India's Economy Strong, But Middle East Tensions Pose Stagflation Risk

A Morgan Stanley report notes India's economy is buoyed by strong domestic demand and improving indicators. However, it cautions that rising geopolitical tensions in the Middle East pose a significant stagflation risk, threatening growth and stability.

India's economic outlook remains supported by strong domestic demand and improving high-frequency indicators, but rising geopolitical tensions, particularly in the Middle East, pose significant risks, including the possibility of stagflation, according to a report by Morgan Stanley. The report noted that "domestic demand remains resilient; however, headwinds are emerging as ongoing geopolitical tensions create a stagflationary risk," adding that while macroeconomic stability indicators are currently favourable, "prolonged disruption poses downside risks to growth and could worsen macro stability."

Domestic Demand and Economic Strength

High-frequency indicators highlighted in the report suggest broad-based strength in the economy. There has been a broad-based improvement in auto sales, while credit growth is improving, indicating sustained consumption and lending activity. Additionally, the report mentioned that the GST collections remain resilient, reflecting stable economic activity, and manufacturing PMI has improved, although services PMI has edged down, suggesting some moderation in the services sector.

The labour market outlook is also showing signs of improvement in CY2025 and CYTD26, alongside a gradual rise in employee expenses among BSE-500 companies, pointing towards strengthening employment conditions. Corporate performance remains steady, with corporate revenue holding up in the December 2025 quarter, while nominal growth is expected to improve in FY2027E.

Financial flows within the economy also remain supportive. The report highlighted that monthly SIP flows remain upbeat, indicating continued retail investor participation, and the flow of funds to the commercial sector remains healthy, suggesting adequate credit availability for businesses.

RBI's Proactive Policy Stance

On the policy front, the Reserve Bank of India has taken proactive steps to maintain liquidity. The report noted that the RBI has conducted proactive liquidity management, with the policy rate currently at 5.25 per cent, while interbank liquidity remains in surplus, ensuring sufficient liquidity in the system.

External Risks and Vulnerabilities

However, the report cautioned that India remains exposed to external risks, particularly from the Middle East. It stated that India remains vulnerable to volatility in global commodity prices, especially energy. The region is also critical for India's external sector, with exports to the Middle East accounting for around 15 per cent of total exports, while the Middle East accounts for 38 per cent of India's remittances.

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