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GS Paper: Indian Economy

  • Why special situation funds are necessary

    Context

    India suffers from a chronic bad debt problem.  To overcome this problem, banks and financial institutions were initially allowed to sell their stressed loans only to ARCs. Now they can sell to SSFs too.

    How bad debt affects the credit supply in economy?

    • Higher bad debt requires higher provisioning, locking up more capital in the banking system.
    • This reduces credit supply and hurts economic growth.
    • To overcome this problem, banks and financial institutions were initially allowed to sell their stressed loans only to ARCs. 
    •  Transfer of stressed loans would release capital locked-up in the banking system and help improve credit supply.

    Two crucial reforms in financial markets

    • Indian financial markets witnessed two crucial reforms earlier this year.
    • 1] SSF: SEBI came out with a dedicated regulatory framework for special situation funds (SSFs).
    • 2] Dual structure bad bank: The RBI approved the new dual-structure bad bank, NARCL-IDRCL.
    • While the bad bank is an upgraded version of the existing asset restructuring companies (ARCs) model, the SSF is a relatively novel concept.

    Understanding AIFs and SSF

    • SEBI has introduced SSFs as a distinct sub-category of Category I Alternative Investment Funds (AIFs). 
    • AIFs manage privately pooled funds raised from sophisticated investors with deep pockets.
    • AIFs in equity market: While AIFs have traditionally played a prominent role in equity markets, their participation in distressed debt markets has been limited.
    • No participation in secondary market for corporate loans: Regulations did not permit AIFs to participate in the secondary market for corporate loans extended by banks and NBFCs.
    • The new regulations now create a special sub-category of AIFs, namely SSFs, which are allowed to participate in the secondary market for loans extended to companies that have defaulted on their debt obligations.

    What is Syndicated lending?

    • Syndicated lending is a financial instrument where a group of lenders, known as a syndicate, work together to provide a large loan to a single borrower.
    • This collaborative approach allows lenders to share the risk of borrower default, making it more manageable for individual lenders.
    • The syndicate typically includes a lead bank or underwriter, which plays a crucial role in assembling the syndicate and managing administrative tasks.

    Why SSFs must be allowed full participation across the entire spectrum of secondary market for corporate debt

    • Default is a lagging indicator of financial stress.
    • Lesser haircut: If lenders and bond investors could offload potentially stressed assets to SSFs before defaulting in the secondary market, they would benefit from a lesser haircut.
    • SSFs would also get adequate time for debt aggregation before default, reducing the collective action problems that may arise after default during insolvency or restructuring.
    • It would improve the liquidity: Allowing SSFs to purchase investment-grade loans would also improve the liquidity in the secondary market for corporate loans.
    • Traditionally, banks originated loans and held them till maturity.
    • Over time, lending moved from involving a single lender to multiple lenders via syndicated lending.
    • As volumes in the primary syndication market increased, demand for secondary trading also developed to allow liquidity, risk and portfolio management.
    • Suggestion by RBI task force: Secondary trading of loans is now institutionalised in international financial markets.
    • The RBI task force on secondary markets for corporate loans, chaired by T N Manoharan, made this suggestion in 2019.
    • These markets are liquid precisely because they are open to a wide variety of non-bank participants including insurance companies, pension funds, hedge funds and private equity funds.
    • SSFs are unlikely to jeopardise financial stability: SSFs cannot borrow funds or engage in any leverage except for temporary funding requirements.
    • Consequently, risks associated with liquidity, credit or maturity transformation and asset-liability mismatches are unlikely to arise.
    • Given their structure, SSFs are likely to acquire sufficient debt in a distressed company to acquire control or to influence its subsequent insolvency or restructuring process to maximise its value through business turnaround or sale.

    Consider the question “What are special situation funds (SSFs)? Suggest the changes needed in the secondary trading of loans in India’s.”

