War On Inflation

On February 7 this year, Prime Minister Narendra Modi said inflation is an issue connected to the common man and his government has tried to handle it with utmost “caution” and “sensitivity.” The context was high-decibel protests by Indian National Congress and other opposition parties over soaring prices of fuels, fruit/vegetables and other daily-use goods.

Tearing into opposition and specifically hitting out at Congress, he said during his reply to motion of thanks on President’s address in Lok Sabha that the country was reeling under double-digit inflation during most of last five years of Congress rule with party leaders conceding they won’t be able to handle the situation. Emphasising that consumer inflation was 5.2% in FY2022 till then, despite the pandemic, while food inflation was under 3%, he said inflation control is “primary objective” of government’s economic policy.

Even as he was talking about his government’s record on tackling inflation, markets globally were planning a surprise. Prices had already started rising after October 2021 as a result of expansion of central bank balance sheets and government doles to lower the impact of Covid-19 on businesses and common man. The liquidity found its way to commodity markets and started pushing up prices. Russia-Ukraine war worsened the crisis by increasing energy rates and disrupting supply chains that were already under stress due to the pandemic. The result: Inflation is at decades-high in all major economies like U.S., Europe and Australia and has mutated into a full-fledged threat to global economic recovery by forcing central banks to increase rates and roll back liquidity at a faster pace than anticipated earlier.

India is no exception. Retail inflation touched an eight-year high of 7.79% in April. Food inflation was 8.38%, up from 1.96% in April 2021. Also, registering 13th consecutive month of double-digit rise, wholesale price index-based inflation touched a nine-year high of 15.8% in April, up from 10.74% in April 2021. Reserve Bank of India seemed to have had a whiff of April inflation numbers. Reports say it was thinking of an off-cycle interest rate increase a month before it decided to bite the bullet on May 4 lest it be seen behind the curve in fighting inflation, especially when other central banks had started increasing rates and sucking out liquidity months ago. So, hours before U.S. Federal Reserve was scheduled to announce a hike in its benchmark lending rates, RBI hiked repo rate by 40 basis points to 4.40%, reversing the low-rate regime introduced two years ago after the Covid-19 lockdown.

“Global crude oil prices are above $100 per barrel and remain volatile. Global food prices touched a new record in March and have firmed up further since then. Inflation-sensitive items relevant to India such as edible oils are in short supply due to conflict in Europe and export ban by key producers. Jump in fertiliser and other (agriculture) input costs has a direct impact on food prices in India,” RBI Governor Shaktikanta Das said while giving the rationale for the decision by the monetary policy committee (MPC), which also announced ₹87,000 crore liquidity withdrawal via 50 basis points increase in cash reserve ratio. Market players anticipate that RBI will restore repo rate back to the pre-pandemic level of 5.15% by the end of the year or even before. Rattled by the April numbers, the government announced measures to control inflation on May 21. Finance minister Nirmala Sitharaman announced excise duty cut of ₹8 per litre on petrol and ₹6 per litre on diesel along with LPG subsidy of ₹200 per cylinder. This will cost government ₹1 lakh crore.

In essence, within months of the prime minister’s tough talk, the tide has turned, decisively. Reversal of interest rate cycle will impact private investment and dent private consumption while also hitting exports that have of late been a major engine of economic growth. With rising inflation expectations fuelling bond yields, government, too, will have to pay more for loans. This assumes significance in the context of plans to borrow ₹14.31 lakh crore in FY2023, of which ₹8.5 lakh crore will be raised in first six months of the year. This is almost double FY2020’s ₹7.10 lakh crore. Also, cut in excise duty on petroleum products and other measures may impact the fiscal deficit target. Barclays says India’s fiscal deficit will overshoot to 6.9% of GDP in FY23, as against the Budget estimate of 6.4%.

Inflation is threatening to play villain in India’s economic revival story. RBI and government have a tough battle on their hands.

