BackThe resilience test for Indian economy
Friday, 24 February, will mark one year of Russia’s invasion of its neighbour Ukraine
PremiumFriday, 24 February, will mark one year of Russia’s invasion of its neighbour Ukraine. The months preceding it were marked by a steady ratcheting up of tensions. The invasion caused prices of fuel , fertilizer, wheat and other critical commodities, of which Russia or Ukraine were major suppliers, to spike. This, in turn, caused the value of imports to skyrocket in countries like India, which were dependent on supplies of foreign fuel to power their economies. Inflation rose as a result, and in ways that were often unprecedented in recent years.
Since late last year, both fuel prices, and prices of other commodities that had spiked in the immediate aftermath of the war, have eased. But the effects of the crisis on the Indian economy are far from over. In January, for instance, the consumer price index grew at its fastest rate (6.5% on a year-on-year basis) for three months, dashing initial hopes that the easing of global fuel prices would lead to a sustained decline in domestic inflation. This, in turn, will influence how the Reserve Bank of India (RBI) decides on the future trajectory of interest rate increases (see chart 1).
The Russia-Ukraine war was, and is, a major test of the resilience of the Indian economy, in the short term and in the longer run as well, to what economists call external ‘shocks’. How has it fared?
Changing Pattern of Trade
One of the most striking shifts in the economy, though it tends to get obscured by the more visible inflation effects, is the shift in India’s pattern of fuel imports (see chart 2). Following the invasion, Russia was effectively banned from the global oil market, and it made strenuous efforts to attract buyers by offering discounts on supplies.
India went all in. As a result, the share of Russia as a source of Indian crude oil supplies jumped sharply from as low as 2% in late-2021, on the eve of the crisis, to well over a quarter a year later. Russia is now among the top three suppliers of crude to India, thus reducing the traditional reliance on the Middle-East. In January, the proportion of crude imports sourced by India from Russia soared to a high of 27%.
When oil prices spike, the trade balance almost inevitably deteriorates, given the limited room to substitute crude with other forms of fuel in a primarily fossil fuel economy. But despite Russian crude being offered below global market prices, the trade balance did worsen. The overall trade deficit in goods and services between April and December 2022—the peak months of the crisis—more than doubled to $118 billion, from $57 billion for the same period in 2021.
What of the future? As the war shows little sign of resolution, the West has actually ratcheted up attempts to economically isolate Russia. In December, for instance, the European Union banned seaborne imports of Russian crude and the G7 countries imposed a price cap on Russian crude imports.
This implies that Russia will be more eager than ever to sell its crude elsewhere, and its share of Indian crude supplies could increase even further. Indeed, while the effective price at which India imports crude still closely tracks the international price (Chart 2), in January, when Russian crude imports of India soared to their highest level ever, the Indian price of crude decoupled from the global price to a sharp extent. If this trend continues, the changing pattern of India’s fuel imports could well have a far bigger impact on the overall domestic inflation rate (and the trade deficit) in the longer term than most other direct attempts to tinker with either of these two indicators.
The Inflationary Aftermath
If Russia does become the mainstay of India’s fuel imports, with resulting moderating effects on the pace of inflation, it could have far-reaching effects on the economy, though the jury is still very much out on this. Upticks in fuel prices have always had a highly predictable effect on the Indian economy—on both growth and inflation.
Initial rises in global fuel prices lead to a direct impact on the consumer price index, as they account for close to 7% of the total index. While this may seem a low weightage, it is the steep jumps in the absolute price of crude and other imports of a similar type—gas, refined petroleum products, etc—that can cause a disproportionate effect on inflation. But the direct effects are only part of the picture.
The problem with any of the main fossil fuels is that they are a critical input into a range of industries. Thus, a sustained fuel price rise inevitably leads to other sectors and industries raising prices of their products. What started as a localized price rise can soon become generalized across industries, and across manufacturing and services. Thus, while there is an initial bump in so-called ‘headline’ inflation, it can soon cause ‘core’ inflation—inflation excluding highly volatile prices of commodities like food and fuel—to rise as well.
This is exactly what happened, according to a study of the inflation episode of the last year, done by Michael Patra, Asish Thomas George, G V Nadhanael and Joice John at the RBI. They write: “What started as a shock to food and fuel prices got increasingly generalized over ensuing months. This was reflected in highly elevated and sticky core inflation. Unprecedented input cost pressures got translated to…goods prices, in spite of muted demand conditions and pricing power. As the direct effects of the conflict waned and international commodity prices softened, the strengthening domestic recovery and rising demand enabled pass-through of pent-up input costs, especially in services, adding persistence to elevated inflationary pressures."
