After the recession, the Indian economy faces a threat of stagflation
The second wave of the pandemic has subsided. Lockdown restrictions are being lowered. And economic activity has recovered.
But that does not mean that the road to economic recovery is easy. The strong rebound in inflation figures in May has surprised analysts. With world commodity prices strengthening, future inflation prospects are expected to remain high. The jury is still out on the damage caused by the economic disruption and the health impact of the second wave on household balance sheets and demand.
Last year at this time, the Indian economy faced a threat of recession. Unless there is a third wave of serious infection, this threat can be ruled out at this point. However, what is real is a threat of stagflation, or low growth and high inflation. Fiscal policy will be very important in deciding whether stagflation takes hold of the Indian economy or not.
Here are four charts that put this argument in perspective.
The second wave has created a second-order base effect illusion.
Thanks to last year’s blockage, the economic figures for the first quarter of the current fiscal year would have had a base effect bias.
Read also | How can India prepare for the third wave?
The first quarter of 2020-21 was the hardest hit during the 68-day national lockdown that began on March 25, 2020. For example, the Industrial Production Index (IIP) jumped a massive 134.4% in April 2021 on an annual basis. However, compared to the April 2019 value, the April 2021 IIP growth is only 0.1%. Economic normalization involves matching and crossing the pre-Covid economic trajectory.
Because much of the country went through a lockdown during the second wave, and restrictions are now being relaxed, the economy, statistically speaking, is back in recovery mode. Nomura India’s Business Resumption Index (NIBRI), for example, jumped to 76 in the week ending June 13, compared with 67.9 the previous week. While the weekly recovery is the highest in the NIBRI series, the latest value is on par with the value on August 30, 2020.
The most important point is that the economy is still struggling to “reactivate and sustain growth in a lasting way”, something that the latest Resolution of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), on 4 June, listed as a key challenge. It is important that this fact is not lost in the ongoing statistical recovery. The World Bank GDP projections for January 2020 (when the pandemic had not affected the Indian economy) and June 2021 well capture the long-term damage to the Indian economy.
The double blow of inflation on consumers and producers
Why is the recent surge in inflation a cause for concern? It is expected to put pressure on the balance sheets of households and businesses.
Let’s take the companies first. There is a widespread consensus that the economic recovery after the first wave of Covid-19 infection was driven by profits. This means that even though revenues fell, companies managed to increase profits by reducing costs. This created inequality but gave growth.
While part of the cost reduction meant a contraction in labor income, low raw material costs helped. This is unlikely to hold now. International commodity prices, according to the Bloomberg Commodity Index, had crossed pre-pandemic levels at the end of 2020. This effect was observed in the cost of raw materials and the purchase of finished products by non-financial companies in the quarter that ended in March 2021, in an analysis by the Center for Monitoring the Indian Economy (CMIE) by Mahesh Vyas.
The Bloomberg Commodity Index was at 83.44 on March 31. It had risen to 94.5 on June 14. Such an increase in raw material costs, everything else remaining constant, will require companies to pass the pressure on to consumers, if they are to maintain profitability. This can only be done when demand is strong. Companies are wary of raising prices when markets are weaker, fearing demand will continue to decline. This means that even the economy’s profit engine is likely to come to a halt in the future.
And then take homes. Thanks to the increase in the price of basic products such as gasoline (a 2014 survey by the Ministry of Oil shows that 60% of India’s gasoline consumption is in two-wheelers) and edible oils, and the cascading effect of the increase in diesel prices through transport. costs, household income is bound to be reduced. At a time when the labor market remains weak, the inflationary shock will further silence the outlook for demand. Undoubtedly, the weekly unemployment rate, according to CMIE estimates, has fallen to 8.7% from the double-digit levels that persisted between May 16 and June 6. But even 8.7% is too high for comfort.
Policy choice: fiscal prudence on stagflation?
If inflation continues to rise, and experts believe it will, monetary policy will find its hands tied behind its back. MPC is mandated to keep the CPI at four percent with a range of two percentage points. While the rate hikes may not happen immediately, and the next MPC meeting is scheduled for August, experts believe a change in political stance cannot be ruled out.
“A change in the relative emphasis of growth versus inflation in the August meeting (or a change in policy stance) would affect the beginning of active policy normalization. Previously, we anticipated that the RBI will seriously consider normalizing the policy from December 2021 onwards, only after being convinced that holiday demand has been strong. This now could be ahead of the October meeting if inflationary pressures do not abate, ”Samiran Chakraborty, India’s chief economist at Citi Research, said in a note.
This brings back the question of fiscal policy support for growth. India has been conservative in using this instrument after the pandemic and has paid for it. Real fiscal support immediately after the lockdown was on the order of only 1% of GDP. This had a particularly adverse effect on poor households.
While these are counterfactual questions now, there is a tangible choice regarding fiscal policy. Central and state taxes account for 61% and 54% of the price of gasoline and diesel in Delhi. The participation of the Center is much greater than that of the states. If these taxes are lowered, it is reasonable to assume that the Center’s tax cut will force states to reciprocate due to political considerations, inflationary pressures can be alleviated. To be sure, both the Center and the states will lose some revenue, but some of it will be offset as money saved on gasoline-diesel is diverted to other items, leading to growth in revenue collection.
A simple calculation shows that it is fair that gasoline and diesel taxes be reduced. The central government collected ₹2.31 and ₹Rs 2.39 crore lakh in union excise duties (after the implementation of the GST in 2017, most are taxes on gasoline and diesel) in 2018-19 and 2019-20. India’s crude oil basket (COB) was priced at $ 69.9 and $ 60.5 per barrel in those years. India’s COB price plummeted to $ 44.8 per barrel and excise duty collections soared to ₹3.9 lakh crore in 2020-21. It can be argued that while the government decided not to pass on the benefits of cheaper oil to consumers, it would not have hurt as much.
Projections from the US Energy Information Administration (US-EIA) expect Brent crude to cost an average of $ 65.4 in 2021-22. The actual price could be higher. Brent crude has been trading above $ 70 per barrel, while the US EIS forecast for June 2021 is $ 69 per barrel. The 2021-22 budget foresees that the collection of excise taxes will be ₹Rs 3.35 million lakh, far more than collections have been when international prices were at comparable levels. Will the government waive an estimated one lakh crore of rupees in taxes to avoid an inflation shock to the economy? This could be the defining fiscal policy option in the current fiscal year.
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