An economic policy response to the West Asia crisis: Managing supply shock

Policymakers will need to rely on both internal and external shock absorbers to guide the economy to its new equilibrium

The US-Iran conflict is about to enter its fourth week, with no sign of de-escalation. Crude prices are up more than 50 per cent and gas prices more than 70 per cent since the start of February, threatening to deliver a large, adverse supply shock to energy importers around the world. 

Supply shocks are notoriously difficult to respond to, as Covid taught us, because they simultaneously impinge on growth and drive up inflation, creating difficult policy trade-offs. How then should India respond in the current environment? 

A blend of Covid and Russia-Ukraine 

The first thing to appreciate is the nature of this supply shock. The current situation is unlike the 2022 Russia-Ukraine conflict, which also spawned a surge in energy prices. That, too, was a supply shock but it worked largely through an adverse terms-of-trade channel by pushing up global prices. 

Here, the adverse price shock is being compounded by a quantitative constraint on volumes of crude, gas and liquefied petroleum gas (LPG). Almost 50 per cent of the LPG and 30 per cent of the natural gas that India consumes comes from the Strait of Hormuz. If that does not open soon, physical availability of energy will become an increasing challenge.  This will amplify the price shock in two pernicious ways: 

First, there is a growing risk that economic activity across various sectors will be impacted, resulting in a hit to activity much larger than the sticker price of crude and gas would suggest. Hypothetically, if restaurants have to temporarily close because of a lack of LPG or auto part production is hit because of a lack of gas availability, the ‘shadow price’ that they, de facto, confront — which results in a sharp curtailment of activity — will be much higher than implied by the price of crude and gas quoted in global markets. 

Second, as we learnt in Covid, non-linearities quickly begin to emerge. If an establishment shuts down, and lets go of its workers, this process is often hard to reverse. If gig workers are impacted, and go back to rural areas, it’s often hard to bring them back, as Covid revealed. 

For both these reasons, when quantitative constraints begin to bind, the hit to economic activity can be much larger than that assumed from the terms-of-trade shock emanating from higher crude and gas prices. It means time is despera­tely of the essence. The longer the Strait of Hor­muz remains closed, the higher the odds that quantitative restrictions impede activity and non-linearities kick in. Policy therefore needs to respond at three levels. 

Phase 1: Keeping the lights on 

The immediate response has to be to keep the economy’s lights on as much as possible, in the wake of a potential energy shortage. Here the playbook from Covid in minimising supply disruptions — and allocating scarce resources — will be more applicable than dealing with higher energy prices in the wake of the Russia-Ukraine war. Some of the solutions may be obvious. 

First, augment domestic production as much as possible (for example, LPG) to offset external shortages. 

Second, scout for oil/gas/LPG anywhere around the world, at whatever price. Even much higher global spot prices will be less damaging than the shadow price that forces closure of economic activity and risks the aforementioned non-linearities. 

Third, ration available stocks in an economically efficient manner. Preventing hoarding is a given, but delicate choices will have to be made about allocation between the household and commercial sectors. The natural instinct is to lean disproportionately towards allocating to the household sector, but if restaurants and firms are meaningfully deprived of LPG and gas, this will eventually impact production and employment, eventually also hurting households. So, getting the household-industrial balance right will be important. 

Fourth, provide fiscal subsidies and associated incentives to the private sector to quickly and sharply ramp up production of alternatives like induction stoves. This would be equivalent to subsidising the production of personal protective equipment (PPE) in the early days of the pandemic. 

All told, the first phase must be to mitigate the volume constraint to avoid disruptive losses in consumption and economic output. 

Phase 2: Activating internal and external shock absorbers 

The second phase must deal with the price fall-out. Even if quantitative constraints are alleviated, it’s likely crude prices will remain elevated for a while, resulting in an adverse terms-of-trade shock. Every $10/barrel increase in crude constitutes about a 0.5 per cent of GDP negative terms-of-trade shock for India’s economy. How the impact is absorbed across growth and inflation will depend on the internal burden-sharing between the public and private sector. 

On one end of the spectrum, the shock can be absorbed completely by the fiscal. No retail prices are raised, and oil marketing companies (OMCs) take the hit. This results in either lower dividends to the budget or, in more extreme scenarios, requiring fiscal support to prop up OMCs. The impact on inflation — and therefore inflation expectations — is lower, but the hit to growth is higher. Why? Because if the fiscal deficit target is not changed, there is a one-for-one crowding out of other expenditures from higher oil subsidies. So, in effect, the government’s marginal propensity to spend is 1, in this scenario. 