    Conclusion

    Overall, the introduction of SSFs promises to usher in a modern era of distressed debt investing in India. To realise their true potential, SSFs must be allowed full participation across the entire spectrum of secondary market for corporate debt and not just be confined to the post-default stage.

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  • Draft National Policy for Medical Devices, 2022

    The government is proposing a new Draft National Policy for Medical Devices, 2022 to reduce India’s dependence on import of high-end medical devices.

    Key features of the policy

    Objectives: Adopting public-private partnerships to reduce the cost of healthcare, drive efficiency, and aid quality improvements in medical devices manufactured in the country

    The key proposals include:

    1. Incentivising the export of medical devices and related technology projects through tax rebates and refunds
    2. Increasing government spending in “high-risk” projects in the medical devices sector
    3. Single-window clearance system for licencing medical devices
    4. Pricing environment with no price control on newly developed innovation in the sector
    5. Allot a dedicated fund for encouraging joint research involving existing industry players, reputed academic institutions and start-ups
    6. Incorporate a framework for a coherent pricing regulation, to make available quality and effective medical devices to all citizens at affordable prices
    7. NPPA (National Pharmaceutical Pricing Authority) shall be strengthened with adequate manpower of suitable expertise to provide effective price regulation balancing patient and industry needs.
    8. Pharmaceuticals Department will also work with industry to implement a Uniform Code for Medical Device Marketing Practices (UCMDMP)

    Need for such policy

    • Policy vacuum: India’s medical devices sector has so far been regulated as per provisions under the Drugs and Cosmetics Act of 1940, and a specific policy on medical devices has been a long standing demand from the industry.
    • Meaningful expense on R&D: The policy also aims to increase India’s per capita spend on medical devices. India has one of the lowest per capita spend on medical devices at $3, compared to the global average of per capita consumption of $47.
    • Reducing import dependence: With the new policy, the government aims to reduce India’s import dependence from 80 per cent to nearly 30 per cent in the next 10 years.
    • Becoming a global hub: It aims to become one of the top five global manufacturing hubs for medical devices by 2047.
    • Domestic manufacturing of high-end products: Indian players in the space have so far typically focussed on low-cost and low-tech products, like consumables and disposables, leading to a higher value share going to foreign companies.

    Earlier attempts for such policy

    • In February 2020, the government notified changes in the Medical Devices Rules, 2017 to regulate medical devices on the same lines as drugs under the Drugs and Cosmetics Act, 1940.
    • This was necessitated after revelations about faulty hip implants marketed by Johnson & Johnson, exposing the lack of regulatory teeth when it came to medical devices.
    • The government said the transition from partial regulation of selected medical services to the complete regulation and licensing of all medical devices is underway.

     

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  • Retail Inflation climbs to 6.07%

    India’s retail inflation inched up to an eight-month high of 6.07% in February from 6.01% in January, with rural India experiencing a sharper price rise at 6.38%.

    What is Retail Inflation?

    • When we generally talk about retail inflation, it often refers to the rate of inflation based on the consumer price index (CPI).
    • The CPI tracks the change in retail prices of goods and services which households purchase for their daily consumption.
    • The CPI monitors retail prices at a certain level for a particular commodity; price movement of goods and services at rural, urban and all-India levels.
    • The change in the price index over a period of time is referred to as CPI-based inflation, or retail inflation.

    What is Consumer Price Index (CPI)?

    • It is an index measuring retail inflation in the economy by collecting the change in prices of most common goods and services used by consumers.
    • In India, there are four consumer price index numbers, which are calculated, and these are as follows:
      1. CPI for Industrial Workers (IW)
      2. CPI for Agricultural Labourers (AL)
      3. CPI for Rural Labourers (RL) and
      4. CPI for Urban Non-Manual Employees (UNME).
    • While the Ministry of Statistics and Program Implementation collects CPI (UNME) data and compiles it, the remaining three are collected by the Labour Bureau in the Ministry of Labour.
    • The base year for CPI is 2012.
    • To calculate CPI, multiply 100 to the fraction of the cost price of the current period and the base period.

