27 May 2022
Inflation rate in India

Why India is gaining clout in the post-COVID universe

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.

27 May 2022
Related topics Tax COVID-19

Challenges to global economies are emanating from high crude prices and supply shortages.  

In brief

  • Rising crude oil prices and supply shortages are impacting growth of economies across the globe.
  • Inflation rates have increased to unprecedented high levels across major economies including the US, UK and India.
  • In India, additional fiscal capacity linked to high nominal growth may facilitate increased infrastructure investment.
  • For FY23, India’s growth prospects appear to be brighter than most of its peers.

Both the Indian as well as global economies are recovering from the COVID shock. Their pace of recovery is getting affected by not only the extent of the impact of COVID but also their capacities to deal with the challenges emanating from the economic fallout of the present geopolitical conflict. Given the pressure on global crude prices and supply side bottlenecks all major countries are experiencing unprecedented domestic inflationary pressures coupled with erosion of growth. 

Crude shock after COVID

Soaring global crude prices and critical supply shortages may adversely impact growth and inflation.

The foremost impact on real growth and inflation is traceable to the sharp surge in global crude prices which have risen from a US$30.3/bbl. in 1QFY21 to US$96.6/bbl. in 4QFY22. This implies a steady upward push of US$9.5/bbl. per quarter on average over a period of seven quarters. In fact, by April 2022 the global crude price had already risen to US$103/bbl. Alongside global crude, as was experienced in earlier episodes, global food price index and prices of important primary metals and other critical inputs have also risen. Some of these trends are depicted in Chart 1.

Amongst critical supply side shortages, the global and Indian economies are getting affected by the following commodities namely semiconductor, food grains (rice, wheat, corn) and edible oil (sunflower oil, palm oil), fertilizers (potassic, nitrogen fertilizers etc.), pharmaceutical inputs (API), metals (nickel, palladium, aluminium and titanium) and Solar cells.

India’s imported inflation

CPI inflation rate at unprecedented high levels in major economies including India.

Driven by surging global crude and commodity prices and supply shortages of critical inputs, India as well as many developed countries are currently struggling with high inflation levels which is forcing them to raise domestic interest rates. In the US, CPI inflation increased to a 40-year high of 8.3% (y-o-y) in April 2022. Inflation in the US is being driven by several factors. First, the pandemic related stimulus package has had an inflationary impact. Second, rising input costs and supply chain disruptions amid rising demand and a tight labour market has led to an upward pressure on inflation. Third, there are broader structural factors such as demographics and a reversal in globalization contributing to the rising trend in inflation. The ‘Fed’s misery index’1 indicates that the Fed is significantly behind the curve in terms of inflation target and the non-accelerating inflation rate of unemployment. The aggressive policy action that is warranted to tame inflationary pressures is likely to cause a recession. It is estimated that the Federal Funds rate may have to be eventually increased to close to 6%, to achieve a real interest rate of 1-2%.

In India, the CPI inflation rate increased to a 95-month high of 7.8% in April 2022. In fact, the WPI inflation has tended to be even higher than the CPI inflation in recent months. It was at an unprecedented level of 15.1% in April 2022. Consequently, the implicit price deflator (IPD)-based inflation, which is a weighted average of CPI and WPI inflation, is expected to be in the range of 10-11% in the next few quarters.

Inflation’s positive fiscal spinoff

Additional fiscal capacity linked to high nominal growth may facilitate further reduction in petroleum taxes and/or increased infrastructure investment.

Even with high CPI and WPI inflation rates, there is one silver lining for the Indian economy. This emerges from the high expected IPD based inflation. In 4QFY22, WPI inflation rate at 13.8% exceeded the CPI inflation at 6.3% by a margin of 7.5% points. Based on NAS data, the IPD-based inflation estimated at 8.7% for 4QFY22, falls between the WPI and CPI inflation levels. A relatively high IPD-based inflation implies that the nominal GDP growth would be tangibly higher than the real GDP growth. This has already been seen for FY22 where the nominal GDP was at 19.4% and real GDP was at 8.9%. For FY23, our expectation is that of a nominal GDP growth in the range of 14.5–15.0% with IPD-based inflation at 7.5%. This relatively high nominal GDP growth for two years in succession, that is, FY22 and FY23 is likely to lead to significant additional fiscal space for the central and state governments compared to previous trends.

It is this additional fiscal capacity which has facilitated a reduction in the union excise duty on petroleum products. Further, since there would still be some additional resources available for the central government over and above the budgetary resources, these may partly be used to support growth by frontloading infrastructure investment in the initial months of FY23 and partly to further reduce tax rates on petroleum products with a view to containing inflation while avoiding any significant increase in the budgeted fiscal deficit. Alongside, the scope of production linked incentive schemes may also be expanded. The government, as per the FY23 budget announcements, is already committed to invest substantially in infrastructure for which National Infrastructure Pipeline (NIP) is already in place and has been integrated into the Gati Shakti masterplan so as to realise benefits of intersectoral linkages.

The RBI, in an out of schedule meeting of the Monetary Policy Committee (MPC) held on 4 May 2022, increased the repo rate by 40 basis points from 4.0% to 4.4%. The repo rate had been retained at 4% since May 2020. This change reflected RBI’s current concern with the rising inflation in India which is largely driven by global factors. Driven by continued global crude price upsurge which impacts food, fuel and light, and transport prices in the CPI basket, India’s April 2022 CPI inflation turned out to be a 95-month high of 7.8%. It was way back in May 2014 that CPI inflation rate was at 8.3%. Given these trends, the RBI may consider increasing the policy rate by increments of 25 basis points in one or more steps in the next few quarters.

Growth: India to overtake major world economies

India may be able to sustain a reasonably high growth rate based on the strength of its domestic demand.

In a comparative perspective, India is expected to do well in the short-to medium term. Its projected growth in FY23 is 8.2% as per IMF and 7.2% according to RBI. The ADB has forecasted India’s growth at 7.5% in FY23, increasing to 8% in FY24 based on continued momentum of infrastructure investment. With these prospects, India would be a global growth leader among major economies of the world. However, India may not remain unaffected by the subdued global growth prospects. Many developed countries are currently struggling with high inflation levels which is forcing them to raise domestic interest rates. This may lead to a growth slowdown and in some cases, even a recession. According to a recent research report2 the US economy is projected to be in recession by end 2023 due to unprecedented high levels of inflation that is expected to last longer than anticipated. India’s exports to the US and the European economies may be adversely affected if these economies go into a recession. Further, India’s foreign exchange reserves have depleted sharply over the period from end October 2021 up to 13 May 2022 by a margin of US$48.7 billion. In the medium term, India is projected to show the highest growth rate up to FY28. Its growth rate is expected to be well above the world average as well as that of China.

Summary

Despite global challenges, India may be able to sustain a reasonably high growth based on the strength of its domestic demand, facilitated by the additional fiscal capacity linked to high nominal growth prospects due to elevated inflation levels.   

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.

Related topics Tax COVID-19