In contrast, if this is passed on to households, the marginal propensity to consume is typically lower than 1. So inflation is higher but the hit to growth is expected to be lower. 

There is, however, a more compelling reason for retail prices of gasoline and diesel to slowly, but progressively, be increased if oil prices remain elevated. To understand why, it’s important to identify which parts of the macros are most susceptible to pressure. Before the oil shock, inflation was benign and growth was experiencing a smart cyclical upswing. Both growth and inflation are therefore confronting the shock from relatively strong starting points, and can absorb some of the shock. 

Instead, the current pressure point is the balance of payments. India’s current account deficit (CAD) is expected to print at a benign 1 per cent of GDP in 2025-26. But even that is proving challenging to finance because capital flows have slowed sharply. On top of that, the current conflict is likely to result in correlated shocks that push the CAD higher: Higher crude and gas prices, lower remittances, lower West Asia exports. If crude averages $85/barrel this year, for instance, the CAD will double and be closer to 2 per cent of GDP, which will be that much harder to finance in the current global environment. 

A key goal of policy will therefore need to be to take the pressure off the balance of payment (BoP). This will require two prices to adjust, thereby creating an internal and external shock absorber, respectively: 

First, only if retail prices are slowly increased — to reflect global crude prices — will domestic economic agents scale back on energy volumes in response to higher prices. In effect, (lower) imported volumes can partially offset (higher) energy prices and provide some relief to the current account. Absent this price discovery, the CAD will face a double whammy with higher crude prices and no commensurate volume adjustment, because economic agents are not incentivised to do so. Think of this as the internal shock absorber. 

Second, the BoP will also need an external shock absorber in the form of calibrated rupee depreciation. A negative terms-of-trade shock would argue for a weaker equilibrium real effective exchange rate (REER), and policymakers should enable that transition. As evidence has found, a weaker REER will, over time, help contain the CAD by making exports more competitive and imports more expensive. There are other benefits from letting the rupee play an external shock absorption role. It frees up monetary and fiscal policy to focus on domestic growth and inflation dynamics and conserves valuable foreign exchange (FX) reserves. 

All told, the macro response must first identify the soft spot (CAD) and then use both internal (retail energy prices) and external (rupee) shock absorbers to ensure sustainability. 

Phase 3: Strategic reset 

Finally, when the dust settles, on this sh­o­ck it’s important to draw the right less­o­ns. After the taper tantrum of 2013, In­d­ia realised the value of buffers and framew­o­rks to preserve macroeconomic stabili­ty. FX reserves were stockpiled, an infla- tion targeting framework was instituted, and a new fiscal anchor introduced. 

India must now adopt a similar risk-management mindset to guard against growth shocks. At a time when supply chains are fragile and trade is being increasingly weaponised, chokepoints in the economy must be systematically identified — across energy, food, commodities, and critical minerals — and volume and price risk mitigated as far as possible. Physical buffers will either need to be introduced or increased sharply. In Asia, for instance, China, Korea, Japan all have close to 120 days of strategic reserves. Similarly, China has systematically built buffers across energy, metals, minerals and food to smooth external shocks. In this new world, the concept of reserves for India cannot just be limited to foreign exchange. Volume risk apart, India should be hedging crude price risks through financial instruments as much as possible. What is preventing a more systematic programme of hedging crude prices using financial instruments? Medium-term risk management will necessarily entail diversifying away from fossil fuels as much as possible, by incentivising renewables, energy storage and electrification. 

The goal cannot simply be to maximise ‘average growth rates’, but to minimise growth volatility by being better prepared to absorb shocks. All this will extract fiscal and foreign currency costs and, more generally, the opportunity costs of using scarce resources to build buffers. But at a time when the distribution of risks has widened dramatically and the tails are getting increasingly fat, this would be a small cost to pay to avoid disruptive swings in growth and employment. If proof were needed, one only needs to look at the role that FX reserves have played in smoothing the impact of external shocks on the rupee over the last decade. 

This strategic reset, however, must occupy us when the dust settles. For now, the priority must be to navigate this latest storm in the least disruptive manner possible. 

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The writer is head of Asia economics at J P Morgan. Views are personal