Policy adjustments: A sustained West Asia crisis will force tough decisions

United States (US) President Donald Trump is not impressed with Iran’s latest proposal to end the war. Iran reportedly sent a 14-point proposal through Pakistan, which is mediating between the two sides. Although both sides are negotiating and the ceasefire is holding, it is unclear how long the impasse will continue. Both the US and Iran have blocked the Strait of Hormuz, severely affecting energy supplies. The benchmark Brent crude topped $125 per barrel last week. Some analysts believe that oil prices could sharply increase in the coming weeks due to the depletion of the global stockpile. The US-Iran deadlock is affecting the global economy. The European Central Bank, for instance, last week noted that upside risks to inflation and downside risks to growth had increased. As a large energy importer, India is also facing multiple challenges.

 

State-run oil-marketing companies (OMCs) last week sharply increased the price of commercial liquefied petroleum gas (LPG). The prices of a 5-kg LPG cylinder and aviation turbine fuel, too, were adjusted. Notably, the pump prices of petrol and diesel have not increased, though the government reduced special excise duty to ease the burden on OMCs. Last week’s price adjustments signal an acknowledgement of the problem and the need for policy recalibration. More needs to be done in the coming days, as neither OMCs nor the government can permanently absorb the elevated costs. Union Expenditure Secretary V Vualnam, for instance, noted last week that fiscal stress was a reality. Government finances will be affected from both the revenue and expenditure sides. The government sacrificed about ₹1.5 trillion in revenue for the full year due to the reduction in excise duty.

 

Given that the shortage of gas has affected economic activities, tax collection  too will be impacted. On the expenditure side, subsidies on fuel and fertilisers could surge, depending on how long the deadlock continues. Nevertheless, despite fiscal pressure, the government seems committed to capital expenditure, which will help sustain growth. However, given the fiscal position, the government’s ability to support the economy will remain constrained. Although the fiscal deficit and public debt declined in a major way after the Covid-year jump, they remain elevated. The Union government has budgeted to contain the fiscal deficit at 4.3 per cent of gross domestic product (GDP) this financial year, which will now be difficult to achieve. Projections of the International Monetary Fund show that India’s general government debt, currently at about 83 per cent of GDP, will remain above the pre-pandemic level even in 2031.

 

A significant slippage this year, owing to the ongoing conflict, could adversely affect the debt trajectory and increase risks to macroeconomic stability. Thus, while there will be pressure to provide short-term relief, the government must not lose sight of medium-term risks. It can offset the limited fiscal space by pushing the reform agenda and strengthening medium-term growth prospects. The adjustments in fuel prices will push up the inflation rate, which is currently running below the target of 4 per cent. The forecast of a below-normal monsoon will only complicate things for the Monetary Policy Committee of the Reserve Bank of India. An early resolution to the conflict and the reopening of the strait would obviously ease the pressure. However, if the deadlock persists for a prolonged period, which is a possibility, it would force difficult fiscal and monetary-policy decisions.