Slowing growth, high inflation challenge budget assumptions

Slowing growth, high inflation challenge budget assumptions

New Delhi: Amonth into the new fiscal year, the assumptions holding together the Union budget are beginning to unravel due to a steady increase in the prices of crude oil.

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Since the rise has not been passed on to consumers through higher petrol and diesel prices, the exchequer has had to absorb the fiscal shock.

Brent crude oil closed at $125.89 a barrel for June delivery on Friday, significantly above the $95 a barrel that underlies the budget’s forecasts.

The most significant prediction was that fiscal deficit would be squeezed by 50 basis points to 4.6% of gross domestic product (GDP), or 4.12 trillion.

One basis point is one-hundredth of a percentage point.

“Administered price of diesel has to be increased," a finance ministry official said on condition of anonymity, explaining that it held the key to preserving the budget forecasts.

Diesel, which makes up about 60% of fuel subsidy, last saw an increase in retail price in June 2010 when the Indian crude basket cost around $75.

Increasing prices is not an easy decision. The nature and magnitude of inflation has surprised, the ministry official said. Political turbulence has also worked its way into the equation.

There are four milestones the government is likely to consider when it takes a call on the possibility of increasing the administered price of subsidized fuel, the official said.

The message on inflation conveyed by the Reserve Bank of India (RBI) in Tuesday’s credit policy, the April inflation numbers, the political space provided by the outcome of assembly elections and the June update on the progress of south-west monsoon would be the four factors influencing the government’s decision, the official said.

“They are likely to keep in mind the trajectory of global commodity prices (particularly crude), the progress of the monsoon and the stickiness of headline and core inflation," Sajjid Chinoy, India economist at JPMorgan India Pvt. Ltd, said of the factors likely to influence the government.

India Meteorological Department said on 19 April that the south-west monsoon will be normal. The June update on the prediction is crucial as it offers a closer look at the progress and geographical spread of rainfall.

“There is an asymmetrical bias in the impact of the monsoon on food prices. While a good monsoon may not lead to a sharp fall in food inflation as was witnessed in 2010, a bad monsoon will most definitely lead to a spike in prices," Kaushik Das, India economist for Deutsche Bank AG, wrote in Mint on 28 April.

Food was a key driver of inflation last year. But now the renewed rise is being driven by core inflation or the rise in prices of manufactured items. In March, inflation as measured by Wholesale Price Index (WPI), was 8.98%, almost a percentage point higher than RBI’s fiscal-end forecast.

Within WPI, core inflation had increased to 7.1%. It was first time core inflation had exceeded 7% since 2008, even though global commodity prices had not reached 2008 highs.

In this backdrop, the firm trend in crude price seems ominous. Of all major Asian economies, India is most sensitive to the spillover of an increase in energy prices into core inflation.

The International Monetary Fund (IMF) has pointed out that a 1% increase in domestic energy price leads to a little over 30 basis points increase in core inflation in India.

“The central bank faces a more acute growth/inflation dilemma than at any time in the recent past," Standard Chartered Bank said last week in a research report.

An increase in fuel prices and hardening interest rates are expected to have an adverse impact on economic growth.

Last week, Goldman Sachs published a report reducing GDP forecast for 2012 to 7.8% from the earlier forecast of 8.7% on account of higher interest rates and a weaker capital spending cycle.

Around the same time, IMF said growth in both India and China would slow in 2011 and 2012 due to tightening of policy rates, which would hold back investment.

Goldman Sachs also revised its inflation forecast for India to 7.5% in 2011-12 from 6.7%.

Despite the external shock to fuel prices in the wake of political turmoil in the Arab world, economists Mint spoke with felt the government should bite the bullet and increase administered fuel prices. An increase in fuel prices would inflate price levels in two phases. First, would be the immediate impact. Later, a second-order impact would be felt on core inflation as higher energy prices work their way through the system. An increase in fuel prices means inflation is likely to accelerate.

“We believe neither headline nor core inflation has peaked yet," Chinoy said. “If monetary tightening is front-loaded and if the planned fiscal consolidation is not derailed, inflation is expected to peak around September after the second-round effects of the expected increase in petroleum product prices plays out."

Inflation is likely to escalate in the short term.

“Any meaningful hike in diesel prices is likely to spiral the headline inflation, at least in the short term," said Manoj Vohra, co-lead of Economist Intelligence Unit’s Asia research.

“Assuming the absence of shocks such as an unexpectedly sharp or sustained rise in global commodity prices or a failure of the monsoon, inflationary pressures should begin to subside in the second half of 2011," Vohra said.

An increase in administered fuel prices at a time when headline inflation is headed towards double digits is not an easy decision. But with core inflation climbing, economists feel it would be worse for the government to absorb the shock by keeping prices constant and missing fiscal targets.

“Fiscal slippage always creates demand pressure," D.K. Joshi, principal economist at Crisil Ltd, said. “There are always trade-offs, but right now my sense is it’s important to curb fiscal slippage."

Fiscal deficit, which represents the excess of expenditure over income that is bridged through borrowings, is a closely tracked figure. The government’s stated resolve is to bring down relative level of borrowings and clear space for the private borrowings to fund investments.

Other than having a long-term impact on the pace of economic growth, fiscal slippage now could prolong the current spell of high inflation.

“Significant fiscal slippage and monetary policy remaining consistently behind the curve would result in elevated core and headline (inflation) through most of the year," JP Morgan’s Chinoy said.

“If the government decides not to deregulate diesel prices, it will not only miss the fiscal deficit target, but also run the risk of higher inflation in the medium to long term on account of an excessive monetary expansion," Economist Intelligence Unit’s Vohra said.

For now, the finance ministry is just planning to closely watch the milestones. By end-June, it will be clear on which of the alternatives it chooses.