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How India Can Defend Economy From Global Spillovers


By Sonal Varma

While won't be immune to global spillovers, we need to create the macro preconditions for sustained growth.

Policy agility, prudence, and resilience will be key, suggests Sonal Varma, chief economist (India and Asia ex-Japan) at Nomura.

Over the last two months, geopolitical and market developments have emerged as risks to India's economic outlook.

Geopolitically, the Israel-Hamas conflict continues and there is uncertainty over whether this will escalate.

So far, Brent crude oil prices have risen marginally to build some geopolitical risk premium, but not a full escalation.

Opec+ production cuts had already set a floor, and if the West Asia conflict escalates, then crude oil prices could rise further.

On the market front, US long-end government bond yields have drifted higher, with 10-year yields breaching 5 per cent for the first time since 2007.

This selloff has been driven by higher real yields, likely reflecting more resilient US growth and a higher term premium due to the bond demand-supply gap.

Higher US real yields have resulted in capital outflows from emerging markets and are weighing on equity and currency markets, tightening financial conditions.

Policymakers in India have muted the domestic spillovers of these external developments so far.

The Reserve Bank of India has used its foreign exchange (FX) reserves to keep the rupee stable, while retail fuel prices remain unchanged.

However, there have been other spillovers. Capital outflows have weighed on equity prices, the RBI's dollar selling is draining durable liquidity, and oil marketing companies face under-recoveries on petrol and diesel.

The ability of policymakers to sustain these firewalls will depend on the durability and magnitude of the shocks.

If the shocks are short-term, then the firewalls can be sustained.

However, if the shocks are longer-lasting, then some adjustments will become necessary.

For example, the more the RBI tries to defend India's currency via FX intervention, the greater will be the fall in FX reserves, which could trigger speculative attacks, while putting upward pressure on domestic interest rates due to tighter liquidity.

Similarly, sustained higher oil prices will add to fiscal pressures directly or indirectly, if they are not passed on to consumers.

From an economics perspective, these developments are stagflationary in nature (they will weigh on growth and add to inflation) and pressurise the twin deficits (fiscal and current account).

If the shock is short-term, then the impact on growth, inflation, and the fiscal situation can be contained, with the immediate impact mainly on the balance of payments.

This is because the rising cost of imported oil will worsen the current account, while capital outflows are likely on portfolio equity and debt, with overseas debt fund raising also likely to slow.

India does have the cushion from the bond index inclusion, but those benefits are likely to accrue mainly from mid-2024 onwards.

However, if these external pressures are more longer-lasting and/or escalate, then this can become a bigger drag on growth.

Higher oil prices will weigh on the terms of trade. Higher uncertainty, weak sentiment, and tight financial conditions typically bode ill for investments. Sustained equity market weakness and tight banking liquidity can further delay the expected turn in the private capex cycle.

If fiscal pressures build, then the room available for public capex will become constrained. The impact on private consumption should be less, but an uneven rural-urban recovery is already a concern.

None of these effects will be visible immediately, as transmission takes time. However, downside risks to gross domestic product (GDP) growth in 2024-25 are rising.

On inflation, we see no discernible impact in the short-term, because of the policy firewalls.

The correction in tomato prices has offset rising price pressures in the broader food basket — rice, wheat, pulses, sugar, spices — due to the El Nino risks.

Underlying price pressures also remain contained, with core consumer price index-based inflation continuing to disinflate and household inflation expectations down to single-digits for the first time since the pandemic.

Although not immediate, upside risks to medium-term inflation from food, oil, and currency remain. For policymakers, these developments mean that maintaining financial stability takes precedence, while still managing the price stability-growth mandate.

In the short-term, the RBI can sustain its eclectic approach of using FX reserves to manage the currency and open market operation sales to keep liquidity on leash and real rates attractive, while the government uses supply-side policies to keep food and oil inflation at bay.

These buffers enable the RBI to focus on domestic issues. It does not need to hike, as core inflation is low, neither should it cut, as supply-side inflation risks are still prevalent.

The Northlines is an independent source on the Web for news, facts and figures relating to Jammu, Kashmir and Ladakh and its neighbourhood.

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