    Significance of CPI

    • Generally, CPI is used as a macroeconomic indicator of inflation, as a tool by the central bank and government for inflation targeting and for inspecting price stability, and as deflator in the national accounts.
    • CPI also helps understand the real value of salaries, wages, and pensions, the purchasing power of the nation’s currency, and regulating rates.
    • CPI, one of the most important statistics to ascertain economic health, is generally based on the weighted average of the prices of commodities.
    • It basically gives an idea of the cost of the standard of living.

     

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  • Issues with high gold demand

    Context

    Gold’s appeal as a safe haven is only rising: as tensions escalate in Ukraine, its price is approaching records.

    Factors explaining demand for gold in India

    • India is the world’s second-largest market for the yellow metal, behind China, though it produces almost none at home.
    • This is partly driven by tradition.
    • Brides are given jewellery as part of their dowry and it is deemed auspicious to buy bullion around certain religious festivals.
    • It is a handy store of undeclared wealth, too, often stashed in wardrobes or under the mattress.
    • But the pandemic has also affirmed an investment advice passed on over generations: park savings in gold as a rainy-day fund.

    Concerns with such a high demand

    • Vast gold imports can destabilise the economy.
    • During the 2013 “taper tantrum”, when India’s foreign-exchange reserves were lower than they are now, a rush of gold imports helped push the current-account deficit to 4.8% of GDP and fuelled worries of a currency crisis.
    • Savings stashed away as idle gold could be put to more productive use elsewhere. 
    • Indian households hold 22,500 tonnes of the physical metal—five times the stock in America’s bullion depository .

    Policy measures by the government

    • Import duties hover around 10%, even after cuts in last year’s budget aimed at keeping smuggling in check.
    • The central bank has ramped up issuance of sovereign gold bonds, which are denominated in grams of gold.
    • Of the 86 tonnes’ worth issued since 2015, about 60% were sold after the pandemic began.
    • And the gold monetisation scheme, which allows households to hand gold over to a bank and earn interest, was revamped last year to reduce limits on the size of deposits.
    • Lockdowns inadvertently helped the state’s agenda.
    • Mobile payments platforms like PhonePe and Google Pay reported rising appetite for digital gold, which is sold online and stored by the seller.
    • Money also rushed into gold exchange-traded funds (ETFs).
    • Their assets hit 184bn rupees ($2.5bn) in December, a 30% rise in a year.

    Conclusion

    Still, only a sliver of the population, mostly well-off urban types and millennials, invest in complex financial products. A large part of India’s demand for physical gold comes from rural areas, where it seems in no danger of losing its lustre.

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  • Taking stock of the Indian economy

    Context

    This article takes the stock of the Indian economy using the EFGHIJ framework.

    Export

    • The $400-billion target of goods exports in FY22 appears achievable:
    • This is a structural break from ~$300-330 billion per year over the last decade.
    • Note that in calendar year 2021, India exported almost $400 billion worth of goods.
    • This export growth comes at a time when global shipping and freight markets have been in a tizzy over the last few months as Covid-related supply chain disruptions across commodities and final products reverberated across the globe.

    Fiscal growth

    • India has significant fiscal headroom in FY23 with a 6.4% fiscal deficit pencilled in.
    • The revenue buoyancy, assumed at less than 1, is conservative as is the overall assumption on nominal growth at 11%.
    • In as volatile a world as this, the conservatism in forecasting should come to India’s advantage.
    • India saw healthy direct and indirect tax receipts in FY22: the GST collections have consistently remained above the `1 trillion-a-month mark for many months now.
    • Two aspects need a close watch:
    • (a) as the prices of various commodities rise, there can be calls for softening the blow on the final consumer via tax cuts or direct support, and
    • (b) the disinvestment programme of the government which could face a market where investor appetite is uncertain.

