Ring-fencing From Ukraine Shock!

As Russia-Ukraine war stretches beyond a month with no signs of de-escalation, threatening the post-pandemic fragile recovery, Indian policy makers are looking for the right ammunition to fight back and meet the new economic challenges. So, if India used supply-side measures to salvage its economy during the pandemic, what could be the right tools to deal with macroeconomic uncertainties brought by the war?

The signs are ominous. In a few days of the start of the war, Brent crude oil prices touched a 14-year high of $140 per barrel due to U.S. sanctions on Russia, including expulsion from the SWIFT payment system. Though prices have dipped somewhat since then, they are still high. Crude’s gyration threatens to put India’s economy in disarray with high inflation, widening current account deficit (CAD), depreciating currency, disruption of supply chains and raw material shortage. All of these will significantly dent the much-elusive, post-coronavirus, recovery. According to Japanese research firm Nomura, every 10% increase in oil prices would shave off 0.20 percentage points from GDP growth, widen CAD by 0.3% of GDP and lead to 0.3-0.4% rise in headline inflation.

It looked getting from bad to worse, when international crude oil prices were projected to touch $200 a barrel. Much to India’s relief, they were $109 a barrel at the time of going to press, lending support to rupee, which had fallen to an all-time low of 76.96 against the U.S. dollar in first week of March.

That, however, has not stopped financial institutions from lowering India’s gross domestic product (GDP) growth forecast for FY2023. The United Nations Conference on Trade and Development (UNCTAD) has cut India’s growth forecast for CY2022 to 4.6% from 6.7% earlier. Fitch Ratings has downgraded its growth forecast by 180 basis points to 8.5% citing high energy prices. Moody’s has downgraded CY2022 GDP growth estimate from 9.5% to 9.1% while Morgan Stanley has lowered it from 8.4% to 7.9%. Citigroup has cut the estimate from 8.3% to 8%. The Economic Survey had projected 8-8.5% growth for FY2023.

With most of the fiscal and monetary arsenal used up in fight against the pandemic, what options does India have to deal with the challenges at hand? The magnitude of combined fiscal and monetary stimulus has been over ₹30 lakh crore. Fiscal space is constrained. Monetary policy, too, has limited scope with repo rate at 4% for about two years now and impending withdrawal of post-pandemic liquidity. High global inflation and hawkish U.S. Federal Reserve are adding to the woes.

Finance minister Nirmala Sitharaman and Reserve Bank of India (RBI) governor Shaktikanta Das have tried to soothe nerves. After the onset of the crisis, Sitharaman said, “India’s development is going to be challenged by newer challenges emanating from the world. You (industry) can be assured that we are fairly seized of the matter in its granular form.”

At a CII National Council meeting on March 21, Das said, “I would like to make it very clear with a lot of emphasis that even going forward we will ensure abundant liquidity in the market for credit system to function normally.”

Options For India

Experts say gauging the damage to the economy due to Russia-Ukraine crisis should not be based on any one premise as the situation is full of uncertainty. They say government should keep its focus on capital expenditure—the fulcrum of FY2023 Budget was allocation of ₹7.5 lakh crore—as both private investment and private consumption may remain subdued.

“In a situation like this, risk aversion will be a natural response of corporates and households. Only government can do it. In doing so, it will be instilling confidence in the economy. This is the only way to support economic recovery,” says Sunil Sinha, director, public finance, India Ratings. “Capex should be maintained even if that means borrowing more as corporate sector will avoid borrowing under current circumstances,” says Sinha.

Economist N.R. Bhanumurthy, vice chancellor, Dr. B.R. Ambedkar School of Economics, suggests front-loading of expenditure like in FY2022. “The 6.4% fiscal deficit target for next financial year shows government wants to go ahead with its capital expenditure strategy. Going by what we saw in FY2022, front-loading strategy was important. Government needs to front-load capital expenditure from day one in FY2023 too,” says Bhanumurthy. “If capital expenditure continues, there will be pick-up in demand and private investment in next six months,” says Bhanumurthy.

Inflation: Discounted oil, currency pact a way out?

Consumer price index (CPI) inflation has risen slightly above RBI’s upper tolerance limit of 6%. It was 6.07% in February and 6.01% in January. According to Crisil, average CPI inflation will be 5.4% if crude oil averages $85-90 per barrel in FY2023, while it will be 5.8% at $100 per barrel, 6.1% at $110 per barrel and 6.4% at $120 per barrel. Experts say there is no need for a knee-jerk policy reaction. Instead, government should spread out the impact of the rise in oil prices. “Small daily adjustments over a period will not lead to inflationary expectations and will be accepted by people. That is a correct approach,” he says, adding India should buy Russian oil being offered at a discount. Indian Oil Corporation has bought three million barrels Russian Ural crude, while HPCL has bought two million barrels from European traders. Mangalore Refineries and Petrochemicals Ltd. has also floated a tender for buying one million barrels Russian crude oil at a discount. However, these supplies are minuscule considering India’s annual consumption is 1,500 million barrels.