Macro Risk

Economic growth will undoubtedly be the first casualty. Morgan Stanley has revised India’s FY2023 projected growth from 7.9% to 7.6% citing impact of inflation on global growth, which, it says, will slow from 6.2% in 2021 (calendar year) to 2.9% in 2022. Morgan Stanley says within Asia, India will be “most exposed to upside risk” from inflation owing to high energy import costs. World Bank, too, has cut India’s FY2023 growth forecast from 8.7% to 8% due to supply bottlenecks and inflation. UBS has lowered its FY2023 GDP growth forecast by 70 basis points to 7% on account of high commodity prices and weak domestic demand due to rise in energy prices. “With higher interest rates, investment and growth may be affected. CPI may exceed 6% for at least the next four quarters,” says D.K. Srivastava, who heads policy advisory at EY India. “High cost of energy is a major concern. Industrial sector will face supply-side pressure due to higher energy costs and supply bottlenecks. As long as this continues, we will not reach our potential growth rate. The impact will be large on industrial sector but less on agriculture and services,” he says. Index of industrial production had risen 1.9% in March 2022 compared with 24.2% in March 2021.

India Ratings and Research, a Fitch group company, has built two scenarios of the impact of Russia-Ukraine war. It had projected 7.6% GDP growth for FY2023. It has revised this to 7.2% if the war continues for three months and 7% if it continues for six months. “The impact will be higher if the shock continues,” says Sunil Sinha, director, public finance, India Ratings.

S&P Global company Crisil says inflation will become more broad-based this fiscal and emerge as the “biggest headwind” to economic recovery. “Indian economy may have won the rounds against Covid-19, but there’s a new opponent in the ring, rising prices, which are threatening to deliver a one-two punch. Inflation based on CPI has risen consistently for past seven months, reaching an eight-year high of 7.8% in April,” Crisil said in a research note.

“CPI-linked inflation may have spent three years above 4%, the mid-point of the target range set by RBI. But it is set to become broad-based, across most goods and services, this fiscal, ominously rising to 6.3% in fiscal 2023,” it said. This spells trouble for consumption, exports as well as Indian rupee.

Micro Impact

Private consumption showed resilience in FY2022 and was one of the major engines of growth. “Sectors such as FMCG, consumer discretionary, auto and construction could be hit as rising input costs coalesce with continued supply-chain disruptions,” Sumant Sinha, Assocham president and CEO, ReNew Power, tells Fortune India. “Consumption demand has been coming from people in the middle of the pyramid who are not much impacted by inflation. Expectation that demand will become broad-based may not bear fruit due to higher prices. It will remain skewed,” says Sunil Sinha.

Private final consumption expenditure was ₹23,21,609 crore in third quarter of FY2022, higher than the pre-pandemic level of ₹21,57,091 crore in third quarter of FY2020 and ₹21,69,130 crore in third quarter of FY2021. In fact, over past couple of years, private consumption expenditure and exports had been propelling economic growth as private investment was subdued. CRISIL Ratings expects bank credit growth to hit a four-year high of 11-12% in FY23, but sounds a note of caution. “After the second wave of the pandemic, we saw a good rebound in retail credit. But in scenarios of prolonged high inflation or if another wave of the pandemic accompanied with stringent lockdowns manifests, consumers can turn more cautious in spending and borrowing,” says Krishnan Sitaraman, senior director and deputy chief ratings officer, CRISIL Ratings.

High inflation will also have a bearing on global demand and, hence, Indian exports. The country’s merchandise exports touched a record $418 billion in FY2022 compared with $291.8 billion in FY2021 and $313.36 billion in FY2020.

Another casualty of rising inflation has been rupee. One reason is flight of capital from India as most countries increase rates. Rupee has plummeted to all-time low of 77.63 against the dollar. Rising crude oil prices will add to the pressure. Ravindra Rao, head (commodity research), Kotak Securities, says barring any major demand disruption, crude oil prices are likely to remain close to $100/bbl in the near term. “While crude oil prices have come off highs, they are likely to remain elevated as supply risks related to Russia persist,” says Rao.

Even if crude oil prices stay elevated but stable, depreciation of currency in the wake of rising global interest rates can increase cost of energy imports, impacting current account deficit. “Rate hikes in coming policy meetings of U.S. Federal Reserve could lead to more outflows from emerging markets and make dollar stronger. Outflows from Indian government securities will weaken rupee further. A weaker rupee will put more pressure on already high prices of imported crude oil and raw materials,” says Heena Imtiaz Naik, research analyst, currencies, Angel One, adding that if rupee breaks and sustains above 77.80 levels, the agency expects it to touch 78.20 levels.