    Growth challenges and opportunities for India

    • India’s GDP growth in FY23 is projected to be 7.6-8.5%, making it one of the fastest-growing economies.
    • With the newly changed circumstances, it is possible that this tight range and the absolute number may require revision.
    • It is, however, too early to say in which direction and by what amounts.
    • Opportunities for India: Global dislocations of supply chain or the creation of new supply sources could create divergent challenges and opportunities for India.
    • The post Covid rebound in high frequency indicators (air and rail passengers, toll collections, UPI payments, etc.) suggests that the internal consumption economy is currently back on track.
    • It is important to note that India continues to be the fastest-growing nation of its size in the world.

    Health

    • India has now completed almost 1.8 billion doses.
    • The Omicron wave, thankfully both due to the inherent nature of the virus and the large vaccination drive, did not cause significant economic upheaval.
    •  It may be time to think of Covid as endemic and plan accordingly.

    Inflation

    • The inflation in 2021 was based on a sudden bout of fiscal-support-driven spending meeting with tight supply chain bottlenecks.
    • It was expected that as spending normalises and supply chains open, prices will stabilise.
    • However, the sharp uptick in the prices of crude, coal, commodities, and chips has created a more sustained scare for inflation.
    • Many measures may be taken across the world to curb the impact for the common man: from opening of oil reserves, to cutting of taxes, to direct support, etc—all of which could impact the fiscal.

    Capital

    • Denoted by K by economists, expect to see a lot of ebb-and-flow here as investors react to evolving, volatile trends.
    • Higher public investment in the last two years has supported economic recovery: India has planned for a record `10 lakh crore plus public capex.
    • Net FDI has been strong at $25.3 billion up to December in FY2022.
    • While FPIs have withdrawn $9.5 billion in FY22, DIIs and retail investors have supported the markets.

    Conclusion

    With two waves of COVID-19 largely behind us, many macroeconomic factors have changed dramatically, especially in the last fortnight.

    Source:

    https://www.financialexpress.com/opinion/efghijk-taking-stock-of-the-indian-economy/2457255/

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  • Why society gains when start-ups fail

    Context

    As per the Economic Survey 2021-22, India has become the third-largest startup ecosystem in the world after the US and China.

    Start-up ecosystem in India

    • India attracted huge investment in startups in 2021: Private equity investment was $77 billion, of which $42 billion went to early-stage ventures.
    • Every startup where salaries are paid by investors rather than customers is breathlessly rethinking business plans.

    How do startups benefit society?

    1] Innovation, productivity and job creation:

    • The high failure rate of startups is not a problem per se — society only needs a few successes to harness the gains of innovation, productivity and job creation.
    • A new book, The Power Law makes the case that startup investing is unlike public market investing.
    • He suggests public markets follow a “normal” distribution like human height — most people cluster around the average with a few exceptionally low or high.
    • But venture investments follow a “power law” of distribution, that is, most go to zero but the tiny number that succeeds more than compensate for the losses or mediocrity of the many.

    2] Losses caused by startups are not passed on to society

    • Startups don’t socialise their losses, Corporate bank loans expanded from Rs 18 lakh crore in 2008 to Rs 54 lakh crore in 2014.
    • Such high corporate bank loans created bad loans that needed many lakh crores of government money to recapitalise nationalised banks.
    • This money was diverted from government spending on healthcare, education and defence.
    • The current venture capital binge will also create many write-offs but this cost will fall on consenting adults with broad shoulders — foreign institutions, angel investors and entrepreneurs with successful previous exits.

    3] Startups will solve real problems for Indians:

    • Ending our poverty needs higher productivity regions, cities, sectors, firms and individuals.
    • A modern state is a welfare state that does less commercially so it can do more socially.
    • It needs allies in reimagining financial inclusion, supply chains, distribution logistics, employability, retail, transport, media, healthcare, agriculture and much else.
    • Many of our startups shall redeem their pledge to solve these problems “not wholly or in full measure, but very substantially”.

