Geopolitical Spillovers and the Indian Economy1
Shri Pradeep Multani, President, Shri Saket Dalmia, Senior Vice-
President, Shri Sanjeev Agarwal, Vice President, Shri Saurabh Sanyal,
Secretary General, Dr. S P Sharma, Chief Economist, esteemed
members of the PhD Chamber of Commerce and Industry, eminent
dignitaries and friends.
I am honoured to be invited to address and interact with you today. I am
inspired by the Chamber's glorious history of 117 years as an apex
chamber of national eminence catalysing Indian businesses towards rapid
economic development and nation building, including by building
partnerships with government.
A special mention is warranted of the PhD Research Bureau that was
established in 2010. By providing regular updates on the economic
situation, the Bureau has been sensitising the nation to socio-economic
and business developments of contemporaneous relevance. Dr. Satya
Prakash Sharma, with whom I go back a little way, and his team in the
Research Bureau are also part of the RBI's survey of professional
forecasters and their work figures in our fan charts describing the balance
of risks around our forecasts.
The Context
The world has been overwhelmed by the fallout of geopolitical conflict,
which threatens to snuff out a recovery that was hesitantly and haltingly
making its way through multiple waves of the pandemic and multiple
mutations of the virus. India's economic prospects are also challenged by
these ongoing developments, and the outlook is darkened and highly
uncertain. I thought I would take this opportunity to share with you how
the RBI is navigating this tsunami in its endeavour to shield the Indian
economy and secure its tryst with a brighter future.
On February 10, 2022 as Governor Shri Shaktikanta Das made his
statement on the occasion of the sixth and final meeting of the monetary
policy committee (MPC) for the year 2021-22, the mood was one of
cautious optimism. In spite of the Omicron-driven third wave, India was
decoupling from the rest of the world and fashioning a gradual but
strengthening course of recovery. Projections made by the International
Monetary Fund (IMF) just a month ago showed India poised to grow at the
fastest pace year-on-year among major economies. In that meeting, the
RBI projected real GDP growth at 7.8 per cent for 2022-23. CPI inflation
was projected to average 4.5 per cent, benefiting from the softening of
food prices at that time on improving prospects for foodgrains production,
the imminent arrival of the winter crop and strong supply side
interventions. In the words of Governor, "Our monetary policy would
continue to be guided by its primary mandate of price stability over the
medium term, while also ensuring a strong and sustained economic
recovery... We, in the Reserve Bank, have remained steadfast in our
commitment to safeguard trust and confidence in the domestic financial
system as we rebuild the foundations of strong and sustainable growth
with macroeconomic stability. This has been our anchor in the ocean of
uncertainty."
In a fortnight from then, the world changed. The escalation of geopolitical
tensions into war from late February 2022 delivered a brutal blow to the
global economy, battered as it had been through 2021 by the pandemic,
supply chain and logistics disruptions, elevated inflation and bouts of
financial market turbulence triggered by diverging paths of monetary
policy normalisation. Since then, the global macroeconomic outlook has
become suddenly overcast with the economic costs of the war and
retaliatory sanctions. Emerging market and developing economies
(EMDEs) are bearing the brunt of these geopolitical spillovers as I speak,
despite being bystanders. Capital outflows and currency depreciations
have tightened external funding conditions, and along with elevated debt
levels, put their hesitant and incomplete recoveries in danger. Heightened
volatility in financial markets and surges in prices of commodities -
especially of energy, metals, grain futures and fertilizers - have
accentuated risks to growth, inflation and financial stability.
Like other emerging market economies (EMEs), India too faces major
risks, the immediate ones being soaring crude prices and tightening
financial conditions. Spillovers in the form of large and sudden swings in
financial markets, portfolio capital outflows and supply chain disruptions
resulting in shortages of key intermediates, are clouding the outlook.
While the external sector is reasonably well-buffered with high level of
reserves and a modest current account deficit, it is prudent to be watchful
about the rising intensity and scale of headwinds from the geopolitical
conflict which could be overwhelming for all EMEs, including India.
In the next meeting of the MPC in April 2022, Governor's statement was
sombre. He termed the war in Europe and its fallout as 'tectonic shifts',
little realising that these words would be forerunners to descriptions of the
global outlook in terms of extreme weather conditions2. In his words, "We
are confronted with new but humungous challenges - shortages in key
commodities; fractures in the international financial architecture; and fears
of deglobalisation. Extreme volatility characterises commodity and
financial markets.... the conflict in Europe has the potential to derail the
global economy." In a span of two months, the projection of real GDP
growth was revised downwards by 60 basis points to 7.2 per cent for 2022-
23 while the CPI inflation projection for the year was raised by 120 basis
points to 5.7 per cent. These adjustments to the projections can be
regarded as the first authentic assessment of the toll that geopolitical
spillovers are expected to take on the Indian economy. By the June 2022
meeting of the MPC, it was clear that risks were materialising faster than
anticipated in inflation prints, with three-fourth of the consumer price index
(CPI) under siege. In that meeting, therefore, the inflation projection for
2022-23 was raised by another 100 basis points to 6.7 per cent.
