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Dear Readers,
Last week, voters in the five states that went for polls settled a key concern: that of political uncertainty in India. Going into these elections, there was considerable economic stress — from unemployment to inflation to sub-par economic growth. The BJP was the incumbent party in four of the five states; in Punjab, it wasn’t expected to win. If the BJP had lost even two of those four states where it was in power, especially Uttar Pradesh, the country’s political discourse would have gone into hyperdrive. With no clear national alternatives, BJP’s loss would have resulted in increased political uncertainty in the country. The results of March 10, however, suggest that the BJP and Prime Minister Narendra Modi have been able to shrug off several state-level electoral losses since late 2018 — most recently in West Bengal — and look set to return in 2024.
In most countries, political stability and certainty would augur well for the country’s economic prospects. It is another matter that as far as India is concerned, “political” certainty hasn’t always resulted in “policy” certainty. This might be one of the key reasons why India’s economy has often grown faster during phases when “weak” coalitions were at the helm. Oddly enough, single-party majorities haven’t yielded phases of fast economic growth. Be that as it may, the March 10 results have settled any worries on the political certainty front.
But from a macroeconomic point of view, India continues to face another wave of economic uncertainty. Three years of secular deceleration (see CHART 1) in economic growth before the Covid pandemic and the severe income and price shocks during the past two years have meant that India’s economic recovery is still quite iffy.
Source: National Statistical Office, CRISIL
As CHART 2 shows, private consumption (PFCE), the biggest engine of India’s economic growth (accounting for more than 55% of the country’s GDP), is also the slowest to recover.
In the chart, PFCE: Private final consumption expenditure; M: Imports; X: Exports; GFCE: Government final consumption expenditure; GFCF: Gross fixed capital formation. (Source: National Statistical Office, CRISIL)
But just as the threat from Covid, as seen by the meagre impact of the Omicron variant, was receding, the economy faces an old nemesis: High crude oil prices. Russia’s invasion of Ukraine and the ensuing bans and sanctions on Russia have already led to a spike in crude oil prices. There are apprehensions that if this conflict is allowed to drag on for months on end, then oil prices could not only spike further but stay that way for long. As this explains, there is no easy way to replace Russia in the global energy market.
How vulnerable is India?
India is particularly vulnerable to higher oil prices because we import over 84% of all our oil needs. Thanks to the aforementioned state elections, Indian consumers have been shielded from the spike in oil prices in the global market.
If domestic prices were to be brought in line with the global spike then, according to calculations by Sonal Varma (Managing Director and Chief Economist of Nomura Holdings), a litre of petrol and diesel would go up by Rs 25 and Rs 35, respectively, and a cylinder of LPG would be costlier by around Rs 400.
If you were thinking of buying a car until yesterday and the fuel prices went up that much in one go, you can imagine how demand for cars may come down.
What is worse is the fact that oil prices don’t just raise retail fuel prices. Speaking at a panel discussion (organised by CRISIL Ltd) on the outlook for the Indian economy, Neelkanth Mishra (Managing Director and India Strategist of Credit Suisse as well as a part-time member of the Economic Advisory Council to the Prime Minister) said the indirect impact on India would be “very meaningful”. When oil prices go up, so do the prices of edible oils because of the bio-fuel linkage. Similarly, coal prices go up, making electricity costlier. Natural gas prices also go up and so do the prices of fertilisers since they use gas as the feedstock and gas accounts for 80% of all fertiliser production costs. According to Mishra, costlier oil and other related commodities could imply an additional import burden of $100 billion on the economy in the coming 12 months. That’s roughly Rs 7.7 lakh crore (around 10 years of MGNREGA budget allocation) that Indians would have to spend more just to maintain consumption levels.
Now, regardless of who pays this money — whether the government passes through the higher prices on to the consumers or shields them completely by increasing subsidies — such an increase in the import bill will knock down the aggregate demand in the economy. That, in turn, will hurt India’s overall growth.
How will this play out in the economy?
Varma, also part of the same panel, explained the two main channels through which this adverse impact on demand may happen.
“It all depends on the extent to which the government lets consumers pay the higher prices,” she said.
Imagine if all or most of the prices are passed through to the consumers, then they are likely to experience a “pretty significant cost-of-living shock,” she said. That’s because consumption of food and fuel is very “inelastic” — that is, it does not change much when prices change. What’s worse, this inelasticity is higher for poorer consumers — the same lot of millions of people who have been struggling to recover their income and consumption levels, the so-called labharthis in political lingo — and as such, they would be worst affected by the resultant inflation.