    Three issues related to startups

    • 1] Fiscal and monetary policy normalisation: The global capital supply fuelling startup funding faces challenges from fiscal and monetary policy normalisation: The rate-sensitive two-year US government bond recently touched a 1.6 per cent yield after being at 0.4 per cent as recently as November — because the risk-free return cannot be return-free-risk forever.
    • Investors are returning to weighing financial sustainability and capital efficiency along with addressable markets.
    • 2] Excesses: This explosive startup funding has created excesses.
    • 3] A different approach of public markets: Private markets are not only delaying IPOs — Amazon went public within three years of starting with less than half the value of a unicorn — but unicorn IPOs’ underperformance suggests that public markets have a different calibration.

    Conclusion

    The few startups that survive will raise India’s soft power and prosperity by using improbable ideas to solve impossible problems. What we need is to ensure the policy environment for the startups to boom.

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  • [pib] National Land Monetisation Corporation (NLMC)

    The Union Cabinet has approved the setting up of a new government-owned firm National Land Monetisation Corporation (NLMC) for pooling and monetizing sovereign and public sector land assets.

    What is NLMC?

    • The National Land Monetisation Corporation (NLMC) is being formed with an initial authorised share capital of ₹5,000 crore and paid-up capital of ₹150 crore.
    • The government will appoint a chairman to head the NLMC through a “merit-based selection process” and hire private sector professionals with expertise.
    • The NLMC will undertake monetization of surplus land and building assets of Central public sector enterprises (CPSEs) as well as government agencies.

    How will it function?

    • NLMC will own, hold, manage and monetise surplus land and building assets of CPSEs under closure and surplus non-core land assets of Government-owned CPSEs under strategic disinvestment.
    • This will speed up the closure process of CPSEs and smoothen the strategic disinvestment process of Government-owned CPSEs, the statement said.
    • NLMC will undertake surplus land asset monetisation as an agency function, and assist and provide technical advice to the Centre in this regard.
    • The NLMC board will comprise senior Government officers and eminent experts, while its chairman and non-Government directors will be appointed through a merit-based selection process, the statement said.
    • The Corporation will have minimal full-time staff, hired directly from the market on a contract basis.

    Stipulated tasks

    • CPSEs have referred around 3,400 acres of land and other non-core assets to the Department of Investment and Public Asset Management (DIPAM) for monetisation.
    • Monetisation of non-core assets of MTNL, BSNL, BPCL, BEML, HMT, is currently at various stages of the transaction, as per latest data in the Economic Survey 2021-22.

    Significance of NLMC

    • The government would be able to generate substantial revenues by monetizing unused and under-used assets.
    • The new corporation will also help carry out monetization of assets belonging to public sector firms that have closed or are lined up for a strategic sale.

     

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  • Centre and RBI must rely on unconventional policies to manage finances better

    Context

    Amid Ukraine crisis and high oil prices, the larger concern is how the government and the RBI will navigate this period at a time of record government borrowings, and prevent domestic interest rates from hardening.

    The Triffin paradox in current context

    • It is ironic that even as emerging economies running current account deficits are getting punished by a depreciating currency and a hardening of interest rates, we are witnessing the US dollar appreciating and US treasuries strengthening.
    • The most common argument for such a macroeconomic paradox is named after the economist Robert Triffin (the Triffin Paradox).
    •  It postulates that the US current account deficit is purely a reflection of the US supplying large amounts of dollars to fulfil the world’s demand.
    • In other words, central banks across the world must build up claims on the US to back their domestic money growth.

    Dollar’s dominance

    • Former US Federal Reserve Chairman Bernanke even extended this argument in 2005 to the “saving glut” proposition by espousing that emerging economies were accumulating foreign exchange reserves in dollars, and diverting domestic savings to buy US treasuries.
    • There are several counter arguments to this view that effectively state that the dominance of the US dollar is inevitable in the global financial architecture, and it is purely a fault of emerging market economies.

