Macro policy for uncertain times

External storms are morphing into hurricanes. India is in a relatively better position than many other countries, but this period of heightened volatility will require agility and clarity on policy

Despite recovering from the pandemic, repeated global shocks have presented numerous challenges for India’s economy this year, driving inflation and evoking balance of payments (BoP) pressures. These shocks will likely persist for much longer. 

In the US, even amidst signs of weakening growth, underlying inflation remains too high for the Fed to pivot; we expect the fed funds rate to rise to 5.25-5.50 per cent by early next year, which means further market repricing is likely. The synchronised global tightening, inventory destocking and the cost of living crisis mean that the world is in the midst of a synchronised global growth downturn, akin to the early 1980s. We expect recessions across major developed economies, with gross domestic product (GDP) growth likely to contract in 2023 across the US (-1.1 per cent, year-on-year), euro area (-1.6 per cent) and the UK (-1.4 per cent).

Geopolitical risks also remain, with signs of escalation in the Russia-Ukraine war and US-China tech tensions. The outlook for commodity prices, especially food and energy, remains uncertain, considering the tug-of-war between weak demand and potential supply shocks. A higher commodity price floor, even amidst a recession, cannot be ruled out. Following decades of debt build-up during a period of low interest rates, financial stability risks could materialise anywhere and at any time.

We are entering a period of weak growth, high volatility, and extreme uncertainty.

What this means for India’s macro outlook

This global backdrop has material domestic repercussions. Growth will likely be a casualty. Although the domestic growth engine is humming right now, the decline in exports last month could be just the beginning, and a deeper contraction may lie ahead. The combination of tight financial conditions, weak global demand and high uncertainty will further delay the private capex cycle, by at least another year, in our view. Private consumption growth should hold up well relative to exports and investment, but it too will likely slow, as the reopening boost fades and tighter domestic monetary conditions bite. We expect GDP growth of around 7 per cent y-o-y in FY23, but see downside risks; we then expect it to slow sharply to 5.2 per cent in FY24.

Weak growth should eventually moderate inflation, but only gradually, because the positives from easing supply-chain constraints and lower oil prices are being offset by currency weakness and upside risks to food inflation. On our forecasts, consumer price index inflation will remain above 6 per cent until February 2023 and then moderate to below 6 per cent, but average above 5 per cent even in FY24.

The twin deficits will likely remain a challenge. The fiscal deficit target of 6.4 per cent of GDP can be achieved this year by pruning non-capex spending, but fiscal consolidation in FY24 will be difficult amid weak growth impulses. We also expect the current account deficit to remain above sustainable levels of 2.5-3 per cent of GDP, both in FY23 and FY24, due to a higher growth gap (India versus rest of the world) and higher energy prices. Funding the BoP will likely remain a challenge in FY23. India’s higher relative growth should eventually garner more capital inflows, but only when the global dust settles.

Illustration: Binay Sinha

Policy choices: Macro stability or growth?

Domestic policymakers are in the unenviable position of trying to balance inflation and stability while supporting growth. In the near term, policy should be focussed on ensuring macro stability.

Fiscal policy should stick to the consolidation road map, while monetary policy normalisation should continue to ensure that inflation sustainably moderates back to the 2-6 per cent target range, to nip any second-round effects in the bud and steer away from negative real rates.

BoP pressures can be managed through a multipronged strategy. The fall in headline foreign exchange (FX) reserves has received significant attention, but India’s FX buffers remain ample by most reserve adequacy metrics, and FX intervention should continue to be used to smooth out volatility. At the same time, the currency should also be allowed to adjust, acting as a shock absorber to correct trade imbalances by making imports more expensive and boosting exports, although weak global demand will offset this channel. Additionally, macroprudential, trade and capital account measures, such as stricter curbs on nonessential imports, can be used as a supplement to slow the pace of depreciation.

Rate hikes should not be used to defend the currency. Higher rates don’t necessarily lead to capital inflows when investors are in a risk reduction mode and when a country mainly attracts growth capital (like India). Monetary policy should account for the impact from a weaker currency but respond to domestic growth-inflation dynamics. FX intervention will tighten banking system liquidity, but we think that is par for the course, since the monetary policy stance should be neutral now rather than in a withdrawal of accommodation mode. Importantly, policymakers should not pre-commit, because shocks could appear from either side.

Over the medium term, we believe growth will need more policy focus. India’s post-pandemic recovery is middling. The Q1 FY23 GDP data show that the underlying growth trend is still below the pre-pandemic trends. The incoming global growth shock will likely cut short the domestic recovery, meaning that the road back to the pre-pandemic trends will take even longer. Sectors that were hit hardest during the pandemic, such as micro, small and medium enterprises, could again be at risk. Monitoring the potential sources of vulnerability will be important.

Supporting growth will mean an even bigger push on public capex, but above target (4 per cent) inflation and the higher fiscal deficit restrict the scope for pro-cyclical growth policies. Cutting back on unproductive spending, steering away from more giveaways and relying on tax compliance and asset sales for higher revenues are possible options. We will also need to push on new economic growth drivers, such as the integration with global value chains, digitalisation, green spending and start-ups, among others, to create more jobs.

As we look forward, the current global storms may turn into hurricanes. India’s economy is in a better position today both relative to other open economies and also due to its cleaner balance sheet, but it can’t escape global disruptions. Navigating this period of heightened volatility requires agility and clarity on policy priorities.

The writer is chief economist (India and Asia ex-Japan) at Nomura