The State of the Economy
The State of the Economy article published in the RBI's monthly Bulletin
has established its credentials as a reliable and comprehensive source of
information and analysis on the Indian economy. In its latest edition, it
points out that domestic economic activity has been gaining traction in
spite of the formidable geopolitical headwinds. Gauged from high
frequency indicators, the Indian economy is consolidating its path of
recovery. It is heartening that contact-intensive sectors which were hit
hard by the pandemic, are regaining traction. E-way bills generation and
toll collections indicate a sustained momentum in trade and transport
activity. The aviation sector is fast reaching normal levels. Even the
automobile industry has recorded recovery across all segments. The
labour market is strengthening, but mostly in manufacturing.
Although India's merchandise exports have stayed above US$ 30 billion
over the past 15 months, there has been a moderation in pace in May
2022, reflecting the renewed supply chain disruptions in the wake of the
war. Yet, bucking the global decline, India registered robust growth in
manufacturing export orders. Import growth is broad-based, taking the
trade deficit to its highest monthly level in May 2022, but this is an
indication that the recovery in domestic economic activity is gathering
strength. Seen in the broader context of balance of payments - which is
a summary record of all of India's external transactions - the decline in
India's current account deficit (CAD) to 1.5 per cent of GDP in the fourth
quarter from 2.6 per cent in the third quarter of 2021-22 augurs well for
India's external viability as it is backed by strong merchandise export
performance, rising net earnings from computer and business services
and a rejuvenation of remittances by overseas Indians from pandemic
lows. On an annual basis, therefore, the CAD turned out to be a modest
1.2 per cent of GDP in 2021-22, with the intrinsic strength of India's foreign
exchange earnings mitigating the terms of trade shocks imposed by
geopolitical spillovers and the surge in import demand.
With foodgrains production touching a record level for the sixth
consecutive year in 2021-22, food security has been bolstered amidst
widespread global shortages. As of May 31, 2022 the stock of rice and
wheat stood at 3.7 and 4.2 times the quarterly buffer norms. Minimum
support prices (MSP) for 14 major kharif crops for the marketing season
of 2022-23 have been announced, but upward revisions have been
modest, averaging 6.1 per cent, which is a positive for the inflation outlook.
In the industrial sector, the headline manufacturing purchasing managers'
index (PMI) maintained its improvement in May 2022, turning out to be
among the highest in the world. While the expansion was led by an
increase in factory orders and sales, the increase in input cost pressures
remains a point of concern. The PMI services accelerated in May 2022,
marking a solid recovery. The business expectations index (BEI) for
services expanded for the tenth successive month, but it was also
accompanied by large increases in input prices.
Headline CPI inflation moderated to 7.0 per cent in May 2022 from 7.8 per
cent in April, with the easing observed across the board. Core inflation fell
sharply to 5.9 per cent in May from 7.1 per cent in April. For June so far,
cereals prices have increased but pulses and edible oil prices have
registered a decline. With inflationary pressures from global commodity
prices, a number of steps have been taken on the supply side to ease
domestic prices. The latest round of the inflation expectations survey
(IES) of the Reserve Bank incorporated an extension survey of urban
households undertaken after the excise duty cuts on petrol and diesel and
the results show a significant moderation in their inflation expectations
post the excise duty cut.
The Role of Monetary Policy
It will be remiss of me not to speak about the role of monetary policy in
the context of geopolitical spillovers. As a backdrop, it is perhaps useful
to summarise the monetary policy actions and stance adopted in 2022-23
so far. Starting in April and up to June, monetary policy has effectively
tightened by 130 basis points, which is fully reflected in the movement of
the overnight weighted average call money rate, the operating target of
monetary policy. The stance of monetary policy has shifted from being
'accommodative as long as necessary to revive and sustain growth on a
durable basis and continue to mitigate the impact of COVID-19 on the
economy while ensuring that inflation remains within the target going
forward' to 'withdrawal of accommodation to ensure that inflation remains
within the target going forward, while supporting growth.'
With headline inflation having moved up by 80 bps in April but reverting
by almost the same magnitude in May, the RBI has surged ahead of the
curve. In fact, the question that the now blind-sided are asking is: with
prices of food and fuel driving up inflation everywhere and in India as well,
how will increases in the policy rate help? This issue has been addressed
in some detail in the State of the Economy article, but I will draw out the
essence of its argumentation.
