10 minute read 29 Mar 2022
India's economic challenges

How can India restore growth while minimizing the impact of crude prices and supply bottlenecks?

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

10 minute read 29 Mar 2022

While the Indian economy is expected to normalize in FY23, it has to address emergent global challenges.

In brief

  • With average crude price expected at US$100/bbl. in FY23, growth may slip to 6.3% and CPI inflation may increase to 6%.
  • The RBI may find it advisable to uplift the policy rate with a view to stemming inflationary pressures and outward flow of US dollar.
  • Scope for demand-supporting fiscal policy options may emanate from additional fiscal capacity amounting to nearly INR3.2 lakh crore of Center’s gross tax revenues in FY23.

It has taken two years for the Indian economy to get close to the normal growth levels. While in FY21, it suffered a major contraction, FY22 allowed only enough recovery to enable the economy to reach a real GDP magnitude marginally above its pre-pandemic FY20 level. Even as policymakers have been looking forward to the prospects of a normalized Indian economy, another layer of challenges has gathered momentum in the form of surging prices of global crude and primary products along with an accentuation of supply-side bottlenecks. These issues in fact, pre-date the recent geopolitical developments. 

Estimating adverse impact of crude price upsurges

Global crude prices averaged at a 16-year low of US$43.8/bbl. in FY21 due to a comprehensive demand slowdown in the wake of the pandemic. In FY22, prices increased, averaging close to US$75/bbl. during April-February FY22 with the overall global economic recovery. In FY23, crude prices have come under pressure due to significant supply-side issues. Already, average brent crude price has increased to US$115.1/bbl. during the first two weeks of March 2022. In tandem, there are visible increasing trends in some critical input prices such as coal, iron ore, and potassium chloride. These are important commodities in the WPI basket which has a relatively larger weight in the implicit price deflator (IPD).

A review of India’s growth history indicates that two periods of recent slowdowns coincided with upsurges in global crude prices. In the first period from FY11 to FY13, real GDP growth fell from 8.5% to 5.5%, a fall of 3% points. Correspondingly, global crude price increased from an average of US$70/bbl. in FY10 to US$107.2/bbl. in FY12. In the second period spanning from FY17 to FY20, growth fell from 8.3% to 3.7%, a fall of 4.5% points. Alongside, global crude prices showed an increase from US$46/bbl. in FY16 to US$67.3/bbl. in FY19. In explaining the fall in growth in these periods, we recognize the adverse role of an increase in global crude prices although there might have been other contributing factors that led to the slowdown.

While recent growth history confirms the deleterious growth effects of global oil price increases, there are empirical studies also highlighting the magnitude of impact of an increase in global crude price on key macroeconomic parameters. Table 1 shows that the estimated impact of a US$10/bbl. increase in the price of Indian crude basket is a reduction in real GDP growth by 27 basis points and an increase in CPI inflation by 40 basis points. An earlier RBI (2019) study had estimated the impact on current account deficit and Center’s fiscal deficit relative to GDP of a US$10/bbl. increase in the Indian crude basket. The adverse impact for both cases is of the order of 43 basis points. For Center’s fiscal deficit, it is assumed that the burden of increased price is not passed on to the consumers. The RBI (2021) study had assumed a baseline price of Indian crude basket at US$75/bbl. Using this as the baseline, we may consider two benchmarks relating to the average price of the Indian crude basket in FY23 at US$100/bbl. (scenario 1) and at US$125/bbl. (scenario 2). Thus, the increase from the baseline price would be US$25/bbl. (scenario 1) and US$50/bbl. (scenario 2).

Estimated impact of increase in price of Indian crude basket on key macro parameters

With reference to baseline FY23 real GDP growth at 7% and CPI inflation at 5%, the revised levels of these variables may be put at 6.3% and 6% respectively after taking into account, the impact of crude price increase by a margin of US$25/bbl. as per scenario 1 (Table 2). The impact would be larger if other factors are also taken into account, or if the margin of increase is enhanced.

Revision in selected FY23 estimates due to the impact of an increase in the price of Indian crude basket

There may also be some sectoral supply-side bottlenecks and cost escalation. Sectors that draw heavily on petroleum products such as fertilizers, iron and steel foundries, transportation, construction and coal would be adversely affected. Some adverse effects in regard to financial flows have also become noticeable. Net FPI outflows during October 2021 to January 2022 increased to US$11.2 billion. Net FDI inflows, although positive, have also been falling during this period as compared to the corresponding period of the previous year.

