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After recession, the Indian economy faces a stagflation threat

The economy is still struggling to “revive and sustain growth on a durable basis”, something which the latest Reserve Bank of India Monetary Policy Committee Resolution, on June 4, listed as a key challenge
UPDATED ON JUN 16, 2021 03:26 PM IST
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Representational image. (AFP)

The second wave of the pandemic has ebbed. Lockdown restrictions are being eased. And economic activity has picked up.

But that does not mean that the path to economic recovery will be smooth. The sharp spike in inflation numbers in May have surprised analysts. With global commodity prices firming up, inflation outlook, going forward, is expected to remain elevated. The jury is still out on the damage caused by the economic disruption and health shock of the second wave to household balance sheets and demand.

Last year, at this point of time, the Indian economy was facing a recession threat. Unless there is a severe third wave of infection, this threat can be ruled out at the moment. However, what is real is a threat of stagflation, or low growth and high inflation. Fiscal policy will matter a lot in deciding whether or not stagflation grips the Indian economy.

Here are four charts which put this argument in perspective.

The second wave has created a second order base effect illusion

Thanks to last year’s lockdown, economic numbers from the first quarter of the ongoing fiscal year would have had a base effect bias.

The first quarter of 2020-21 was the worst affected during the 68-day long nation-wide lockdown which began from March, 25, 2020. For example, the Index of Industrial Production (IIP) jumped by a massive 134.4% in April 2021 on a year-on-year basis. However, when compared with the April 2019 value, the April 2021 IIP growth is just 0.1%. Economic normalisation entails matching and crossing the pre-Covid economic trajectory.

Because large parts of the country went through a lockdown during the second wave, and restrictions are being eased now, the economy, statistically speaking, is in recovery mode once again. The Nomura India Business Resumption Index (NIBRI) for example, jumped to 76 in the week ending June 13, compared to a value of 67.9 the week before. While the week-on-week recovery is the highest in the NIBRI series, the latest value is at par with the August 30, 2020 value.

The larger point is that the economy is still struggling to “revive and sustain growth on a durable basis”, something which the latest Reserve Bank of India (RBI) Monetary Policy Committee (MPC) Resolution, on June 4, listed as a key challenge. It is important that this fact is not lost in the ongoing statistical recovery. World Bank’s GDP projections from January 2020 (when the pandemic had not hit the Indian economy) and June 2021 capture the long-term damage to Indian economy well.

The double whammy of inflation on consumers and producers

Why is the recent spike in inflation a matter of concern? It is expected to strain the balance sheets of both household and businesses.

Let us take businesses first. There is widespread consensus that the economic recovery after the first wave of Covid-19 infection was profit-led. This means that even though revenues fell, companies managed to increase profits by reducing costs. This created inequality but gave growth.

While a part of the cost reduction meant a squeeze on labour incomes, low commodity costs helped. This is unlikely to hold now. International commodity prices, as per the Bloomberg Commodity Index, had crossed pre-pandemic levels by the end of 2020. This effect was seen in the raw material and purchase of finished goods cost of non-financial firms in the quarter ending March 2021, in a Centre for Monitoring Indian Economy (CMIE) analysis by Mahesh Vyas.

The Bloomberg Commodity Index was at 83.44 on March 31. It had increased to 94.5 by June 14. Such an increase in commodity costs, everything else remaining constant, will require firms to pass on the pressure to consumers, if they have to maintain profitability. This can only be done when demand is strong. Firms are wary of increasing prices when markets are weaker, lest demand goes down further. This means that even the profit engine of the economy is likely to stall going forward.

And then take households. Thanks to the rise in price of essential commodities such as petrol (a 2014 survey by ministry of petroleum shows that 60% of India’s petrol consumption is done by two-wheelers) and edible oils, and the cascading effect of rise in diesel prices via transportation costs, household incomes are bound to come under squeeze. At a time when labour market continues to be weak, the inflationary shock will further mute demand prospects. To be sure, weekly unemployment rate, according to CMIE estimates, has come down to 8.7% from the double-digit levels which persisted between May 16 and June 6. But even 8.7% is too high for comfort.

