What is the main reason for India being the bright spot in the world economy? Well, investment demand is tepid and external demand sluggish, so those can’t be the reasons. We’re left with consumption demand, which has been the driver of economic growth. But how has consumption demand done so well, despite two consecutive years of drought? The answer lies in lower commodity and oil prices, which has resulted in windfall gains for oil and commodity importing countries such as India.
But everybody knows that India has benefitted immensely from the fall in crude oil and commodity prices. The big question is: how much did it benefit? Can we put a number to it? The International Monetary Fund (IMF), in its latest World Economic Outlook report, has calculated the windfall terms-of-trade gains that have accrued to several economies as a result of the fall in oil and commodity prices. The windfall has been computed as an estimate of the change in disposable income, as a percentage of gross domestic product, arising from commodity price changes. The chart has the details. The table on the left shows countries that have lost out due to the shift in oil and commodity prices. As you can see from the first column of the table, the biggest losers have been the oil exporting countries, with the losses in disposable income being more than a quarter of 2015 GDP for Iraq, Qatar and Saudi Arabia. No wonder these countries are desperate to get an agreement to limit oil production and push up prices.
On the other hand, the table on the right shows that in 2015, India was second only to Thailand among major economies that gained the most from falling commodity and oil prices. The terms-of-trade windfall gains for India in 2015, according to the IMF, were as high as 3.3% of GDP. It is amply clear then that a very big reason for the high GDP growth was the windfall gains from lower commodity and oil prices.
These windfall gains have reduced inflation and helped the fiscal position. As the IMF’s World Economic Outlook for April 2016 said, ‘Oil-importing emerging market and developing economies … have enjoyed significant terms-of-trade windfall gains from the sharp drop in oil prices. Lower oil prices have alleviated inflation pressures and reduced external vulnerabilities. In some importing countries with oil-related subsidies, the windfall gains from lower oil prices have been used to increase public sector savings and strengthen fiscal positions.’
Next, look at the second column of the tables, both for the losers as well as the winners from lower commodity prices. It shows the terms-of-trade gains over 2016-17 if commodity prices remain on an average at the level they were in August 2016. Note the sharp fall in windfall gains, as both commodity and oil prices have bottomed out. For India over 2016-17, the terms-of-trade gains will be a mere 0.04% of GDP, according to the IMF’s calculations. In short, the Indian economy will no longer have the benefit of plunging commodity prices that provided such an impetus to growth last year. It will therefore have to rely more on domestic sources of growth. That could be one reason for the doves taking wing at the recent RBI policy meet.
Why did the new regime at the Reserve Bank of India deliver a surprise interest rate cut? Very likely, it has to do with concerns on growth. Note that, in spite of the 25 basis point rate cut, the central bank doesn’t envisage any improvement in growth and the estimated growth of gross value added for 2016-17 has been retained at 7.6%. That suggests the 25 basis point cut was aimed at supporting growth.
Why did the Monetary Policy Committee think growth needs to be supported? After all, there has been no dearth of tom-tomming the impetus domestic growth will receive both from the good monsoons and from the government pay hike. The key to the central bank’s move lies in the external sector. The monetary policy statement said, ‘The continuing sluggishness in world trade and smaller terms of trade gains than in the past point, however, to further slackening of external demand going forward.’
At the very brief press conference that followed, governor Urjit Patel started off by talking of the risks to growth in the international situation. He said, ‘For the first time in a long time, the weak global demand is actually going to drag down trade volumes to decline.’ And Michael Patra cited the global situation with negative real rates as being the reason for revising down the neutral rate of interest for India. In short, the RBI believes the external situation is worrying and it knows that the windfall gains of last year will not be available this year. All the more necessary, therefore, to stoke domestic demand to offset that. Hence, the rate cut.