Riding out the storm

External shocks and stagflation risks require optimal policy responses

Just as India was crawling its way out of the pandemic, the war, a hawkish Fed, and China shocks have reignited macro uncertainties. Combined, they risk higher inflation and slower growth in FY23, alongside more policy trade-offs.

Looming external shocks

The Russia-Ukraine war: The ongoing war has fewer direct effects on India, but more indirect ones through higher commodity prices and weaker global demand. Global supply chains have been disrupted again due to the key roles of Russia and Ukraine in the exports of food, energy, fertilisers, industrial metals, and gases. Globally, the European economies are the most exposed due to their dependence on Russian natural gas. Even if there is a ceasefire, sanctions on Russia are likely to continue, which will mean a tight demand-supply balance in the energy markets. A spill-over from energy costs to food prices is a concern.

A hawkish Fed: Unlike Europe, the impact of the war 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 credibility. We think this means 200 basis points (bps) in tightening this year, with consecutive 50 bps in frontloaded hikes in May and June. A balance sheet runoff is likely from mid-May.

Sluggish China: We believe the chances of China exiting its dynamic zero Covid strategy this year are 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 will mean rising economic costs for China, which could offset the gains from policy easing.

Illustration by Binay Sinha

Higher inflation and lower growth ahead

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

The consumer price index inflation rate is at risk of nearing or even breaching 6 per cent in FY23 due to supply and demand-side pressures. Supply-side pressures include the ongoing adjustment in fuel prices, the upcoming 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 put upward pressure on local prices. Edible oil prices are already rising. The higher cost of farm production will raise 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.

Gross domestic product (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 minimise the hit to their profits. A slowdown in Europe and China could puncture the export cycle, albeit 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 keep domestic monetary conditions are still accommodative. On balance, we expect GDP growth of just over 7.5 per cent in FY23, with the risk of a slowdown in the second half of the fiscal year.

The balance of payments will also come under pressure as India faces a shock on the current and capital accounts. Our estimates suggest the current account deficit will rise above 3 per cent of GDP in FY23, versus net FDI inflows half that amount. The basic balance of payments will 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. Pressures on fiscal finances are already likely from a much higher fertiliser subsidy bill in FY23, so a reduction in excise duty on fuels will mean choosing between cutting capex or allowing a fiscal deficit slippage. The Reserve Bank of India (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 and producer, and between fiscal and monetary policies.

If crude oil prices stay high, the government should reduce excise duties to lower the burden on consumers. It should also steer away from compromising on capex because private investments remain lacklustre. This may mean relying more on asset sales, other taxes, or a marginal fiscal slippage in the worst case. Meanwhile, the RBI should focus on inflation risks because the chances of a more durable inflation outturn are no longer trivial and any benefit from easy policies in the short term will be more than offset in the medium term due to a belated policy catch-up and as inflation itself becomes a drag on growth. In our view, inflation and current account challenges, despite a negative output gap, suggest 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 war on global economic and geopolitical order may mean building domestic resilience on 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.

The writer is chief economist (India & Asia ex-Japan), Nomura