If the government chooses to save consumers and decides to pay the extra cost from its coffers then one of two things will happen: Either its fiscal deficit will go up or it will have to restrict capital expenditure. The Fiscal deficit (expressed as a percentage of the country’s GDP) essentially refers to the amount of money the government has to borrow from the market to plug the gap between its total expenses and its total revenues. Higher levels of fiscal deficit (borrowings) typically result in fewer loanable funds being available in the market for the private sector to get a new loan (e.g. to start a new business).
If the government decides that it will both save the consumers as well as meet its fiscal deficit target then it will have to restrict its spending on capital expenditure. But ramping up capital expenditure has been the central strategy adopted by this government to boost growth and create jobs. Here is a piece that explains the government’s Budget strategy. Cutting back on capital expenditure in 2022-23 would derail the government’s medium-term growth strategy. It is also important to note in this regard that the financial year after that (i.e. FY24 or 2023-24) will be a pre-election year and there is a good chance that the government may want to keep some finances available for pre-poll freebies.
But demand destruction is not the only way higher oil prices will impact the Indian economy. That is just the first-order effect.
Mishra said if the oil prices stay high for longer than 3-4 months then the second-order effects will start to kick in. These will include events such as firms starting to fail — because demand for their goods has fallen — and as a result, the profitability of banks that gave loans to such faltering firms will come into question — because those firms will struggle to pay back the money, leading to those loans turning into non-performing assets (or NPAs).
The second-order effect essentially captures what may happen to investments in the economy. The investments — or the money spent by private firms and governments to build new productive assets — is the second-biggest engine of GDP growth in India; it accounts for 33% of all GDP. But faltering demand as consumers struggle with higher inflation will remove the incentive among private sector firms and entrepreneurs to spend money and invest in scaling up capacities.
Varma explained this succinctly: While it is true that a lot of corporate firms have much healthier balance sheets today than 2-3 years ago, that per se is only the necessary condition for boosting private sector investments. The sufficient condition is for the economy to have durable demand. In the absence of robust and widespread demand, the government’s Budget strategy of a private sector investment-led growth can, and will, unravel.
What about the RBI? Can it not help?
Varma said that typically central banks should not react to supply-side shocks. But when such shocks lead to persistent inflation, which, in turn, leads to higher inflation expectations among the people, then the central bank should intervene.
The problem, according to Varma, is that the RBI has been “significantly underestimating” inflation risks in India. Given this background, RBI will do one of two things: Either it will be forced to resort to a sharp course correction in the coming months or it will continue to accommodate higher inflation in its continuing bid to support higher growth.
If it does the former, then, Varma expects the repo rate — the interest rate that the RBI charges commercial banks when it lends money to them — to go up sharply from 4% at present to 5%. Since the repo rate is one of the most fundamental rates in the economy, this hike will raise the costs of borrowing across the board, thus hurting fresh investments.
In case the RBI decides to see through higher inflation and solely bother about boosting GDP growth then it will risk India facing stagflation. That’s because higher inflation would continue to erode consumers’ purchasing power and overall demand. This, in turn, will bring down the returns on investment for private sector firms. The net result would be unrestrained inflation and stagnant growth — or stagflation.
What is the way out for India?
As Varma said, the net effect of the Covid pandemic on India is that the trajectory of India’s GDP growth has moderated while the trajectory of domestic inflation has spiked. Add to this the uneven — “K-shaped” — economic recovery. In such a situation, the oil price shock will further exacerbate all these recent trends.
The only way out is for the Ukraine conflict to end within the next month or two. Mishra, who was far more optimistic about the economy’s prospects, said that the Indian economy was poised to “take-off” just before the Ukraine crisis. As such, if the Ukraine crisis blows over in just three months, then India’s economic recovery will march on and the “outlook is very positive”.
What do you think will happen to the economy? Will India be able to break free from past shackles, grow fast and create millions of jobs in the coming year? Share your views and queries at [email protected]
Lastly, do continue to watch The Express Economist — here is the playlist. Last week, we interviewed Sergi Lanau, Deputy Chief Economist at the Institute of International Finance in Washington, US. The IIF is the global association of the financial industry with more than 450 members from more than 70 countries. We asked Lanau why he has already designated India as an economy facing stagflation. Here’s the link to that episode.
Stay safe
Udit