reason cited for the penal tariffs is continued import of crude oil by Indian oil companies from Russia. The Indian government has clearly communicated to the US administration that this reason is not valid, as several other countries, including the EU, which also import crude from Russia are not subject to penal tariffs.

The situation is still evolving as the trade negotiations with the US are still under way, and these high tariffs are not permanent as of now. Nonetheless, the probability of these tariffs staying for a longer term is not zero. It is therefore important for everyone, including businesses, policymakers, and investors, to script a worse-case scenario for themselves and test their preparedness for such a scenario.

Notably, the present tariff action of the US administration is neither a surprise nor an isolated act of aggression against India. In the past 7-8 years there has been a pattern in the evolution of Indo-US relationships. Particularly since 2018, the US administration has been actively looking to base the mutual relationship on equality. President Trump seeking to rebase the relationship seeking full reciprocity from India on key economic, trade and technology issues is just a continuation of the evolving pattern. (Read more on this New chapter in Indo-US relations).

It is also pertinent to note that since 2018, the US has withdrawn the benefits under Generalized System of Preferences (GSP); materially tightened scrutiny on Indian IT and pharma compliance; persistently stalled progress on a bilateral trade deal; virtually downgraded the diplomatic status through exceptional delay in appointing an Ambassador to India (Indian mission of the US headed by an interim Chargé d'affaires during January 2021-March 2023 and January 2025 till present day; see details) and causing inordinate delays in grant of VISA appointments to Indians; disgracefully deported illegal Indian immigrants. These are some of the pointers towards the evolving pattern of Indo-US relations since 2018. The tariff spike is simply an extension of this pattern.

Some entrepreneurs, politicians, investors and thought leaders have called for a 1991 (balance of payment crisis) and 1998 like (economic sanctions post nuclear test) response to the situation. They have suggested that the government should use this opportunity to initiate some major reforms, like 1991 and 1998, to further strengthen the resilience of the Indian economy. Many of them see the current situation equivalent to economic sanction (through trade route) and suggest an appropriate response accordingly.

In my view, the Indian economy urgently needs several major reforms, regardless of the outcome of the present trade conflict with the US. The current situation does provide a catalyst and a valid excuse to implement these reforms that may cause some short-term pain to various stakeholders.

In the next few posts, I shall discuss my thoughts on the areas that need urgent reforms and changes, if any, required in the investment strategy in light of the latest US tariffs. Before that it is important to take note of the 1998 crisis, and how the situation in 2025 may be different.

Operation Shakti triggered global sanctions on India

India had maintained a policy of nuclear ambiguity since its first nuclear test in 1974 (Smiling Buddha). Over the years, global non-proliferation efforts intensified, particularly after the Cold War. On May 11 and 13, 1998, India conducted five underground nuclear tests in Pokhran, Rajasthan, codenamed Operation Shakti.

Operation Shakti, triggered a wave of economic sanctions from the US, Japan, Canada, the EU, and international financial institutions like World Bank, IMF and ADB. Notably, Russia, France, and Israel did not participate in sanctions. China issued strong condemnation but refrained from economic penalties.

Under the sanction, most of the non-humanitarian financial aid was suspended. Export of military and dual use technology to India was banned. All defense cooperation and technology transfer treaties were suspended. A freeze was put on loan guarantees and financial assistance. Lending to India by the World Bank, IMF, and ADB temporarily halted/slowed.

The extant government decided to take the global pressure head-on. It steadfastly refused to sign the Comprehensive Test Ban Treaty (CTBT) under pressure. The government also launched an aggressive diplomatic campaign to explain its position, emphasizing strategic necessity and national security concerns. Most importantly, the government unleashed several structural reforms to strengthen the domestic economy. Notably, the government divested its monopoly over core sectors like coal, power, telecom, oil & gas, civil aviation, etc. An ambitious national highway development plan (NHDP) was launched. Several fiscal incentives were provided to promote exports. A special economic zone (SEZ) policy was implemented. Several tax and other concessions were offered to the ITeS sector.

Consequently, the impact of the sanction remained contained. Reforms attracted material private capital flows from global investors. Turbulence in the market was short lived, and within a year the market scaled new highs. Sensex rose from ~3,300 in Jan 1999 to ~5,100 by March 2000, a jump of 50% in 15months.

Overall, the impact of sanctions was marginal.

The sanctions were lifted within two years as India materially helped the world in managing the Y2K crisis; unilaterally announced a “no first use” nuclear doctrine.

Situation in 2025 is different from 1998

The present situation is however materially different from the 1998 situation. First, the present trade action is limited to the US, unlike 1998 when a number of trade partners had imposed restrictions. Second, the Indian economy is now much stronger and materially more integrated into the global economy as compared to 1998. The impact of trade restrictions on the local economy, therefore, could be materially higher. Third, the political situation in India is much more stable now as compared to 1998, when the coalition was more fragile. Fourth, India has strengthened its global strategic position significantly in the past 27years. With several multilateral alliances (G-20, BRICS, QUAD etc.) and bilateral treaties, India has much stronger support from its global partners as compared to 1998.