Policy choice: fiscal prudence over stagflation?

If inflation continues to rise, and experts believe that it will, monetary policy will find its hands tied behind its back. MPC is mandated to keep CPI at four per cent with a range of two percentage points. While rate hikes might not happen immediately, and the next MPC meeting is scheduled for August, experts believe that a change of policy stance cannot be ruled out.

“A change in the relative emphasis of growth vs. inflation in the August meeting (or a change in policy stance) would affect the beginning of active policy normalization. Earlier, we were anticipating that the RBI will seriously consider policy normalization from December 2021 onwards, only after being convinced that the festive demand has been strong. This could now be advanced to the October meeting if inflationary pressures do not abate”, Samiran Chakraborty, India Chief Economist of Citi Research said in a note.

This brings back the question of fiscal policy support to growth. India has been conservative in using this instrument post-pandemic and it has paid for it. Actual fiscal support immediately after the lockdown was to the tune of just 1% of GDP. This had a particularly adverse effect on poor households.

While these are counterfactual questions now, there is a tangible choice vis a vis fiscal policy. Central and state taxes account for 61% and 54% of the price of petrol and diesel in Delhi. The Centre’s share is much bigger than that of states. If these taxes are brought down — it is reasonable to assume that the Centre bringing down taxes will force states to reciprocate because of political considerations — inflationary pressures can be eased. To be sure, both the Centre and states will lose some revenue, but parts of it will be compensated as the money saved on petrol-diesel is rerouted to other items, leading to a growth in revenue collection.

A simple calculation shows that it is only fair that petrol-diesel taxes are brought down. The central government collected 2.31 and 2.39 lakh crore in union excise duties (after the implementation of GST in 2017, bulk of it are petrol-diesel taxes) 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 crashed 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 against passing on the benefits of cheaper oil to consumers, it would not have hurt so much.

Projections by 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 expects excise duty collections to be 3.35 lakh crore, much more than what the collections have been when international prices were at comparable levels. Will the government give up on an estimated one lakh crore rupees in taxes in order to spare an inflationary shock to the economy? This might be the defining fiscal policy choice in the current fiscal year.

The second wave of the pandemic has ebbed. Lockdown restrictions are being eased. And economic activity has picked up.

But that does not mean that the path to economic recovery will be smooth. The sharp spike in inflation numbers in May have surprised analysts. With global commodity prices firming up, inflation outlook, going forward, is expected to remain elevated. The jury is still out on the damage caused by the economic disruption and health shock of the second wave to household balance sheets and demand.

Last year, at this point of time, the Indian economy was facing a recession threat. Unless there is a severe third wave of infection, this threat can be ruled out at the moment. However, what is real is a threat of stagflation, or low growth and high inflation. Fiscal policy will matter a lot in deciding whether or not stagflation grips the Indian economy.

Here are four charts which put this argument in perspective.

The second wave has created a second order base effect illusion

Thanks to last year’s lockdown, economic numbers from the first quarter of the ongoing fiscal year would have had a base effect bias.

Also Read | How can India prepare for the third wave

The first quarter of 2020-21 was the worst affected during the 68-day long nation-wide lockdown which began from March, 25, 2020. For example, the Index of Industrial Production (IIP) jumped by a massive 134.4% in April 2021 on a year-on-year basis. However, when compared with the April 2019 value, the April 2021 IIP growth is just 0.1%. Economic normalisation entails matching and crossing the pre-Covid economic trajectory.

Because large parts of the country went through a lockdown during the second wave, and restrictions are being eased now, the economy, statistically speaking, is in recovery mode once again. The Nomura India Business Resumption Index (NIBRI) for example, jumped to 76 in the week ending June 13, compared to a value of 67.9 the week before. While the week-on-week recovery is the highest in the NIBRI series, the latest value is at par with the August 30, 2020 value.

