India: External shocks, stagflation risks and policy trade-offs

Three external shocks confront us

1. The Russia-Ukraine conflict. The ongoing conflict has less direct effects on India, but more indirect effects via higher commodity prices and weaker global demand. Global supply chains have been disrupted again, due to Russia and Ukraine’s key roles in the global supply of food, energy, fertilisers, industrial metals and gases. Globally, the European economies are the most exposed due to their dependence on Russian natural gas imports. Even if there is a ceasefire, sanctions on Russia are likely to continue, which means a tight demand-supply balance in the energy markets. Spill-over effects from energy costs to food prices are a concern.

2. A hawkish Fed. Unlike Europe, the impact of the conflict on the US will be felt primarily via higher inflation. With signs of inflation broadening out and worries about a wage-price spiral, the Fed wants to regain its inflation-fighting credibility. Including the 25 basis points hike in March, we think this means 250 basis points in cumulative tightening this year, with three consecutive 50 basis points hikes followed by three 25 basis points hikes. Balance sheet run-off is likely from mid-May.

3. Sluggish China. We believe the likelihood of China exiting its dynamic zero Covid strategy this year is quite low, because it still needs to develop its own more effective vaccine and the next 12 months are critical due to the once-in-a-decade leadership change. Amid the highly transmissible Omicron variant, this strategy means rising economic costs for China that could offset the gains from policy easing.

Higher inflation and lower growth ahead

For India, this external environment will likely lead to higher inflation and lower growth, with inflation effects dominating the growth hit. It will also likely lead to a worsening of the twin fiscal and current account deficits due to the negative terms-of-trade shock.

CPI inflation is at risk of nearing or even breaching 6% in FY23, due to supply and demand-side pressures. Supply-side pressures include the ongoing adjustment in fuel prices, the rise in domestic gas prices and upward pressure on electricity costs. India is a net food exporter, but rice and wheat exports will also reduce the domestic marketable surplus and exert upward pressure on local prices. Edible oil prices are already rising. The higher cost of farm production should result in higher minimum support prices. Demand-side pressures are likely to firm up as well. Even as the output gap is still negative, the degree of slack is lessening. Higher commodity cost pressures are leading firms to raise their final product prices. The economy’s reopening will also push services inflation higher.

GDP growth faces downside risks. Spending on food and energy tends to be inelastic, so higher costs without a concomitant rise in nominal incomes will squeeze real disposable incomes and hurt low income households disproportionately. High commodity prices could force firms to cut production to minimize the hit to their profits. A slowdown in Europe and China could puncture the export cycle, although with a lag. Tighter financial conditions may lead firms to postpone capex. There are offsets: the economic reopening should buoy the laggard services sectors and domestic monetary conditions remain easy. On balance, we expect GDP growth of just over 7.5% in FY23, with the risk of a slowdown in H2 of the fiscal year.

The balance of payments will also likely come under pressure, as India faces a shock on the current and capital accounts. Our estimates suggest the current account deficit will rise to above 3% of GDP in FY23, versus net FDI inflows of half that amount. The basic balance of payments is set to be deeply negative, leading to currency depreciation pressures.

Rising policy trade-offs

Such an external supply-side shock ideally requires fiscal policy to step in via tax cuts or subsidies, but policymakers will have to navigate various economic trade-offs. Pressure on fiscal finances is already likely from a much higher fertilizer subsidy bill in FY23, so a reduction in the excise tax on fuels means choosing between reducing capex or allowing fiscal deficit slippage. The RBI also faces a trade-off between higher inflation and slower growth. Continued high inflation tolerance amid a gradual drift higher in inflation expectations risks hurting the RBI’s inflation fighting credibility and financial repression of savers. Thankfully, the external sector trade-offs are easier to manage. The large buffer of foreign exchange reserves means the RBI can intervene and sell dollars, if necessary. This will smooth exchange rate movements, while also draining durable liquidity.

Optimal policy response

Ultimately, the burden of these shocks will have to be shared between consumer/producer and between fiscal/monetary policies.

If crude oil prices stay high, the government should reduce excise taxes to lower the burden on consumers. It should also steer away from compromising on capex, because private investments remain lackluster. This may mean relying more on asset sales, other taxes or marginal fiscal slippage in the worst case. Meanwhile, the RBI should focus on inflation risks, because the likelihood of a more durable inflation outturn is no longer trivial and any benefit from easy policies in the short term will likely be more than offset over the medium term, due to a belated policy catch-up and as inflation itself becomes a drag on growth. Inflation and current account challenges, despite a negative output gap, suggests the steady state of growth is likely lower.

Finally, energy security may require boosting fossil fuel production in the near term, while the medium-term energy transition still requires a continued push towards renewables. India should also look to build its strategic oil reserves, when prices offer the next opportunity. The longer-term effects of the Russia-Ukraine conflict on the global economic and geopolitical order may mean building domestic resilience in energy, supply chains and doubling down on infrastructure spending to drive growth.

It is time to steer the ship towards shallower waves and ride out the storm.

A version of this article was first published in Business Standard on March 24, 2022