How to address the inflation challenge

The impact of the ongoing Russia-Ukraine war on energy and commodity prices has caused global financial turmoil. Some countries are facing food shortages and all oil importing countries are adversely affected. The invasion has come at an unfortunate time for India. When we tackled our double balance sheet problem and our corporate and financial sector balance sheets looked strong, energy prices rose, inflation rose and interest rates started rising, which adversely affected the start of the capital investment cycle in India. Inflation in India is not a result of increased aggregate demand – capacity utilization is still average, around 70% – but due to higher energy prices and supply chain disruptions. Thus, the rise in interest rates cannot be curbed.

Interestingly, inflation in the United States (US) and Organization for Economic Co-operation and Development (OECD) countries is higher than in India. This is the first time this has happened in living memory. Inflation in the US is due to high energy prices (it is an oil exporter), but also due to massive economic stimulus to combat Covid-19. As a result, the Federal Reserve is forced to start raising interest rates to moderate inflation.

A sharp increase in interest rates in the US led to an outflow of funds from India, seriously affecting the exchange rate and causing the rupee to fall to an all-time low against the dollar. Due to this, the Reserve Bank of India (RBI) is in trouble. Raising interest rates suppresses demand even though aggregate demand is still soft. Indeed, raising rates will delay the start of the capex cycle, which will affect the economy’s growth prospects, making the cure worse than the problem.

The basic equation of debt service is that if the nominal growth rate is higher than the interest rate, the country can service its debt. If the rate of growth falls below the level of the interest rate, debt servicing becomes more painful and requires reallocation at a cost away from productive objectives. However, the sharp outflow of money put pressure on the RBI, which led to a hike in rates to support the rupee. Navigating this situation requires deft management and non-standard responses.

Given the geopolitical situation, the Ministry of Finance, RBI and the Ministry of External Affairs (MEA) need to coordinate closely. The MEA has so far been adept at handling the Indian position, highlighting how India imports less oil from Russia than most European countries. Additionally, it emphasized that India is dependent on Russian arms, not only because Moscow is a reliable partner, but also because the West is reluctant to supply arms to India. This robust narrative has allowed India to maintain some strategic autonomy and not become globally isolated. However, most of the international press continues to portray the Indian position badly and draw attention to the country, so the work must continue.

To address inflation in India today, controlling oil prices is the need of the hour, by buying cheap oil from Russia and reducing taxes on oil to match the price consumers pay. However, reducing taxes puts pressure on the fiscal balance. To address this, the distribution program cannot be relaxed. A fall in global indices makes this politically more problematic as price realizations decline. However, the alternative would be worse and therefore, appropriations should not cease. Waiting is unlikely to help as prospects for the global economy fade, with Europe and the U.S. rising into recession, and a zero-covid-19 policy in China that has slowed its growth rate. Sino-Western tensions are likely to further dampen its economic prospects in the medium term. Hence, it is not prudent to delay issuance in the hope that the markets will recover quickly.

Other points addressed in this year’s sound budget should continue. Infrastructure spending should not stagnate; In fact, it should be accelerated. It improves the productivity of the economy and creates demand by creating employment. If interest rates go too high, this process will be adversely affected and therefore deft navigation and full coordination between the RBI and the Finance Ministry is essential.

In the medium term, India will experience geopolitical tailwinds. Superpower rivalry gives India a chance to be seen as a bulwark against China. India’s participation in the Quad, the launch of a new Indo-Pacific Economic Framework for Prosperity and the strengthening of our technology partnership with the US will yield huge benefits.

Fears of China will continue to rise in the US and exploiting that space will be critical for India. Given the state of other emerging economies such as Russia, Brazil, Turkey and South Africa, India’s strong growth has led indices such as Morgan Stanley Capital International to reconsider their emerging market portfolios and increase their exposure to India and Southeast Asia.

This is an important economic period for India. The country must navigate the current complexities well and take advantage of geopolitical tailwinds. The medium term is favorable for India’s growth prospects and its position in the world. We must all work together to seize the opportunity.

Janamejaya Sinha, President, BCG India

Opinions expressed are personal

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