    Need for the unconventional tools to avoid the disruption by government borrowing

    This can be done in the following ways

    1] Spread the borrowing over four quarters after taking real-time view of disruption

    • Every year, the government front-loads its large borrowing programme by completing 60 per cent of the borrowings in the first half of the year.
    • This time, the RBI and the government may take a real-time view of disruptions and spread the borrowings over four quarters, keeping the initial two quarters light.
    • The borrowing programme can also be announced as per a quarterly schedule and there could be even two auctions during the week.
    • These steps could smoothen out the non-disruptive elements in government borrowings.

    2] Reconfigure the borrowing program

    • For example, as rates move up, banks tend to prefer short-term investments while insurance companies, provident funds and others prefer longer-term investments.
    • Given this, the borrowing schedule can be reconfigured with a higher proportion of short-and medium-tenor securities being offered in the initial months, while pushing back the longer tenor securities to the second half of the year.

    3] Push Small Savings Schemes

    • Third, small savings collections have significantly exceeded budget estimates.
    • The government could think of giving a push to small savings schemes such as the Sukanya Samriddhi Yojana (SSY).
    • The SSY has witnessed the registration of 2.82 crore girl children in the seven years since its inception in 2015, leaving enough room for further mop-up.
    • The newly opened accounts may even be given an enhanced savings limit in the first year to catch up for the years lost for these new additions.

    4] Listing of LIC

    • LIC currently holds around Rs 23.5 trillion worth of government bonds, higher than even than the RBI.
    • LIC’s G-sec holding is around 19 per cent, while in comparison the banking system’s ownership stands at around 38 per cent.
    • Thus LIC’s listing should augur well for the bond market as the insurance behemoth may have to deploy a greater share of inflows in safer avenues domestically.
    • This is a plausible option as banks may have to readjust their deposits into credit as the economic recovery gains momentum.

    Conclusion

    Rising oil prices have placed policymakers in an unenviable position. If higher oil prices are fully passed through, it will result in higher inflation and hence higher rates as a consequence.  In such a scenario it is best to follow the first option by using unconventional policy measures.

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  • Stagflation’ in India

    Reports suggest that crude oil prices soared and touched almost $140 per barrel mark amid Russian invasion of Ukraine. This has posed a risk of causing Stagflation in India.

    What is Stagflation?

    • Stagflation is a stagnant growth and persistently high inflation. It, thus, describes a rather rare and curious condition of an economy.
    • Iain Macleod, a Conservative Party MP in the United Kingdom, is known to have coined the phrase during his speech on the UK economy in November 1965.
    • Typically, rising inflation happens when an economy is booming — people are earning lots of money, demanding lots of goods and services and as a result, prices keep going up.
    • When the demand is down and the economy is in the doldrums, by the reverse logic, prices tend to stagnate (or even fall).
    • But stagflation is a condition where an economy experiences the worst of both worlds — the growth rate is largely stagnant (along with rising unemployment) and inflation is not only high but persistently so.

    How does one get into Stagflation?

    • The best-known case of stagflation is what happened in the early and mid-1970s.
    • The OPEC (Organisation of Petroleum Exporting Countries), which works like a cartel, decided to cut crude oil supply.
    • This sent oil prices soaring across the world; they were up by almost 70%.
    • This sudden oil price shock not only raised inflation everywhere, especially in the western economies but also constrained their ability to produce, thus hampering their economic growth.
    • High inflation and stalled growth (and the resulting unemployment) created stagflation.

    Is India facing stagflation?

    • In the recent past, this question has gained prominence since late 2019, when retail inflation spiked due to unseasonal rains causing a spike in food inflation.
    • In December 2019, it was also becoming difficult for the government to deny that India’s growth rate was witnessing a secular deceleration.
    • As revised estimates, released in January end, now show, India’s GDP growth rate decelerated from over 8% in 2016-17 to just 3.7% in 2019-20.
    • However, the answer to this question in December 2019 was a clear no.
    • For one, in absolute terms, India’s GDP was still growing, albeit at a progressively slower rate.

