Tackling Inflation and Other Challenges

15 Jun 2022

With the onset of the war in Europe, the Indian economy is facing the challenge of high inflation. The policy apparatus, which had so far been focused on reviving growth post the pandemic, has now quickly re-oriented itself to focus on inflation. The Government has taken several measures to moderate prices, including reduction in excise duties on petrol and diesel as well as tariff cuts and subsidy hikes. At the same time, the RBI has begun raising the policy repo rate while indicating further increases to be expected.

While rising inflation is now a global phenomenon, different countries are exhibiting varying abilities to tackle it without generating a hard landing. The US, for example, is at risk of a sudden winding down of its still strong growth rate, as the Federal Reserve aggressively hikes interest rates. Many countries also face the risk of stagflation, where the economy stagnates while inflation remains high. The task for central banks is therefore not simple.

In India, inflation hurts the large number of households living on subsistence incomes, particularly due to the rise in food and fuel prices. It reduces their purchasing power for other items that may not be considered necessities. Similarly, a large number of businesses survive on thin margins that get further squeezed by a rise in input costs, often posing a risk to their survival. Hence, it is critical to use fiscal and monetary tools to cool down prices as quickly as possible.

Fortunately, the Indian economy has been resilient so far. It had been recovering after facing the challenges of the pandemic when the war in Europe began. As an importer of oil and other commodities, India is bound to be affected. However, most high frequency indicators show that currently the momentum of economic activity remains strong and business sentiment is rising.

CII’s Business Outlook Survey revealed that business confidence went up during the Apr-June quarter after a dip in the previous quarter when the war began. While there is a widespread concern about rising input costs, buoyancy in sales and new orders is apparent. Indicators such as GST collections, volume growth in core sectors, such as cement and refineries, as well as the PMI for manufacturing and services remain positive well into the first quarter of FY 2023. Contact-intensive services such as hospitality, retail and tourism have bounced back.

As a result, it is hard to see any recessionary prospects in India. The Government’s spending on infrastructure continues to drive investment spending, while the private sector is also expanding capacity in sectors such as metals, chemicals and machinery. Bank credit which had been growing at 5-6% over the last two years has picked up to double-digits during April-May. The spike in oil price will of course have some impact on growth in the months ahead. However, GDP growth in the range of 7.4-8.2% is likely in FY 2023 depending on the trajectory of oil price.

India is also tackling a challenge on the external front – as interest rates rise in developed economies, particularly the US, there is an outflow of capital from developing economies. India has faced a pullout of USD 14.5 billion of portfolio capital during FY 2022 and the outflows have continued into April-May 2022. This has had an impact on the currency, with the rupee falling by 3.1% against the US dollar since the war began in February.

The RBI has handled the situation deftly by dipping into its foreign exchange reserves to manage an orderly depreciation of the rupee. The reserves declined from a peak of USD 642 billion in October 2021 to USD 598 billion in April 2022, butwas back to over USD 600 billion in May 2022. This is still adequate to cover 10 months of imports at today’s elevated levels.

The country has also been fortunate to receive strong inflows of foreign direct investment during this period. This is at a time when FDI flows have been moderating globally. India is currently ranked 7th among the top recipients of FDI in 2021. The opportunities for FDI have expanded following the geo-political shifts that have led to multi-nationals looking to diversify their production locations. Policy makers in India have also welcomed foreign investment with facilitative policies and incentives.

To conclude, India’s macro-economic fundamentals are strong enough to tackle the current challenges of inflation and capital flight.

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