As the authors point out, the difference between the inflationary episode after the war, and recent ones before it, lie in the fact that in earlier episodes, the bulk of inflation came from volatile components like food and fuel, which are prone to wild swings in prices. In the later months of the war, though, the inflation had spread to most categories of goods and services. In fact, those secondary effects are what we see now, with headline inflation still rising, despite fuel prices weakening in recent months.
The problem didn’t lie just with crude oil. Russia is a key exporter of fertilizer as well, and the war seriously disrupted the global fertilizer trade. By April, the International Monetary Fund (IMF)’s index of prices of key fertilizers had risen by over 16% compared with just two months earlier. This came on the back of major increases in the global price of fertilizers during the covid-19 crisis, caused by trade disruptions. Between April 2020 and early-2022, the IMF fertilizer price index had already risen by well over three times.
But it wasn’t just the price of fertilizer on the world market. Natural gas is a key ‘feedstock’, or input, into the domestic fertilizer industry. When Russia cut off gas supplies to Europe through the Nord Stream pipeline, it set off a mad scramble for other sources of natural gas, leading to a global spike in prices.
This further worsened supply conditions in the international and domestic fertilizer markets, and caused the fertilizer subsidy bill to rise by close to 50% in 2022-23, compared with a year earlier. As in crude oil, India imports a substantial volume of its natural gas requirements, and the global price increases lead to price hikes for Indian natural gas customers, such as those using piped gas for cooking or as fuel in Compressed Natural Gas (CNG) vehicles.
Other commodities were affected too, such as edible oils. Ukraine is the world’s leading exporter of sunflower oil. With supplies drying up in the international market, prices of other edible oils rose sharply too. The main producers of other edible oils, such as palm oil, imposed export bans, forcing domestic prices up further. Heat wave conditions during the summer of 2022, and the uneven spread of the monsoon (despite it being a ‘normal’ monsoon year), caused further spikes in the prices of key crops.
The Future
What can we expect in the coming months? Despite the weakening of global fuel and other commodity prices, the world economy is hardly out of the woods. The latest World Bank Global Economic Prospects report, released in January, expects global growth to be just 1.7% in 2023, down from an earlier forecast of 3% six months ago. “This pace of growth would be the third weakest in nearly three decades, overshadowed only by the global recessions caused by the pandemic in 2020 and the global financial crisis in 2009," the report points out.
The Bank expects India’s growth to be 6.9% in 2022-23, and to further weaken to 6.6% in 2023-24. This is still much faster than many other countries. But slowing global growth also implies weak international trade, thus hurting the prospects for Indian exporters. And if the latest increase in domestic consumer price inflation proves not to be a blip, but a more sustained increase, that will almost certainly prompt the RBI to raise interest rates further, hurting growth to a greater extent.
Ultimately, though, the real risks to the Indian economy in the longer term lie elsewhere, rather than Russia-Ukraine war. One of those risks has always been there but we have had little success in addressing it as a country. In spite of all the changes the Indian economy has gone through since 1991, the country is still fundamentally as exposed to a global commodity price ‘shock’ as it was 30 years ago.
At that time, another war, the first American invasion of Iraq, also caused global oil prices to spike, and was one of the major precipitating factors that pushed India into a balance of payments crisis in 1991. As many other subsequent episodes of global fuel price volatility have shown, including the latest one, India remains primarily a fossil fuel economy, facing the ever-present danger of being thrown off balance by events beyond its control.
In January, India imported 87% of its crude oil requirement, sharply up from earlier months, despite strenuous efforts by this government and others, to encourage domestic production. And while the government is attempting to encourage consumers to shift to renewable fuels, this is a change that will only unfold slowly.
The second danger is climate change. As pointed out earlier, last year’s monsoon was ‘normal’ but extremely uneven across the country, with some areas seeing massive flooding even as others reeled under drought conditions. Indications are that this is not a one-off. To stay self-sufficient in basic foodstuffs, agriculture has to adapt to such shifts. Together, it is these two challenges that will be the biggest ones facing the economy in the years ahead, irrespective of other conflicts.
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