Is Indian economy heading towards stagflation?

As pandemic devastates lives and livelihoods, India is heading towards a disastrous “stagflationary” phase. However, bringing in some key structural reforms remains a silver lining in this unprecedented times, going ahead.

India has confirmed  38 lakh COVID-19 cases so far with more than 80000 infections reported daily, making it the world’s third-worst-hit country after US and Brazil. While government deserves an applaud for achieving a low mortality rate of less than 2%, but, in its effort to control rapidly rising infections is imposing fresh lockdowns with some states even observing night curfews and weekend lockdowns.  Hence, as an aftermath of lockdowns and new social distancing norms, economy is gradually getting pushed into state of stagnating growth and accelerating prices, formally known as stagflation. Although, high inflation is seldom accompanied by a period of low growth as typically, a slowing economy would reduce the demand for goods and services, thereby driving down the prices. However, under stagflation, the dual forces of escalating prices and dampening growth compound each other and create a vicious circle to further deepen the growing crisis of “inflationary recession”.

Stagflation phase was first observed in developed countries in the period of 1970s, which saw a breaking down of famous Keynes’ “Phillips curve” (which depicts inverse relation between unemployment and inflation). Experts believe that it was supply shock created by OPEC’s decision to cut oil supply that resulted in situation of “Stagnation plus Inflation”.

A similar situation is building in the present Covid environment too, where stringent restrictions and local lockdowns have halted most of the economic activities and supply chains with millions of people losing their jobs and revenue streams thus leading to falling demand, investment and growth on one hand, and rising inflation on other hand. The latest released data from NSO shows that India’s GDP dropped by 23.9% in the April-June quarter of 2020-21 with Gross value added (GVA), manufacturing and Gross fixed capital formation (GFCF) contracting by 22.8%, 39% and 52.9% respectively. IMF has also forecasted a contraction of growth rate by 4.5% in 2020-21.  On the other hand, Inflation is rearing its head. The retail inflation measured by CPI was as high as 6.93% and 6.23% in month of July and June respectively on account of high food prices depicted by high  Consumer Food Price Index (CFPI) which surged to 9.62% in July and 8.72% in the month of June 2020 .

The stagflationary situation has always worried the Central bank since it presents a major policy dilemma for monetarists with weak growth and high inflation pulling its decision in opposite directions. Such a policy dilemma was observed in recent monetary policy review too. Although since inception of the lockdown from March, RBI has slashed repo rate by 115 bps, however, this time in August policy review, MPC decided not to cut the policy repo rate below 4% as any further 25 bps reduction in repo rate, although could have helped to revive falling growth, however, such a move would have pushed the prices up which are already above the targeted level (July CPI inflation of 6.9% has exceeded the upper limit of the mandated medium-term inflation goal of 4% plus/minus 2%).

Monetary policy has always been seen panacea for all economic problems. However, reducing repo rate further below 4%, to provide cheaper credit is not an answer to an economic crisis like this one. It is not the cost of money that has held investment and private spending back, but prolonged economic uncertainty and a collapse in demand caused by the corona crisis. Unless demand picks up, cheaper loans won’t help much. Further, future reduction in repo rate is not required as banks have enough money to lend which is clearly indicated through banks parking money as much as Rs. 7 lakh crore daily with the central bank under its “reverse repo” liquidity window. Thus, it is not the liquidity problem, but the risk-averse attitude of banks amid growing NPAs in this covid environment which is holding back banks from lending. Further, as “real repo rate” has already turned negative, any further reduction in policy rate, may lead to financial repression, alarming depositors to move their savings from secure bank’s fixed deposits to risky investments and ultimately result in misallocation of capital.

In such a situation where monetary policy can’t help much, an expansionary fiscal policy through increased government expenditures and tax reductions can offer some relief; however, its usage is also limited due to burgeoning fiscal deficit and limited fiscal space available with government in this pandemic situation. Rating agencies suggest that against budget estimate of 3.5%, Centre’s Fiscal deficit is expected to touch around 7% of GDP in 2020-21 and has already reached 83% of the budgeted target in the first three months of the current financial year. Further, falling GST revenues of states, non-realisation of disinvestment targets, and decline in income and corporate tax revenues of the Centre poses limitations on the revenue side on the effective use of fiscal policy to kickstart the recovery. In addition, monetisation of deficit to fill back the government wallet, has its own shortcomings of inflation apprehensions and consequential macroeconomic imbalances.

To this end, the vital question now is “how to fight stagflation”. As already discussed, any dovish monetary stance or loose fiscal policy alone are not suffice to come out of stagflationary situation, rather it will exacerbate inflation, ultimately making matters worse. Instead, stagflation demands a much more farsighted approach where a policy mix of “loose” fiscal policy on one hand and “tight” monetary policy stance on the other hand is required. An expansionary fiscal policy in the form of cutting taxes for individuals & corporates and direct cash transfers to vulnerable population group will increase their immediate buying power and will support growth on one hand and a hawkish monetary policy stance will restrict the availability of money to borrow, thereby preventing the prices to shoot up on demand side. Thus, a right mix of monetary and fiscal policies, stimulating in opposite directions can be used gradually to take economy out of Stagflation, on the demand side.

While experts believe that a part of the decline in growth is cyclical and the recovery will start once covid gets over; however, a major part of downturn is due to structural issues too. In this light, structural reforms can help to boost growth and control inflation arising out of supply side bottlenecks. To this end, firstly, banking and financial sector reforms in the form of passing of Indian Bankruptcy Code to resolve NPAs problem is a step in right direction; nonetheless more needs to be done in the form of greater privatisation of public sector banks, reduction in priority sector lending targets, better supervision of NBFCs by RBI and increasing the depth and liquidity of Indian bond market with adequate regulations to attract portfolio investments. Secondly, labour market reforms in the form of greater flexibility to hire and fire, adequate social security measures, labour contact agreements and unemployment allowances can go a long way to make markets more competitive and labour friendly. Thirdly, with respect to taxation reforms, bringing uniform GST structure and reduction in corporate tax rates from 35% to 25% is welcome; however, adequate and timely GST compensation to the states and efforts to make tax structure progressive without evasions is need of the hour. Fourthly, timely completion of the proposed disinvestment plans with prudent investment of the asset sale proceeds into commercially viable infrastructure projects will go a long way in boosting growth and pushing economy towards recovery. Lastly, while recent revision of MSMEs definition with increased investment and turnover limits is welcome; however, bringing in policies that make SMEs sector more competitive through ease of doing business, technological up-gradation, better skill impartation and consumer oriented policies can make them more resilient to such shocks in future.

Going forward, increase in CPI inflation in the last two months can be just a blip, as with better monsoon, good kharif harvest season and further easing of regional lockdowns, the food inflation is expected to ease in coming months. Further, as worst is over and economy is rebounding back to normal state in a phased manner, it’s quite possible that recovery would take a gradual Nike-swoosh recovery path (if not optimistic V-shaped recovery path) in remaining half of the fiscal year.  Therefore, in conclusion it can be said that India, is of course approaching stagflation, but has not yet entered into stagflationary phase. To this end, adequate and timely policy mix of fiscal and monetary responses in correct magnitudes, along with structural reforms can go a long way to ensure swift recovery and prices coming back to comfortable level of 4%(medium term inflation target), thus alleviating any concerns of this “inflationary recession” in the coming future.