By Megha Jain & Hrishikesh Desai
The global economic environment has rapidly gained complexity since the start of the COVID- 19 pandemic. The Russian Federation’s invasion of Ukraine has exacerbated this complexity due to its rippling effects on supply chains, commodity markets, inflation, energy markets, and macroeconomic growth prospects in general. Even central bankers and prominent economists are not able to accurately read the current economic trends. Recently, the Chair of the Federal Reserve of the United States, Jerome Powell, acknowledged that the Fed got inflation wrong, and they thought it was just ‘transitory.’ Even prominent economist and US Treasury Secretary, Janet Yellen, admitted her economic predictions were wrong by stating, “I was wrong then about the path that inflation would take.”
It is not a leap to suggest that the mindsets and priorities of policymakers and experts are fundamentally changing due to the unprecedented disruptions to people’s lives, world trade, and the global economy.
Emerging market economies like India are hit harder due to the significant rise in agricultural commodity prices, higher food insecurity, slowing growth, surging borrowing costs, and an increase in extreme poverty in vulnerable population groups leading to higher inequalities in income and wealth.
We see financial and other news outlets making one or more of the following predictions for what is to come:
- It is going to be a repeat of the 2008 global financial crisis.
- It’s the calm before the storm, which is another 1929 – styled Great Depression.
- It’s going to be a mild to severe recession caused by interest rates hikes pushing down growth.
- It’s characteristic of a period of stagflation due to a combination of events resulting in high prices, low growth, and high unemployment.
- The tech and housing bubbles are starting to burst.
- The inflation is no longer just ‘transitory’ and will persist for some time.
- It’s all just transitory, and we will see recovery over the longer term.
Let’s look at the significance of each of the aforementioned macroeconomic challenges affecting developing countries like India and unpack the magnitude of their impact on India’s economic future.
The COVID-19 pandemic that started in December 2019 has left no sphere of the Indian economy untouched. The continued harsh lockdowns in China and the Russia-Ukraine war have affected global energy, food, and mineral supply chains, and the pent-up demand for goods and services fuelled by pent-up savings in lockdown-free post-pandemic economies (like India) has caused significant inflationary conditions. Moreover, the recent heat waves in India have compounded the inflation problem by jacking up agricultural commodity prices and lowering agricultural output (especially, wheat).
Inflation is aptly termed as a double-edged sword since it requires central banks to raise interest rates, which results in lower borrowing and lower spending and investment by businesses. However, the lower spending results in lower demand and lower job growth that, in turn, arrests the overall economic growth. The latest inflation data for India suggests that India’s retail inflation is around 7.03 percent and wholesale inflation is around 15.50 percent, which are much higher than the Reserve Bank of India’s (RBI’s) tolerance thresholds. The RBI has raised interest rates by 90 basis points so far in 2022, and Governor Shaktikanta Das has signalled more potential rate hikes.
The Crude Oil Conundrum
High crude oil prices have always been the bane of the Indian economy and lead to higher petrol, diesel, and liquefied petroleum gas (LPG) prices causing overall inflation to skyrocket.
Goldman Sachs has indicated that Brent crude prices could go up to $175 per barrel if Russian crude oil exports fall due to sanctions. Other measures such as higher OPEC production or the release of more emergency oil stocks would fail to address the supply shortfall. This spells bad news for India’s post-pandemic economic recovery. India’s sustainable projected economic growth takes place when Brent crude prices hover around $70 per barrel. The only option for the Indian government is to lower taxes on fuel and absorb some of this shock.
However, such a measure would reduce tax revenues and worsen the fiscal (budget) deficit. Moreover, India is heavily reliant on liquified natural gas (LNG) for producing fertilizers, and an oil price shock of this magnitude would send its fertilizer subsidies bill soaring.
High crude oil prices also negatively affect India’s balance of payments and blow up its current account deficit. India imports more than 80% of the oil it needs. Most of this demand is inelastic in nature, and India’s steps towards renewable energy, local oil exploration, and its ethanol- gasoline blending strategy won’t be of much help in addressing this problem over the short- term. A saving grace for India might be a slowing Chinese economy that relives the upward pressure on oil prices due to demand reduction.
Foreign Institutional Investor (FII) outflows
The increase in global economic uncertainty always results in an aggressive selloff by foreign investors due to an increase in perceived risk in developing economies. This is already happening in India with Society General indicating that so far in 2022, FII outflows from India touched record highs. This has put downward pressure on the Indian Rupee (INR), which has touched record lows against the US Dollar (USD). A weak rupee increases the cost of imports for India and causes its forex reserves to decline.
A weak currency is helpful if a country has a strong export base since it makes its exports more attractive for foreign buyers. However, India is facing a Catch-22 situation since its imports of crude oil and essential commodities are growing at a much faster pace than its exports. Moreover, its key export industries such as petroleum products, pharmaceuticals, automobiles, and jewellery are highly reliant on imported items, which increases the cost for Indian exporters. Further, many of India’s exports (e.g., textiles and agricultural commodities) are price elastic, which means that the higher costs of production cannot be passed on to foreign consumers without reducing export demand.
The Black Swan theory
The Black Swan Theory suggests that highly improbable, outlier (black swan) events can invalidate all prior general beliefs and knowledge about something that is borne out of more likely, routine (white swan) events. These low predictability and large impact events are often ignored and cannot be predicted, but they have the most significant influence on shaping the world as we know it. We believe we are seeing a black swan paradox in India – a few significant black swan events (e.g., the COVID-19 pandemic, the Russia-Ukraine war) that were not reasonably conceivable are significantly influencing all aspects of the Indian economy compared to the routine and predictable white swan events, the impact of which most experts predict and explain.
Most expert analysis of the black swan events is ‘after the fact’ (after they have occurred), which doesn’t really help plan for them. Also, most economic and political science experts also fail in assigning the correct probability of occurrence to these events. Developing countries like India need to implement highly customized and targeted fiscal and monetary policy measures along with a complete rethink of their trade policies. Traditional economic remedies such as liquidity injections, interest rate hikes, central bank currency market interventions, and other ‘one-size-fits-all’ policies are not feasible in managing such black swan events.
A better approach for developing countries like India is to focus on the strength and revival of their flagship export sectors and pushing for structural changes to the economy to absorb black swan shocks via technological innovations, efficient management of capital, labor, and natural resources, and maintaining a progressive political landscape.
(Megha Jain is an assistant professor at Daulat Ram College, University of Delhi, and Hrishikesh Desai teaches at Arkansas State University, United States; views are personal.)