Now is the time to make policy decisions aimed at protecting the Indian economy from global shocks

The year 2022 was a difficult year for most economies. While many countries managed to emerge from the worst of Covid-19, they entered another challenging area characterized by uncontrollably high inflation rates, recalcitrant monetary tightening by advanced economies and ongoing supply chain disruptions. The situation was exacerbated by the war between Russia and Ukraine, which dashed any remaining hopes for a holistic recovery in a post-Covid world.

India faced its own challenges in the form of a reversal in capital flows coupled with a sharp rise in oil prices and elevated domestic inflation. It ended up riding through them, cleverly deploying a policy toolkit that included tight monetary policy, exchange rate depreciation, use of foreign exchange reserves, and specific fiscal measures. Despite overcoming these challenges, the Indian economy grew 9.7% cumulatively in the first half of the fiscal year. And it appears to be on track to post a growth rate of around 6.8%-7% over the year.

The global environment appears to have become less hostile as inflation rates in advanced economies have peaked and oil prices have stabilized at lower levels. So capital flows return to India, the exchange rate recovers and foreign exchange reserves are rebuilt.

When such recurring shocks occur, all policymakers can do is fight fires. A good time to develop measures to shield the economy from them is when the situation is calmer – like now. This is the right time to build resilience to equity account volatility and create policy frameworks to mitigate the impact of oil price shocks and vegetable price inflation.

Within the mix of international capital we attract, FDI is the most stable form of capital and portfolio flows are the most volatile. In order to reduce capital account volatility, it is prudent to change the mix of capital inflows towards more stable forms of capital, particularly foreign direct investment.

With the decreasing intensity of oil in GDP, the importance of oil prices to the Indian economy has decreased, but not disappeared. It will be useful to devise an “oil price mitigation strategy” that includes an oil price stabilization fund, replenishment of strategic reserves, hedging against sharp price increases, and securing oil supplies at low prices.

Food inflation, particularly vegetable price inflation, has been particularly volatile in India. Monetary policy is a blunt tool to counteract this. Instead, better demand-supply management is needed to tame it. It will be a win-win for everyone: it will stabilize farmers’ incomes, free monetary policy from reacting to food inflation, and provide a useful policy narrative. In the meantime, policymakers must keep an eye on the evolving global economic outlook. Global growth is likely to slow as the effects of monetary tightening take hold. The IMF has lowered its growth forecast for 2023 — from 3.8% in January 2022 to 2.7% in October 2022.

Global growth is affecting India in two ways. The first is the demand for Indian exports. Since the growth elasticity of Indian goods exports to global demand is close to 1, a slowdown in global demand will directly affect Indian exports. Second, dovish global investment sentiment has a proportional impact on domestic sentiment.

For example, the latest projections point to a lower growth rate of 6-6.5% and a lower inflation rate of 5-5.5% for India. The IMF forecasts a real growth rate of 6.1%, inflation of 5.1% and thus a nominal growth rate of 11.2%. The corresponding figures in RBI’s Survey of Professional Forecasters are 6%, 5.2% and 11.2%, respectively. RBI’s own forecasts for the first half of 2023 assume a compound annual growth rate of 6.5% and inflation of 5.2%.

These forecasts have implications for the upcoming budget. The 2023 budget should be prepared assuming modest nominal growth; and it should make arrangements to support specific sectors likely to be hit by the effects of a global slowdown.

On the broader policy front, the budget should keep the focus on growth with macroeconomic stability and fiscal prudence, complemented by efforts to attract higher foreign direct investment and more globally competitive and integrated manufacturing capacity. Overall, while we should hope for the best, we should be prepared for another difficult year.

Gupta is Director General of the National Council of Applied Economic Research (NCAER); Ahmed is a research associate at NCAER