Why in news?
Surging oil prices constitute visible terms of trade shock and will necessitate skilled macro management.
What are the channels through which the Russia-Ukraine conflict will impact economy?
- The negative terms of trade shock from higher commodity prices, particularly oil
- A direct trade channel to the affected region
- An indirect trade channel from weaker global growth
- The tightening of financial conditions and capital flows as global risk appetite wanes
To know more about war impacts beyond oil, click here
What is the trend in crude prices?
- Crude prices have surged well past a 110 dollar per barrel and as the conflict gets more entrenched, crude could remain elevated for much longer.
- This would constitute a large, negative terms of trade shock to India to the tune of 1.2% of GDP.
- The size of the commodity shock rises once higher prices for coal and gas imports are included.
What will be the implications on Indian economy?
- The situation is similiar to an adverse supply shock to the economy that simultaneously impacts growth, inflation and the current account deficit (CAD).
- Growth- The growth impact will manifest through
- constraints on fiscal space
- household purchasing power being impinged
- firm margins coming under pressure
- The quantum of the growth impact will depend on how the shock is distributed across the fiscal, households and firms.
- The excise duty cuts will absorb the shock from oil and this year’s budget, therefore, forecasted lower excise duties collections and has less spending space.
- External balances- Oil at 100 dollars will leave a tangible imprint on India’s external balances.
- CAD- The October-December CAD is tracking 3% of GDP and the CAD is likely to stay close to those elevated levels in the coming quarters if crude is in triple digits.
- The RBI has a war chest of foreign currency reserves, so there is no imminent threat to macroeconomic stability but the current account and balance of payments needs close monitoring.
- Inflation- Higher commodity prices can pressure inflation.
- Depreciation of rupee- The widening of the CAD and associated BoP pressures will create some depreciation pressures on the rupee.
- A persistent negative term of trade shock will argue for a weaker equilibrium real effective exchange rate.
How should policy respond in the wake of terms of trade shock?
- Allowing real depreciation of currency- Policymakers should let the rupee reach the new equilibrium in a gradual and non-disruptive manner
- This is because it will facilitate the necessary expenditure switching to reduce imports, boost exports and help narrow an elevated CAD.
- A real depreciation of the currency that acts as a shock absorber for the economy is the optimal response to a negative terms of trade shock.
- While a real deprecation can be expansionary, it can also be inflationary generating an aggregate demand boost in the wake of an adverse supply shock.
- All this will contribute to inflationary pressures, and will warrant a commensurate monetary policy response.
- Excise duty cut- Cutting excise duties would buffer the impact on households and protect consumption, but potentially result in a larger hit to demand by shrinking fiscal space to spend.
- If the government doesn’t cut duties, this will mean higher retail prices that can harden inflationary expectations, increasing the challenges for monetary policy.
- Disinvestment- As soon as markets begin to stabilise, authorities must plough ahead with planned asset sales/disinvestment to create more fiscal headroom.
- The new equilibrium will inevitably need some combination of a weaker rupee, higher rates, and judicious fiscal management.
- Reducing import dependence- Policymakers must seriously 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 our dependence on imported crude.
Reference
- https://indianexpress.com/article/opinion/columns/managing-the-crude-oil-price-pressure-7799847/
