Conflicts and macro threaten India's firewalls

Policy agility, prudence, and resilience will be key for sustained growth in a rapidly changing global landscape

Over the last two months, geopolitical and market developments have emerged as risks to India’s economic outlook. 

External shocks
 

Geopolitically, the Israel-Hamas conflict continues and there is uncertainty over whether this will escalate. So far, Brent crude oil prices have risen marginally to build some geopolitical risk premium, but not a full escalation. Opec+ production cuts had already set a floor, and if the West Asia conflict escalates, then crude oil prices could rise further.

On the market front, US long-end government bond yields have drifted higher, with 10-year yields breaching 5 per cent for the first time since 2007. This selloff has been driven by higher real yields, likely reflecting more resilient US growth and a higher term premium due to the bond demand-supply gap. Higher US real yields have resulted in capital outflows from emerging markets and are weighing on equity and currency markets, tightening financial conditions.

India’s firewalls

Policymakers in India have muted the domestic spillovers of these external developments so far. The Reserve Bank of India (RBI) has used its foreign exchange (FX) reserves to keep the rupee stable, while retail fuel prices remain unchanged.

However, there have been other spillovers. Capital outflows have weighed on equity prices, the RBI’s dollar selling is draining durable liquidity, and oil marketing companies face under-recoveries on petrol and diesel.

The ability of policymakers to sustain these firewalls will depend on the durability and magnitude of the shocks. If the shocks are short-term, then the firewalls can be sustained. However, if the shocks are longer-lasting, then some adjustments will become necessary. For example, the more the RBI tries to defend India’s currency via FX intervention, the greater will be the fall in FX reserves, which could trigger speculative attacks, while putting upward pressure on domestic interest rates due to tighter liquidity. Similarly, sustained higher oil prices will add to fiscal pressures directly or indirectly, if they are not passed on to consumers. 

A stagflationary shock, if it is sustained

From an economics perspective, these developments are stagflationary in nature (they will weigh on growth and add to inflation) and pressurise the twin deficits (fiscal and current account).
 

If the shock is short-term, then the impact on growth, inflation, and the fiscal situation can be contained, with the immediate impact mainly on the balance of payments. This is because the rising cost of imported oil will worsen the current account, while capital outflows are likely on portfolio equity and debt, with overseas debt fund raising also likely to slow. India does have the cushion from the bond index inclusion, but those benefits are likely to accrue mainly from mid-2024 onwards.

However, if these external pressures are more longer-lasting and/or escalate, then this can become a bigger drag on growth.

Higher oil prices will weigh on the terms of trade. Higher uncertainty, weak sentiment, and tight financial conditions typically bode ill for investments. Sustained equity market weakness and tight banking liquidity can further delay the expected turn in the private capex cycle. If fiscal pressures build, then the room available for public capex will become constrained. The impact on private consumption should be less, but an uneven rural-urban recovery is already a concern. None of these effects will be visible immediately, as transmission takes time. However, downside risks to gross domestic product (GDP) growth in 2024-25 are rising.  

On inflation, we see no discernible impact in the short-term, because of the policy firewalls. The correction in tomato prices has offset rising price pressures in the broader food basket — rice, wheat, pulses, sugar, spices — due to the El Niño risks.

Underlying price pressures also remain contained, with core consumer price index-based inflation continuing to disinflate and household inflation expectations down to single-digits for the first time since the pandemic. Although not immediate, upside risks to medium-term inflation from food, oil, and currency remain.

Agility, prudence and resilience

For policymakers, these developments mean that maintaining financial stability takes precedence, while still managing the price stability-growth mandate.

In the short-term, the RBI can sustain its eclectic approach of using FX reserves to manage the currency and open market operation sales to keep liquidity on leash and real rates attractive, while the government uses supply-side policies to keep food and oil inflation at bay. These buffers enable the RBI to focus on domestic issues. It does not need to hike, as core inflation is low, neither should it cut, as supply-side inflation risks are still prevalent.

However, if these external pressures are sustained, then the trade-off between growth and inflation could become more pronounced. In this situation, policy prudence can help prevent India’s risk premia from rising. Price stability is the bedrock for sustained growth, and the RBI will need to stand ready to respond, if second-round inflation effects start materialising. Fiscal pressures will likely rise due to a higher subsidy bill and weaker tax collection, as growth softens. As we enter the election season, fiscal prudence at both the central and state levels will be needed to stick to the fiscal glide path. This will ensure that fiscal-monetary policies work in sync.

That said, uncertainty remains high. While the US economy has remained resilient for longer than expected, it is not certain how long this will last. Hence, policy agility is important.

The world economy has faced repeated shocks over the last four years. Geopolitics and climate change are no longer just medium-term risks; they are affecting the economic outlook at this very moment. This calls for building resilience.

India should build its FX reserves buffer and diversify them. We should set aside a countercyclical fiscal buffer during good times to smooth out the shocks during bad times. Monetary policy must ensure real rates balance saving and investment needs, and inflation is aligned closer to the target. Regulatory norms should ensure that credit creation is more geared towards productive purposes, and not just for leverage-driven consumption.

While India will not be immune to global spillovers, we need to create the macro preconditions for sustained growth. Policy agility, prudence, and resilience will be key.

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