From UPSC perspective, the following things are important :
Prelims level : Marginal propensities to consume
Mains level : Paper 3- Impact of high crude price
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?
- 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.
- 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 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.
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
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.
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.