And that’s where bilateral currency pacts to bypass dollar trade come into play. India and Russia are examining a rupee-ruble pact. Professor Biswajit Dhar from Centre for Economic Studies and Planning, Jawahar Lal Nehru University, tells Fortune India that there is a sense of urgency on both sides to sign the pact as Russia cannot keep its economy in limbo for long. Payments of a number of Indian exporters to Russia are also stuck.

“Overcoming bottlenecks created by the sanctions becomes imperative as it is affecting business. It is important to sit across and find a solution which protects interests of both sides. They will have to arrive at some kind of a consensus on exchange rate too because ruble is currently very volatile,” says Dhar.

But there is one downside risk to steps such as currency pacts and discount shopping of crude oil--sanctions on Russian energy supplies, though their extent is still uncertain. “Sanctions are unlikely to be extended to oil imports as, unlike sanctions on Iran, which did not affect U.S. allies, sanction on Russian crude oil will affect European allies of U.S. That’s the reason for discount shopping as a hedge against inflation, which may hurt growth if not tackled at the earliest,” says Dhar.

Foreign exchange experts say that more than being a stop-gap arrangement, bilateral currency pacts can serve as a long-term payment mechanism to reduce dollar dependency. The widespread use of U.S. dollar gives the country a lot of powers that it exercises through tariffs, sanctions and bans on blacklisted nations and companies.

“Alternative mechanisms such as providing a bilateral arrangement similar to one with Iran and allowing companies in both nations to trade in rupees through escrow accounts will provide relief to India’s economy and its importers and exporters,” says Heena Imtiaz Naik, research analyst (currencies), Angel One Ltd. “There could be a possibility of India avoiding use of dollars and opting for country-specific currencies to avoid dependence on a third party,” says Naik.

In a relief of sorts, the war is changing global power equations, offering India more options for sourcing crude oil, which will have a direct bearing on inflationary pressures. U.S. is considering lifting sanctions on Iran so that Iranian oil can enter world markets and lower prices. Interestingly, Iranian ambassador to New Delhi, Ali Chegeni, has offered India a rupee-rial trade agreement. U.S. is also trying to ease curbs on Venezuela in order to increase oil supply.

However, what can complicate matters is that the conflict has come at a time when RBI was expected to suck out the liquidity unleashed after the outbreak of coronavirus in 2020. Even though the RBI governor has assured adequate liquidity, Crisil expects that in base case scenario of CPI inflation at 5.4%, RBI will raise repo rate by 50-75 basis points in FY2023. “RBI will now have to take a call on keeping inflation from rising significantly and at the same time support growth,” says Dipti Deshpande, principal economist, Crisil. That said, with conflict in Europe, balancing growth and inflation, while being mindful of government’s borrowing costs, will be nothing short of a tight-rope walk.

Boost Exports

In a shot in the arm for the idea of self-reliant economy propounded by prime minister Narendra Modi in the wake of the Covid-19 crisis, India has met its merchandise export target of $400 billion for FY2022 ahead of schedule. In FY2021, exports were 298.1 billion.

In order to boost exports, Parliamentary Standing Committee on Commerce has said that interim and mini trade agreements can help exporters tap opportunities from nations that want to invest in India under the ‘China plus one’ strategy. The committee, though, has raised concerns over declining export to GDP ratio. It says merchandise exports as percentage of GDP fell to 11.07% in FY2020 and 10.94% in FY2021, from 12.2% in FY2019.

Impact on Budget Projections

The finance ministry is confident that the disruptions will not impact key budget projections for FY2023. A finance ministry official said the bottom line number–fiscal deficit–will remain 6.4%. “Any increase in expenditure is likely to be offset by higher revenue as nominal GDP may get a leg-up due to higher inflation,” he says.

The official says fertiliser subsidy is a bigger concern as prices of imported urea, diammonium phosphate and muriate of potash (MoP) will rise due to the Russia–Ukraine crisis. India imports almost 20% of its MoP from Belarus, a Russian ally involved in war against Ukraine.