The initial shock from food and fuel prices to inflation lies outside the
domain of the RBI. Be that as it may, the policy challenge is that food and
fuel prices constitute 55 per cent of the CPI and the food shock emanates
from external sources, in this case, the war in Europe. The sequence from
this 'ground zero' is that households look at recent food and fuel prices
which are salient items in the average consumption basket and they form
their opinions about what inflation would be in the future, say three months
or a year from now. If households expect future inflation to go up and stay
up, they will adjust their behaviour to deal with that situation. As more and
more households and firms increasingly share this view, they will build it
into price mark-ups, wage negotiations, rents on houses, transportation
costs and the prices of services more generally such as personal services
like housekeeping, medical and education fees, entertainment and bus,
train and auto fares. With households accounting for close to 60 per cent
of India's GDP in the form of private consumption expenditure, this will
mean that inflation will become entrenched in the Indian psyche.
As inflation becomes more persistent and generalised as a result,
businesses will stop investing because they will worry that demand for
their products may get postponed at these elevated levels of prices.
Wages and costs will go up, export competitiveness will be damaged and
savings in banks will be pulled out and put into gold - that age old
repository of value - which actually means capital flight from India since
86 per cent of gold demand is met from abroad for which foreign exchange
has to be paid.
If the RBI does nothing, it will be seen as accommodating the inflation
shock, reinforcing the public's view that inflation may persist, broaden and
rise further. On the other hand, if the RBI increases interest rates and
tightens monetary and liquidity conditions to make money dearer, it will
(a) demonstrate that the RBI cares about people's expectations and is
determined that they should remain hinged - by anchoring people's faith
in the RBI's commitment to price stability, the foundations of growth will
be strengthened; (b) prevent the second-round effects of food and fuel
prices, which I just described, from spreading; and (c) deter discretionary
spending so that even if people's spending on food and fuel goes up
because of the price shock, they will adjust their expenditure on other
items so as not to exceed the family budget. In effect, the RBI's actions
will cause inflation other than that related to food and fuel, or what is called
core inflation, to ease and this will bring down headline inflation.
Foreign investors are particularly sensitive to such monetary policy
actions. They tend to see them as Indian policy authorities being resolute
in their intent to protect the value of Indian assets and so they will not pull
out their investments in India. They will, in fact, invest more, with this
assurance of the resolve to preserve macroeconomic and financial
stability. As capital flows return, depreciation pressure on the rupee that
is being experienced now will ease and this, in turn, will curb imported
inflation.
The monetary policy action is not without consequences. It will take its toll
on spending and demand. That is the price of stability. What the RBI is
trying to do is to stabilise the price situation when the economy is able to
bear it because in the longer run, price stability is beneficial for growth.
The RBI kept interest rates and liquidity conditions low and easy through
all of 2020-21 and 2021-22. As a result, the Indian economy recovered
from an unprecedented contraction of 6.6 per cent in 2020-21 to a growth
rate of 8.7 per cent in 2021-22, including an expansion by 4.1 per cent in
the quarter January to March 2022 when several advanced and emerging
economies either shrank or slowed. In the first quarter of 2022-23,
available indicators of economic activity have improved. Unlike the rest of
the world, India is recovering and getting resilient and stronger. This is the
best time to put the stabilising effects of monetary policy into action so that
the costs to the economy are minimised.
Will these monetary policy actions exorcise inflation? The outlook on
inflation is tethered to the war in Ukraine. But will we sit on our hands and
do nothing in a fatalistic acquiescence? What can monetary policy do?
The fact that inflation remains elevated and is broadening indicates that
there is some demand that is able to afford these high prices, perhaps due
to revenge spending in a pandemic stressed response. In fact, the most
sluggish part of the index - CPI excluding food, fuel, petrol, diesel, gold
and silver (44 per cent versus 47 per cent of the CPI in the standard core)
- and the weighted median CPI, a statistical measure of core inflation, are
both showing generalisation and momentum. This warrants monetary
policy action to ensure demand does not exceed the available supply,
even though both are not at full strength.
Another question that has vexed public opinion relates to the RBI's
accountability on monetary policy. The issue has drawn attention in the
context of CPI headline inflation having averaged 6.3 per cent in the fourth
quarter of 2021-22 and projected to average 7.5 per cent in the first
quarter of 2022-23 and 7.4 per cent in the second quarter. Inflation is,
however, forecast to edge down to 6.2 per cent in the third quarter and to
5.8 per cent in the fourth quarter.
