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3 min read . Updated: 02 Mar 2022, 06:50 PM IST A sharp rise in rates—and a steeper selloff in Indian assets—isn’t inevitable, but it could become so if the crisis drags on and oil prices keep moving higher
Once upon a time, Indian Prime Minister Narendra Modi promised to plumb the depths of the ocean and scale the heights of space with Vladimir Putin. Today, Russia’s decision to invade Ukraine couldn't have come at a worse time for its old Cold War ally.
Because India is facing primarily supply push inflation, rather than both supply and demand driven price growth as in the West, the Reserve Bank of India may actually have more space than it seems to play wait-and-see with its policy stance—even given India’s huge dependence on imported oil. But if the crisis persists, then a significant rise in Indian rates may be unavoidable, and a further steep selloff in Indian assets could follow. India’s S&P BSE Sensex has fallen sharply but not disastrously in recent days: about 3% over the past week.
India’s growth was already slowing before the Ukraine crisis: The economy expanded a mere 5.4% year over year in the December quarter, according to official data released Monday, widely missing the median broker estimate which was 6% according to FactSet.
India’s poor growth has left its central bank with few palatable options to tackle impending inflation, which is likely to inch upward with oil prices soaring past $110 a barrel as sanctions mount and supply remains disrupted. India is the third-largest global importer of oil—importing more than 80% of the oil it needs. The RBI’s 4.5% inflation projection for fiscal 2023 might prove a bit optimistic even if the disruptions from the Ukraine crisis fade quickly.
However, unlike the Federal Reserve, which is winding down its stimulus and is expected to raise interest rates several times in 2022, Asia’s third-largest economy has a small window to maintain its benchmark lending rate at 4% and support growth. The retail inflation rate currently stands at 6.01%. That may sound high but it is right at the upper end of the central bank’s medium-term target inflation range, which is centered on 4% with 2 percentage points of wiggle room on either side.
If the conflict drags on or spills further into Europe and oil prices rise further, however, India will have to make some hard choices. If the government lets high fuel prices percolate through the economy and hurt consumers, it will have to deal with public angst in a year filled with many state elections. If it decides to reduce excise duties on gasoline and diesel fuel to protect consumers, it will have to bear a huge fiscal cost.
According to rating agency ICRA, a rollback in excise duties to pre-pandemic levels could prevent any major jump in pump prices, but at a fiscal cost of about 920 billion rupees, equivalent to $12.15 billion. India’s fiscal deficit is expected to hit 6.9% of gross domestic product, or $210.12 billion, this financial year and 6.4% next year as the government continues to try to spend its way out of the pandemic-induced downturn.
Any sharp rise in inflation may compel the central bank to raise rates in the second half of the year. Nomura expects higher than projected inflation and a possible policy pivot in June: 1 percentage point in cumulative repo rate increases in 2022 or financial year 2023. Bond yields have already inched up since Russia invaded Ukraine last week, reflecting the grim outlook for the world economy and stark policy choices India faces.
The RBI—and investors in Indian assets—still have a little room to breathe. But perhaps not that much.
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