According to a finance ministry assessment, the FY2022 fertiliser subsidy bill will go up by ₹15,000 crore from revised estimate of ₹1,40,122. For FY2023, it is likely to be enhanced from budget estimate of ₹1,05,222 to about ₹1,50,000. The ministry is confident that these changes will be offset by higher tax collections.

There is catch, though. The projected excise revenue for FY2023 is ₹3,35,000 crore. Former finance secretary Subhash Garg says if crude oil prices remain at $100 per barrel, government will not be able to pass on the entire burden to consumers. “Government will have to take a call on reducing excise duty. How much it will reduce it by will depend on its political assessment,” says Garg. A one rupee reduction in excise duty on petroleum product costs the exchequer ₹15,000 crore.

For India, reducing the impact of the Russia-Ukraine war would mean juggling with a number of issues at one go. That said, government will have to carry out its heavy lifting through higher capital expenditure for an even longer period.

Focus on exports, spending; join RCEP: Shankar Acharya, former chief economic advisor

There are several ways in which the Russia-Ukraine economic shock is going to impact us negatively, coming as it does on the back of the sharp growth slowdown of 2018-2020, Covid/lockdown shocks and recent resurgence of global inflation. RBI has correctly likened it to a supply shock to the economy–on the back of increased prices of oil, fertiliser, metals and grains. One does not yet know the duration and magnitude of the impact. The Indian economy will be hurt not only by high commodity prices and supply chain disruptions but also by slower global growth. Current account deficit and capital inflows from abroad will be impacted, leading to depreciation of the rupee against the dollar. Also, due to these factors and heightened uncertainty, I anticipate weak private investment and consumption.

Compared with my published post-budget outlook, qualitatively, GDP growth will be lower, inflation will be higher, interest rates will rise, current account deficit in BoP will widen and employment situation will get worse.

The question now is, what can the government do? First, it must maintain a tight leash on the fiscal situation. Second, there is a need to gradually normalise our very accommodative monetary policy. Third, we should keep ‘soft brakes’ on rupee depreciation through foreign exchange intervention, reducing volatility but allowing depreciation. We should not try and defend any particular exchange rate. The government should also try to sustain its public investment programme.

Additionally, India must try every means to improve the foreign trade account. More focus is needed on exports as they may be the only relatively dynamic element of demand that our economy will have, since private investment and private consumption are likely to remain subdued.

In this context, given the observer status that we already have in the Regional Comprehensive Economic Partnership (RCEP), from which India withdrew in 2019, it should not be difficult to re-apply. The RCEP region is likely to be the most dynamic part of the world economy in medium-term compared to others.

That said, there may be no such thing as ring-fencing the Indian economy amid an ongoing severe shock arising out of geo-political and geo-economic factors. We cannot wish away the challenges, but can reduce the negative impact and ensure that the situation is kept under control.

De-dollarise non-US, non-Europe trade: Rajnish Kumar, former chairman, SBI

For crude oil, India is dependent on imports and Russia is an important supplier. It is feasible for India to de-dollarise non-U.S., non-Europe trade. Any such bilateral arrangement can be done through Indian banks that do not have any operations in U.S. and other parts of the world, especially Europe. Several banks have now been merged but even before merger such deals have been examined with Vijaya Bank or UCO Bank as a channel. Today, even though State Bank of India, Punjab National Bank, Bank of Baroda and Canara Bank cannot be part of such arrangement due to significant international presence, smaller banks such as Bank of Maharashtra and Indian Overseas Bank can be part of such an arrangement.

The challenge, however, is fixing the exchange rate and dealing with imbalance in trade. Russia has annual trade surplus of $5 billion or `38,500 crore. Because India will make payment in rupee, the problem for Russian companies would be how to use the rupees sitting in the VOSTRO (Russian banks’ rupee account with a bank in India) account of Russian banks. If the ruble depreciates faster than the rupee, Russian exporters will incur exchange losses. The best solution is to increase exports of Indian goods to Russia invoiced in rupees. The exporters will determine the value of exports in USD but will raise the invoice in equivalent rupees and get paid utilising the rupee balances lying in VOSTRO accounts.

A possible option could be to convert the surplus into RMB/Chinese Yuan and credit to Chinese banks who, in turn, will settle with Russia. An alternative to SWIFT ban could be potentially linking India’s flagship payments system—Unified Payments Interface—to Russia’s own System for Transfer of Financial Messages, which it developed in 2014.

Whatever bilateral arrangement is made between India and Russia, a delicate balancing act is required keeping in view India’s equally important relationship with U.S. and Europe. Fortunately, the rise in its global stature in the last few years, has created the required elbow room for India to finalise an arrangement to safeguard its economic interests from the supply shocks emanating from the Russia-Ukraine war.