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Oil price volatility is less of a worry now for the Indian economy | Photo Credit: Prakash Bharti
Escalating Middle-East tensions and higher oil prices have made the issue of macroeconomic policy design under poly-shocks live again. Although pass through of oil shocks in the first six months of the year, was lower than expected for many countries, not only India, old fears seem to have magnified. This sentiment particularly hits oil-importers, creating pressure to give up attempts to smooth shocks and revert to standard tightening under external shocks.
The view seems to be that adjustments that worked cannot continue indefinitely. Oil reserves have fallen and will need re-building. But the many longer term trends that reduce vulnerability to oil shocks are only getting reinforced. Lower and falling energy intensity means oil impacts unit costs less. Substitution toward alternative energy sources continues apace and rapid entry of new oil production sources reduces the importance of any one geographical area. India’s large refining capacity continues to be protective.
Moreover, counter-cyclical government excise and oil pricing policy moderates the pass through of oil shocks to the economy and the inflation targeting regime in turn moderates firms’ pass through of the shocks to the consumer. The pass through will rise if oil shocks prove persistent. But oil prices had fallen in the summer when OMCs recovered some of their losses as retail prices were not reduced. India’s high taxes on oil products support such countercyclical adjustments. Falling debt ratios due to post-pandemic fiscal consolidation and tax buoyancy with higher growth give fiscal space to counter shocks.
New production sources and many energy substitutes have changed the oil market. Oil prices cannot continue high for long. Even currently supply exceeds demand but war risk premium keeps prices high. Even so, the effect of a sustained high patch will be lower for the above reasons.
Current oil prices may have crossed the red flag of 100, but in real terms they are much below levels reached in past oil shocks, even as their impact on cost of production has fallen. For example, they are less than half the real levels reached in 2012.
India’s continued high growth despite high oil prices is not surprising, therefore. The IMF had to upgrade Indian growth every year since 2022, so they have made India an exception as a country for which they expect high growth despite being an oil importer and not at the top of the AI league. Signs of learning from outperformance at last!
But markets still haven’t internalised that India no longer has the earlier type of vulnerability to oil shocks. Firms, however, seem finally convinced that India’s growth prospects can survive geo-economic volatility, since the long-awaited rise in private investment is becoming apparent.
Closing the gap between financial stress and real performance requires good communication from policy-makers. But officials tend to highlight various policy measures taken without explaining how elements are customised to and reinforce each other to counter the current set of shocks.
As a result some commentators ascribe high growth to an unsustainable sugar high due to fiscal-monetary stimulus. But this is not true if measures are well calibrated to needs.
Policies can be classified as those improving the supply-side including ongoing fiscal consolidation with better quality of expenditure; use of buffers and regulation to help sustain counter-cyclical policy while reducing market volatility; third, as fiscal policy expands potential output, monetary policy can keep output at potential — which requires preventing large or persistent misalignment from equilibrium real interest and exchange rates.
This sustains aggregate demand while anchoring inflation expectations, which prevents second-round inflation. That the policy rate is conditional on inflation keeps fiscal policy focused on reducing cost-led inflation, where it has an advantage.
Central bank credibility and independence is not compromised. Emerging markets are beginning to understand how monetary-fiscal coordination differs for them. Central Bank of Sri Lanka has a committee for this, but without decision-making power, thus preserving independence.
Supply-side policies have to be specially adapted to current shocks, which require continuing reforms towards green substitution, increasing contributions of States, enhancing India’s natural diversity as well as that in trade, while harnessing technology to raise productivity, competitiveness and therefore jobs.
While transient shocks can be absorbed, persistent ones that supply-side policies are unable to counter must be passed in order not to compromise fiscal consolidation and maintain financial stability. The vulnerable can be protected with targeted and time-limited liquidity and credit that do not create perpetual dependence.
Excess liquidity creation needs to be avoided since it contributes to volatility. This approach helps identify gaps that need to be filled.
The technical meaning of resilience is to revert to status quo after a shock. But it is also possible to use a shock to do better, for example, it may overcome resistance to required changes, or help build on comparative advantage. Then building resilience turns from a cost into an advantage.
Specialisation may be more efficient but diversity creates resilience and India as a large country has a natural diversity that can be enhanced. There is commentary on the cost of using FX reserves, but there is also a cost of carrying FX reserves especially if they are never used. Strategic intervention in troubled times ensures the policy rate does not have to be used for interest rate defence.
Does building fiscal space sacrifice spending? But the discipline imposed on quality of expenditure, falling debt-deficit ratios from lower volatility in real interest and growth, and lower servicing costs can raise spending over time. The regulatory cost of financial stability can be minimised with benefits from reduced crises and lower risk premia. The recommended policy set is feasible only above a threshold of development and of critical buffers.
Consider three areas where hitherto infeasible reform may become possible. If the focus is not just on rising cost but also on soil health, nutritional balance and green local production of urea, the political resistance to fertilizer policy reform may fall.Foreign capital outflows during prolonged global risk-off cause stress, since India’s current account deficit (CAD) creates dependence on foreign financing. Rising AE debt and AI investment may be causing a structural reduction in foreign capital flows to EMs. But in normal years inflows far exceed India’s CAD which is low at less than 1 per cent. It can fall further with FTAs and growing net exports, removing the source of self-fulfilling fears of currency depreciation.
Increasing domestic diversity and compensating for global pressures also requires more States to perform. While many will respond to crisis-time need, this is the time to institutionalise more decentralisation and accountability required to improve the quality of life for the average citizen. Poor local services are triggering protests.
Action on these fronts could reduce domestic and external vulnerability, creating a net gain while raising resilience.
The writer is Professor Emeritus, IGIDR
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