Under normal circumstances, a weaker currency provides a fillip to exports. Even if this happens in some sectors, this time, a bigger concern is impact of inflation and rising interest rates on global demand. “The way U.S. Federal Reserve is increasing benchmark rates is a signal that it wants to suck out money supply. This is bound to impact demand. Our worry is global demand and growth slowing down significantly,” says Ajay Sahai, director general, Federation of Indian Export Organisations.

World Trade Organization has projected 3% growth in global merchandise trade volumes in 2022 versus its previous projection of 4.7%. It has projected 3.4% growth for 2023 which, Sahai believes, will be brought down further.

Hit on Businesses

While bigger businesses may be able to survive the inflation tsunami, micro, small and medium enterprises (MSMEs) will face a lot of stress. “The pandemic has hit MSMEs more than any other sector. Smaller size and scale and lower resilience make them vulnerable to macro challenges. ECLGS, which has now been extended and enhanced, and the restructuring schemes have provided support. At the same time, for some of these credits, return to pre-pandemic normalcy could take time and that coupled with adversities in the macro environment could result in NPAs rising going forward,” says CRISIL Ratings’ Sitaraman. Government had introduced ECLGS after the Covid-19 outbreak. RBI’s latest financial stability report says NPAs among MSMEs rose from 16.8% in March 2021 to 18.5% in September 2021.

Ace investor Warren Buffett recently said inflation swindles almost everybody. At present, it is clear that it will affect economic recovery, exports, private consumption, currency, current account balance and corporate margins. For central government, though, it could bring some advantages, even though its borrowing costs may rise due to pressure on G-Sec yields.

Windfall for Centre?

The current spell of inflation is likely to create additional fiscal room for central government by pushing up nominal GDP and increasing tax collections, say experts. “With CPI at 6% and WPI at 10-12%, index of inflation, or implicit price deflator-based inflation, which marks the difference between real and nominal GDP growth, will be in the range of 7.5% to 8%. When nominal GDP growth is significantly higher than real GDP growth, tax buoyancy is high. This will have a positive impact on tax revenues of both Centre and states. The impact is already visible in GST collections,” says EY’s Srivastava. “So, there will be additional fiscal room. This can have a positive impact on growth if used judiciously,” he adds.

Sinha of India Ratings says everything will depend on government priorities. “If government believes that additional tax revenues can be deployed for cutting deficit, it can do that. If it feels farmers and poor need to be supported, it may increase fertiliser subsidy or extend the food scheme.”

Way Forward

While RBI has begun monetary tightening, ministry of finance has deployed fiscal levers. Ministry officials say there won’t be any change in FY2023’s ₹7.5 lakh crore capital expenditure plan. While cost of funds may rise with monetary tightening, it is important to see that key sectors such as housing, construction and manufacturing are not affected much. “Price stability must be a focus area in the short term,” says Sumant Sinha.

SBI Ecowrap on April inflation mentions a very important point to ensure that housing sector is not hit by high rates. “Weighted average lending rate for housing loans was 7.48% in FY2022. We have estimated that 8.75% is the threshold rate for housing loans beyond which incremental housing loans will turn negative. This implies RBI should not increase repo rate by more than 1.25%. With 40 bps hike in May, repo rate may not be increased by more than 80 bps, that is, the upper limit should be 5.25%.”

Claiming there is space for policy rates to go up to 5% or 5.25%, EY’s Srivastava suggests it is time for private sector to take risks and invest as the entire world is scouting for alternative destinations for supply chains, an area where India has a huge opportunity. “Industrial sector is sitting on surplus since corporate tax rate cut. For three years, they have been waiting for an opportunity to invest. That opportunity is opening up,” he says.

Former chief economic adviser K. Subramanian has always maintained that since the Covid-19 stimulus was biased towards supply-side measures, unlike the demand-heavy stimulus of FY2009, India has not witnessed the runaway inflation seen then. The assumption holds true. But the situation has now turned upside down. The Ukraine war has negated the advantages of the receding pandemic. Supply and subsequent price shock, high interest rates, diminishing real incomes, jittery equity markets, volatile currency and subdued private investments have emerged as new challenges for the economy. A check on inflation might be the answer to most of these problems.