The economic challenges of 2018
Global economic winds have begun to shift. What does this mean for the Indian economy?
Take a look around. Global crude oil prices have climbed to around $70 a barrel. This is higher than what most Indian policy makers seem to have assumed in their models. US interest rates have also begun to tighten. The yield on the two-year US treasury note is now at its highest level since September 2008, the month when Lehman Brothers collapsed. The yield curve has become steeper on expectations of higher inflation. The underlying reason for higher oil prices and US bond yields is that the global economy is in the midst of its best synchronized expansion since 2011.
The Indian data is also very different from what it was six months ago. Economic growth has recovered from the depths it plunged to after the demonetisation shock. Most forecasters expect the Indian economy to accelerate further in 2018. Consumer price inflation has been climbing every month since it touched a low in June, and the latest number is close to the higher end of the acceptable range. Headline inflation has increased by 3.67 percentage points in the six months since June 2017.
The trade deficit is also widening, with oil being the most important contributor but other factors such as higher imports of gold and consumer electronics also playing a part. And finance minister Arun Jaitley will announce the final budget of the Narendra Modi government on 1 February; it seems very likely that the fiscal deficit will be slightly higher than target.
The decline in global oil prices boosted the net incomes of Indians, though the Modi government quite sensibly decided to use the windfall to reduce its fiscal deficit rather than leave it in the hands of consumers. The process could reverse in case oil prices continue to go up.
Is all this a cause for worry? The economic stability that has been achieved after the run on the rupee in mid-2013 does not seem to be at risk—for now.
Consider the example of inflation. The recent rise can at least partly be explained by the low base of the corresponding months a year ago, and it is likely that monthly inflation will remain elevated till June. It would be sensible to look at the average inflation for the year rather than the noisy monthly data, especially in these times when the economy was hit by two successive policy shocks. So, the December 2017 inflation number (5.21%) is not a reason for sharp interest rate hikes just as the June 2017 number (1.54%) was not a reason for a sharp reduction in interest rates. An inflation-targeting central bank would normally look past temporary blips as long as underlying inflation expectations are stable.
Untangling the effects of higher global oil prices on Indian economic growth is not an easy task. There are two research papers that are worth highlighting here.
First, a working paper published by the International Monetary Fund in December 2016, The Differential Effects Of Oil Demand And Supply Shocks On The Global Economy, shows that a lot depends on whether movements in global oil prices are dominated by changes in demand or changes in supply. The economic consequences of the two are quite different from each other in the case of an oil importer such as India.
A surge in oil prices driven by supply constraints typically hurts economic activity over a long period of time. The impact is quite different in case the increase in oil prices is primarily because of higher demand. Oil importers typically experience a temporary increase in output as well as higher inflation over the longer term. In other words, a lot depends on whether the current increase in global oil prices is being driven by higher demand or lower supply (though the shale revolution makes the former a more likely candidate).
Second, Harvard University economist Gita Gopinath showed in a 2007 paper that she wrote with Mark Aguiar that emerging markets such as India have more volatile economic growth than the developed economies. In other words, the business cycles in emerging markets are different from those in the developed economies. The two economists show how “shocks to trend growth are the primary source of fluctuations in these markets as opposed to transitory fluctuations around the trend”. One of the factors they explicitly focus on is countercyclical current accounts. The gist of the argument is to be found in the second half of the title itself: Emerging Market Business Cycles: The Cycle Is The Trend.
India is nowhere near the dangerous place it was in 2013, in terms of the standard indicators of economic stability such as the fiscal deficit, the current account deficit and consumer inflation. Yet, the year ahead is likely to see some deterioration in public finances, a larger current account deficit that needs to be funded with capital inflows and higher inflation as the output gap closes. Indian macroeconomic policy always gets complicated when global oil prices increase steeply.
The economy in 2018 will thus look very different from the one in 2017. And all this at a time when potential growth could have slipped to as low as 6.7%, as credit rating agency Fitch recently estimated. In other words, the Indian economy could begin to heat up quickly—with higher inflation and a bigger trade deficit as the main signals—unless private sector investment picks up soon to increase productive capacity.
The coming quarters will thus test the macroeconomic policy framework that has been in place since the end of 2013.
Niranjan Rajadhyaksha is executive editor of Mint.
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firstname.lastname@example.org. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics