Hi,
Russia’s invasion of Ukraine led to an oil price spike,
Today’s post is about the policy tradeoffs the Indian government will have to make due to the recent surge.
In February, oil prices crossed $100/ barrel. A sharp spike from the lows of December 2021.
India imports 85% of its crude oil requirements. Increasing demand combined with strong oil prices in 2021 means the country’s import bill is expected to balloon to $110-115 billion by the end of the fiscal year ending March 2022.
Such a burden on the exchequer means that fiscal and monetary policy needs to adapt to the situation.
What would this look like?
Sajjid Z. Chinoy and Toshi Jain have dug deep into this for the Indian Public Policy review. You can find their detailed article here.
Here is my understanding based on reading their work.
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Understanding the situation
To examine the impact higher oil prices will have, we need to understand
How will the additional cost of oil be shared amongst fiscal spending (taxation and govt spending), households and firms?
The impact of this cost distribution on the growth of the economy.
Let’s examine the impact if the government is expected to shoulder the cost instead of passing it on to consumers.
If the government absorbs the cost -> there is a reduction in government revenue -> which limits government spending -> meaning a limited budget for infrastructure and support for exports -> with labor heavy infrastructure spending curtailed, jobs and growth are impacted.
The hit to growth could shave off 0.9%-1.1% of GDP.
The important thing to note is the greater the expense borne by the government the larger the hit on growth and demand as government spending can influence GDP more than households or businesses. This is due to the government’s marginal propensity to consume (MPC).
Simply put, the government has the ability to spend its revenue on activities that could boost the economy while companies and individuals have a higher inclination to save or invest.
MPC theory suggests that a boost in government spending will increase consumer income, and in turn, consumer spending will rise. On a macro level, this increase in investment will lead to a higher aggregate level of demand which boosts the economy.
Sluggish growth due to the impact of COVID-19 means that the government is having to spend more to keep the growth engine of the Indian economy chugging along.
But precisely when the onus on government spending has increased, so have the constraints with revenues.
All this increases the policy challenge and creates several delicate trade-offs,
What does the government need to consider?
The government has a few careful decisions to make.
1) External Sector and the Rupee
A widening current account deficit and resulting balance of payments pressure will create depreciation pressures on the rupee. In other terms, we need to buy dollars to pay for oil by selling rupees. Doing so on a large scale will make dollars more expensive to buy.
However, policymakers should let the rupee gradually adjust to this new reality instead of propping it up. Failing to do so means that the exchange rate can’t reach its new equilibrium.
Enabling this adjustment is also important to facilitate “expenditure switching” which makes our exports more attractive and imports more expensive, helping narrow the current account deficit.
2) Monetary Policy
Increased exports due to a weaker currency can be expansionary. However, it could also result in higher levels of inflation, due to the passing through of increased import prices and a demand boost from higher levels of activity for exports.
With India’s inflation sticky these past two years an exchange rate depreciation would increase inflationary pressures and must be weighed carefully.
The oil shock accentuates this dilemma by simultaneously pushing up inflation and pushing down growth.
3) Fiscal Policy
Fiscal policy decisions are hemmed in by two considerations,
First, if crude prices climb even higher and/or the fertiliser subsidy increases, pressure on budgeted expenditures will emerge.
Second, higher oil prices are symptomatic of elevated global uncertainty and corresponding pressure on asset prices (historically when oil price goes up, Indian stocks fall more than other developing countries). Thus, budgeted asset sales could be harder to pull off.
Looking ahead
With all of these factors to consider one might wonder what should be done. The authors’ takeaway on what needs to happen is succinct and insightful,
What is clear to us, however, is that as soon as markets begin to stabilise, authorities must plough ahead with planned asset sales/disinvestments to create much-needed fiscal headroom, without trying to perfectly time the market. This will allow the fiscal to protect expenditures even as it takes on some of the oil shock on the Budget.
A persistent adverse supply shock is complicated and challenging to respond to, and the new equilibrium will inevitably need some combination of a weaker rupee, higher rates, and judicious fiscal management.
Beyond the very near term, however, we believe policymakers must consider systematically hedging crude price imports in global markets to protect the economy from periods of outsized volatility, apart from the medium-term objective of reducing dependence on imported crude.
It is surprising how much thinking from the macroeconomic perspective differs from public policy lens.
Public policy theory states that for every Rs.1 of government spending it costs Rs.3 to society. Meaning the benefit accrued from the spending should be three times the cost.
But in macroeconomics government spending is seen as beneficial and even essential to the growth of the country. The higher the spending, the higher the growth.
It just goes to show there is no one right answer to our problems. Viewing them through different lenses shows us a more complete picture.
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