Scope for additional fiscal capacity

The FY23 budget estimates may have to be modified due to two main reasons: 

  • likely upward revision of expenditures/ subsidies particularly those related to global crude prices and 
  • likely additional fiscal capacity due to underassessment of some critical determinants of Center’s gross tax revenues (GTR). These determinants relate to an underestimation of:
    1. base magnitude that is FY22 GTR, 
    2. FY23 assumed tax buoyancy and 
    3. FY23 assumed nominal GDP growth

The nominal GDP growth for FY23 was budgeted at 11.1%. However, assuming a revised real growth component of 6.3% and an IPD-based inflation component of 6.5%, we may estimate a revised nominal GDP growth close to 13.0%. This would also be the growth of Center’s GTR if the tax buoyancy is 1[1]. Using a modified FY22 GTR base magnitude and applying on this, a growth of 13%, the resultant Centre’s GTR for FY23 would be higher than the budgeted magnitude of INR27.6 lakh crore by a margin of about INR3.2 lakh crore (Table 3). Alongside, there would also be increases in some components of expenditures linked to global crude prices including petroleum and fertilizer subsidies which were budgeted at INR5,813 crore and INR1,05,222 crore respectively. Already in FY22, the third and last supplementary demand for grants has been presented involving an increase of INR14,902 crores in fertilizer subsidies when the original allocation as per the RE was INR1,40,122 crores. In FY23, the corresponding allocation being considerably lower, there is a strong likelihood of its upward revision.

Estimation of additional fiscal capacity in FY23 relative to BE

Relying on fiscal policy for supporting growth

The developed countries are uplifting their interest rates under inflationary pressures. The US Fed raised its policy rate by 25 basis points on 16 March 2022[2]. This may be considered as the first tranche of the likely increases during the course of the year. In this context, the RBI may find it advisable to uplift the policy rate with a view to stemming inflationary pressures and outward flow of US dollar. In February 2022, CPI inflation at 6.1% was at or above the 6% upper end of the RBI’s inflation tolerance range for the second successive month. WPI inflation also remained elevated at 13.1% during the month. With monetary policy options getting constrained by rising inflation, the main policy support to growth may have to come from the fiscal side.

Post-COVID, as the Indian economy has started to normalize, focus may be on some of the immediate compulsions emanating from the current pressures on prices of global crude and primary products. Other things remaining the same, this may have an adverse impact on real growth and CPI inflation. There would also be some slippage in fiscal and current account deficits relative to GDP. The magnitude of such an adverse impact will depend on the extent to which crude prices increase in FY23 on average. Policymakers may have to exercise a critical choice regarding who bears the burden of higher prices of petroleum products in India amongst consumers and industrial users, oil marketing companies (OMCs), and the government. The government may have to strike an appropriate balance amongst these options.

Some of the adverse effects can be mitigated by undertaking policy initiatives that would support demand and growth. One critical segment of demand pertains to private final consumption expenditure (PFCE). This would partly get supported by Center’s current thrust on accelerating infrastructure investment which is expected to have strong positive multiplier effects. As investment side multipliers have a longer time lag, it may be advisable to support demand through revenue expenditures by extending for example, the employment guarantee scheme to urban areas to complement the existing scheme for the rural areas. Some state-governments have taken an initiative on this account (Rajasthan, Kerala, Odisha, Himachal Pradesh, Madhya Pradesh and Jharkhand)[3]. It may be useful to evolve a unified employment guarantee scheme covering both rural and urban areas.

India now requires laying a solid foundation for achieving a high and stable medium-term growth consistent with its potential in the range of 7-7.5%. For this purpose, Center’s FRBM in which critical state-level debt and deficit targets are also embedded, may require to be recast. We consider that in view of Center’s larger responsibility with respect to macro stabilization, it may be given a higher fiscal deficit benchmark of 4% of GDP while states may continue with the target of 3% of GDP. Both tiers of government should be made to achieve revenue account balance so that the combined fiscal deficit can be devoted to financing capital expenditures which will support infrastructure expansion at an adequate pace.

Summary

With monetary policy options getting constrained due to rising crude prices, support to domestic demand may have to come from the fiscal side. Policymakers may have to strike an appropriate balance regarding who bears the burden of higher prices. In the medium-term, recasting the FRBM would enable laying a solid foundation for achieving high and stable growth in the range of 7-7.5%.

About this article

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.