Testing times for the economy

Amid tightening global liquidity, rising protectionist sentiment and high oil prices, Indian policymakers are faced with difficult choices to keep the country's macroeconomic stability intact

The success of the liberalisation policy and wide-ranging economic reforms that were introduced during the early 1990s put India on an unprecedented growth path. What’s important to acknowledge is that the growth story was built around services rather than manufacturing, unlike what had happened in other Asian countries. Another distinctive aspect of the Indian growth story has been its foremost reliance on domestic factors, thereby also helping to limit the potentially destabilising impact of global developments such as the last global financial crisis.

Signs of a difficult global environment are visible again and it is important to analyse if India can continue to minimise the impact of global uncertainty, key among them being tightening of global financial conditions, rising protectionist sentiment, increasing commodity prices (especially crude prices), volatile currency markets and fiscal slippages.

After a year of slowdown on account of market-disruptive policies, India’s growth is now expected to follow an upward trajectory in the year ahead. Consumption remains the engine of growth and the lead indicators seem to suggest that domestic conditions are showing signs of vitality. The policy agenda continues to focus on building domestic infrastructure, with greater emphasis on increasing formalisation and inclusion within the economy.

While externally, protectionism appears to be on the rise, there are strong indications of global demand picking up as well. In an environment of global headwinds to increasing trade, world economic growth is expected to be 3.9 per cent for both 2018 and 2019, which marks a 0.2 percentage point increase from its last update in October1.

Having said this, India is by no means immune to global risks. A big concern for the economy and all future policy plans is the winding down of the era of “low” crude oil prices. Crude oil prices have risen by almost 17 per cent from a level of approximately $48 to the range of $75-80 currently (see Fig 1). Such an increase in crude prices, in a situation where India imports more than 80 per cent of its crude requirement, can likely lead to a general price rise.

While India has embarked on the long-term vision of shifting to renewable energy sources, in the immediate and short term, imports of oil can be optimised not minimised. Hence, high inflation is a fear that growing economies cannot ignore. India has won a hard battle to stabilise its macroeconomic fundamentals. 

Therefore, if crude prices remain elevated, policymakers may have to make difficult choices where short-term fiscal expansion may have to be curtailed to keep this hard-won macroeconomic stability intact. The Reserve Bank of India (RBI), recognising the change, has already increased the repo rate by 25 points and may increase it further during the year if the inflationary environment persists.

Separately, factors such as US trade and monetary policy are likely to have a substantial effect. Trade policies that can lead to a full-scale tariff war can create disruptions, especially for exporters. Coming immediately after the recent regulatory changes in India, the impact, even if it is for the short term, may limit the ability of Indian exporters to take advantage of buoyant global demand. Even if India is not directly involved, any significant trade disputes are likely to have spillover effects on other economies as well.

In terms of monetary policy, US Fed projections of at least two more rate hikes this year and three next year together with currency weakening can lead to capital being diverted away from emerging economies like India, a scenario which has already started playing out, reflective of global incentives to reroute investments. However, to some extent a weakening rupee may help in boosting exports, as in real terms, India’s currency is still overvalued when compared to some of its competitors. The Real Effective Exchange Rate (REER) of the rupee for India continues to be more than 100 (see Fig 2).

Given the risks, it should be safe to account for certain domestic and external challenges in advance, which can help policymakers, investors and businesses to better prepare for strategies to mitigate any incoming impact. It would be important to set fiscal and monetary policy perspectives keeping in mind the fiscal limits while maintaining the growth-inflation balance. 

In this backdrop, it can be rightly argued that India is likely more vulnerable to domestic variations while global uncertainty is likely to largely arise from tightening financial conditions and rising protectionist sentiment. Overall, a lot will depend on time management with respect to effective implementation of economic schemes.   

Richa Gupta is Senior Economist and Senior Director, Deloitte India. Umang Aggarwal is Economist, Deloitte India

1https://www.reuters.com/article/us-imf-economy-outlook/imf-raises-global-growth-forecast-sees-trump-tax-boost-idUSKBN1FB1TK