    Why this is a cause of concern?

    • Russia is the world’s second-largest oil producer and, as such, if its oil is kept out of the market because of sanctions, it will not only lead to prices spiking, but also mean they will stay that way for long.
    • While India is not directly involved in the conflict, it will be badly affected if oil prices move higher and stay that way.
    • India imports more than 84% of its total oil demand. At one level, that puts into perspective all the talk of being Atmanirbhar (or self-reliant).
    • Without these imports, India’s economy would come to a sudden halt — both metaphorically as well as actually.

    Expected impact on Indian Economy

    • Higher inflation would rob Indians of their purchasing power, thus bringing down their overall demand.
    • In other words, people are not demanding enough for the economy to grow fast.
    • Private consumer demand is the biggest driver of growth in India.
    • Such aggregate demand — the monetary sum of all the soaps, phones, cars, refrigerators, holidays etc. that we all spend on in our personal capacity — accounts for more than 55% of India’s total GDP.
    • Higher prices will reduce this demand, which is already struggling to come back up to the pre-Covid level.
    • Fewer goods and services being demanded will then disincentivise businesses from investing in new capacities, which, in turn, will exacerbate the unemployment crisis and lead to even lower incomes.

    Back2Basics: Inflation and its impact

    • Depression: It is Economic depression is a sustained, long-term downturn in economic
    • Deflation: It is the general fall in the price level over a period of time.
    • Disinflation: It is the fall in the rate of inflation or a slower rate of inflation. Example: a fall in the inflation rate from 8% to 6%.
    • Reflation: It is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle. It is the opposite of disinflation.
    • Skewflation: It is the skewed rise in the price of some items while remaining item prices remain the same. E.g. Seasonal rise in the price of onions.
    • Stagflation: The situation of rising prices along with falling growth and employment, is called stagflation. Inflation accompanied by an economic recession.

     

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  • Hike in crude oil prices and its impact on India

    Context

    The Russia-Ukraine conflict will impact India’s economy through several channels. The first order impact, emanates from the negative terms of trade shock from higher commodity prices, particularly oil.

    • Crude prices have surged well past a $110/barrel and there is a growing expectation that, as the conflict gets more entrenched, crude could remain elevated for much longer and average close to $100/barrel in 2022, vis-a-vis $70/barrel in 2021.

    Why crude oil price is increasing?

    Limited Supply:

    • Major oil-producing countries had cut oil production last year amid a sharp fall in demand due to the Covid-19 pandemic.
    • Saudi Arabia pledged extra supply cuts in February and March 2020 following reductions by other members of the Organization of the Petroleum Exporting Countries (OPEC) and its allies.
    • In early January 2021, the OPEC and Russia (as OPEC+) agreed to cut back on oil production to increase prices.

    Rising Demand:

    • The production and rollout of vaccines for Covid-19 and the rising consumption post the Covid lockdowns last year have both led to a revival in international crude oil prices.

    Geopolitical reasons

    • Geopolitical tension has risen between Russia, which is the second largest oil producer in the world, and neighbouring Ukraine.
    • In January, there were drone attacks on oil facilities in UAE, another major oil producer.
    • An outage on a major oil pipeline linking Saudi Arabia and Turkey further added to the pressures.

    How it will impact India?