The RBI Act mandates that in the case of the inflation target not being met
for three consecutive quarters, the RBI shall set out in a report to the
Central Government (a) the reasons for failure to achieve the inflation
target; (b) remedial actions proposed to be taken; and (c) an estimate of
the time-period within which the inflation target shall be achieved pursuant
to timely implementation of proposed remedial actions. What constitutes
failure has been notified by the Central Government in the Official Gazette
of India as (a) average inflation being more than the upper tolerance level
of the inflation target for any three consecutive quarters; or (b) average
inflation being less than the lower tolerance level of the inflation target for
any three consecutive quarters.
Let me speak to these issues squarely. Monetary policy is essentially a
contract between the sovereign - through its delegated authority, the
central bank - and the people. It is an assurance by the sovereign that it
will give to the people a money they can trust, a money that does not lose
value or purchasing power, and in fact, stores value into the future.
Therefore, it is indeed appropriate that monetary policy is accountable,
without any escape clauses. In India, this accountability is provided for
with sufficient flexibility in the form of an inflation target defined in
averages rather than as a point; achievement of the target over a period
of time rather than continuously; a reasonably wide tolerance band around
the target to accommodate measurement issues, forecast errors and
supply shocks; and failure being defined as three consecutive quarters of
deviation of inflation from the tolerance band, rather than every deviation
from the target.
Let me now turn to the specific aspects of the accountability conditions.
Research within the RBI, published in the Report on Currency and
Finance 2020-21, and outside it clearly demonstrates that growth is
unambiguously impaired when inflation crosses 6 per cent. Hence,
breaching of the appropriate upper tolerance limit of 6 per cent for India's
inflation target should trigger accountability if monetary policy has to
remain credible.
Currently, we live in extraordinary times. With inflation at multi-decadal
highs across advanced and emerging and developing economies, the
inflation crisis is global. Actually, it is just the face of one of the most se-
vere food and energy crises in recent history that now threatens the most
vulnerable across the globe. In response, the most widespread monetary
policy tightening in decades is underway. It is the most coordinated
tightening cycle in many years, and the actions are appearing
synchronised because imported inflation pressures are being
exacerbated by country-specific factors acting at the same time.
India is being impacted by the global inflation crisis, reflecting the
materialising of geopolitical risks. Although it is largely driven by food and
fuel supply disruptions and bottlenecks, mending supply always takes
time. Several steps have been taken, demonstrating that price stability is
a shared responsibility between the government and the central bank, but
these measures will inevitably have gestations: they will show results only
over a period. To gain time for supply to respond, monetary policy has to
be deployed, but it is not likely to be painless.
As I stated in my minutes in the June 2022 MPC meeting, the
accountability mechanism enhances credibility in the monetary policy
framework, especially in its commitment to re-align inflation with its target
in the event of prolonged divergences and that is of paramount
importance. The wide public sensitivity to accountability works in the same
direction as monetary policy in the pursuit of ensuring price stability. It
shows that inflation expectations are anchored around the conviction that
monetary policy will not tolerate persistent deviations from the target
because it is enjoined by legislation (not) to do so.
One final question on accountability engages public attention: what is the
role of the MPC here? After all, the Act enjoins the RBI - not the MPC - to
write the letter on causes, remedial actions and time to return to target.
Will the commitments made by the RBI in the letter render the MPC on
auto pilot? Once again, the MPC regulations are unambiguous on this
issue. The Secretary to the MPC shall schedule a separate meeting as
part of the normal policy process to discuss and draft the report to be sent
to the Central Government under the provisions of the Act.
Conclusion
Monetary policy is usually unsung. Whenever risks surround the Indian
economy, the RBI rises up with everything at its command in defence of
the Indian economy. When the danger recedes, the RBI reposes back to
anonymity, ready to rise again when the going gets tough.
It may be a premature prognosis, but there are indications that inflation
may be peaking. As monetary policy works through into the economy and
inflation falls back into the tolerance band by the fourth quarter of 2022-
23, it will be the playing out of the baseline scenario. In an alternative
simulation which incorporates the policy actions undertaken so far, the
easing of inflation could be even sooner and faster. The key is the
direction of change in inflation - not its level - in these extraordinary times.
Against this backdrop, it is our hope that required monetary policy actions
in India will be more moderate than elsewhere in the world and that we
will be able bring inflation back to target within a two-year time span. If the
monsoon brings with it a more benign outlook on food prices, India would
have tamed the inflation crisis even earlier. Without a doubt, the impact of
geopolitical risks will cause a very grudging decline in inflation and a
possible breach of the accountability criteria, but India would succeed in
bending down the future trajectory of inflation, winning the war in spite of
losing the battle. If real GDP growth averages between 6-7 percent of
GDP in 2022-23 and 2023-24, the recovery that is increasingly solidifying
gets a fair chance of traction. The RBI will have fulfilled its mandate of
prioritising price stability while being mindful of growth.
Thank you.