The larger point is that the economy is still struggling to “revive and sustain growth on a durable basis”, something which the latest Reserve Bank of India (RBI) Monetary Policy Committee (MPC) Resolution, on June 4, listed as a key challenge. It is important that this fact is not lost in the ongoing statistical recovery. World Bank’s GDP projections from January 2020 (when the pandemic had not hit the Indian economy) and June 2021 capture the long-term damage to Indian economy well.

The double whammy of inflation on consumers and producers

Why is the recent spike in inflation a matter of concern? It is expected to strain the balance sheets of both household and businesses.

Let us take businesses first. There is widespread consensus that the economic recovery after the first wave of Covid-19 infection was profit-led. This means that even though revenues fell, companies managed to increase profits by reducing costs. This created inequality but gave growth.

While a part of the cost reduction meant a squeeze on labour incomes, low commodity costs helped. This is unlikely to hold now. International commodity prices, as per the Bloomberg Commodity Index, had crossed pre-pandemic levels by the end of 2020. This effect was seen in the raw material and purchase of finished goods cost of non-financial firms in the quarter ending March 2021, in a Centre for Monitoring Indian Economy (CMIE) analysis by Mahesh Vyas.

The Bloomberg Commodity Index was at 83.44 on March 31. It had increased to 94.5 by June 14. Such an increase in commodity costs, everything else remaining constant, will require firms to pass on the pressure to consumers, if they have to maintain profitability. This can only be done when demand is strong. Firms are wary of increasing prices when markets are weaker, lest demand goes down further. This means that even the profit engine of the economy is likely to stall going forward.

And then take households. Thanks to the rise in price of essential commodities such as petrol (a 2014 survey by ministry of petroleum shows that 60% of India’s petrol consumption is done by two-wheelers) and edible oils, and the cascading effect of rise in diesel prices via transportation costs, household incomes are bound to come under squeeze. At a time when labour market continues to be weak, the inflationary shock will further mute demand prospects. To be sure, weekly unemployment rate, according to CMIE estimates, has come down to 8.7% from the double-digit levels which persisted between May 16 and June 6. But even 8.7% is too high for comfort.

Policy choice: fiscal prudence over stagflation?

If inflation continues to rise, and experts believe that it will, monetary policy will find its hands tied behind its back. MPC is mandated to keep CPI at four per cent with a range of two percentage points. While rate hikes might not happen immediately, and the next MPC meeting is scheduled for August, experts believe that a change of policy stance cannot be ruled out.

“A change in the relative emphasis of growth vs. inflation in the August meeting (or a change in policy stance) would affect the beginning of active policy normalization. Earlier, we were anticipating that the RBI will seriously consider policy normalization from December 2021 onwards, only after being convinced that the festive demand has been strong. This could now be advanced to the October meeting if inflationary pressures do not abate”, Samiran Chakraborty, India Chief Economist of Citi Research said in a note.

This brings back the question of fiscal policy support to growth. India has been conservative in using this instrument post-pandemic and it has paid for it. Actual fiscal support immediately after the lockdown was to the tune of just 1% of GDP. This had a particularly adverse effect on poor households.

While these are counterfactual questions now, there is a tangible choice vis a vis fiscal policy. Central and state taxes account for 61% and 54% of the price of petrol and diesel in Delhi. The Centre’s share is much bigger than that of states. If these taxes are brought down — it is reasonable to assume that the Centre bringing down taxes will force states to reciprocate because of political considerations — inflationary pressures can be eased. To be sure, both the Centre and states will lose some revenue, but parts of it will be compensated as the money saved on petrol-diesel is rerouted to other items, leading to a growth in revenue collection.

A simple calculation shows that it is only fair that petrol-diesel taxes are brought down. The central government collected 2.31 and 2.39 lakh crore in union excise duties (after the implementation of GST in 2017, bulk of it are petrol-diesel taxes) 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 crashed 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 against passing on the benefits of cheaper oil to consumers, it would not have hurt so much.

Projections by 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 expects excise duty collections to be 3.35 lakh crore, much more than what the collections have been when international prices were at comparable levels. Will the government give up on an estimated one lakh crore rupees in taxes in order to spare an inflationary shock to the economy? This might be the defining fiscal policy choice in the current fiscal year.

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