    • Current Account Deficit: The increase in oil prices will increase the country’s import bill, and further disturb its current account deficit (excess of imports of goods and services over exports).
      • According to estimates, a one-dollar increase in crude oil price increases the oil bill by around USD 1.6 billion per year.
    • Inflation: The increase in crude prices could also also further increase inflationary pressures that have been building up over the past few months.
      • This will decrease the space for the monetary policy committee to ease policy rates further.
      • The government had hiked central taxes on petrol and diesel by Rs. 13 per litre and Rs. 11 per litre in 2020 to boost revenues amid lower economic activity.
    • Fiscal Health: If oil prices continue to increase, the government shall be forced to cut taxes on petroleum and diesel which may cause loss of revenue and deteriorate its fiscal balance.
      • The growth slowdown in the last two years has already resulted in a precarious fiscal situation because of tax revenue shortfalls.
      • The revenue lost will erode the government’s ability to spend or meet its fiscal commitments in the form of budgetary transfers to states, payment of dues and compensation for revenue shortfalls to state governments under the goods and services tax (GST) framework.

    Why high growth impact on fiscal space leads to a greater hit to demand and growth?

    • The growth impact will manifest through constraints on fiscal space, household purchasing power being impinged and firm margins coming under pressure.
    • Why does marginal propensity to consume matter? The quantum of the growth impact will depend on how the shock is distributed across the fiscal, households and firms because of the different marginal propensities to consume.
    • For example, the excise duty cuts last November have already absorbed about one-third of the shock from oil (0.4 per cent of GDP).
    • The cost of this, however, is commensurate pressures on fiscal expenditures and growth, agnostically assuming a fiscal multiplier of 1.
    • In contrast, the marginal propensity to consume/invest out of income/earnings is typically lower than 1 for households/firms.
    • So, the greater the fraction of the shock absorbed on the fiscal, the greater the hit to demand and growth. 

    Way forward

    1] Let the rupee reach the new equilibrium

    • The widening of the CAD and associated BoP pressures will create some depreciation pressures on the rupee.
    • More fundamentally, a persistent negative terms of trade shock will argue for a weaker equilibrium real effective exchange rate.
    • Policymakers should let the rupee reach this new equilibrium – albeit in a gradual and non-disruptive manner – and not prevent this adjustment because it will facilitate the necessary “expenditure switching” to reduce imports, boost exports and help narrow an elevated CAD.

    2] Pragmatic fiscal policies

    • Cutting excise duties would buffer the impact on households and protect consumption, but potentially result in a larger hit to demand by shrinking fiscal space to spend.
    • If the government doesn’t cut duties, it has resources that can potentially be used to more directly target affected households at the bottom of the pyramid.
    • But this will mean higher retail prices that can harden inflationary expectations, increasing the challenges for monetary policy.
    • Finally, policymakers could always cut duties, not cut spending and let the deficit widen commensurately — effectively pushing out some of the terms of trade costs to the future — but negative surprises on the fiscal during periods of heightened macro uncertainty can generate significantly risk premia in markets.
    • All told, the fiscal will confront several trade-offs, and should try avoiding corner solutions.
    • What should be clear is that as soon as markets begin to stabilise, authorities must plough ahead with planned asset sales/disinvestment to create more fiscal headroom, without trying to perfectly time the market.

    3) Reduce the dependence

    • India has proposed Oil Buyer’s club. This would be a grouping of India, China, Japan and South Korea. The objective is to reduce the dependence on OPEC, have better bargains, increase the imports of crude oil imports from USA etc
    • It was put forward by Mani Shankar Ayyar in 2005
    • Create a stabilization fund or reserve account – Thailand, UK etc

    Conclusion

    A persistent adverse supply shock is complicated and challenging to respond to, and the new equilibrium will inevitably need some combination of a weaker rupee, higher rates, and judicious fiscal management.

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    Back2Basics: What is a fiscal multiplier?

    • The fiscal multiplier measures the effect that increases in fiscal spending will have on a nation’s economic output, or gross domestic product (GDP).
    • Fiscal multipliers are important because they can help guide a government’s policies during an economic crisis and help set the stage for economic recovery.

    What is Marginal Propensity to Consume?

    • In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it.
    • Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income.
    • MPC varies by income level. MPC is typically lower at higher incomes.