How real is the Stagflation Risk to the Indian economy?

27 Jun 2022 , 09:17 AM

It is not often that the World Bank uses terms like Stagflation in its World Economic Outlook. In the June 2022 WEO, the World Bank has called out the risk of stagflation impacting the US and trickling to other nations. India is likely to be part of stagflation too. However, World Bank has not predicted stagflation, just highlighted the possibility due to the similarities between the current macroeconomic scenario and the situation back in the 1970s.

What is stagflation all about?

The Corporate Finance Institute has given, perhaps, the most comprehensive explanation of stagflation; as an economic event wherein the rate of inflation is high, economic growth rate slows and unemployment spikes. This is a rare but challenging combination and can pose a dilemma to governments. Actions designed to lower inflation could raise unemployment levels, while the policies designed to decrease unemployment may worsen inflation.

But, what causes stagflation? If you look at the last stagflation of the 1970s, it was driven by supply shocks and poor economic policies. Supply shocks can include a spike crude prices or other mineral, making production costlier and less profitable, thus slowing economic growth. The other reason for stagflation is a spurt in money supply, which leads to lower growth and higher inflation. Normally, stagflation is a combination of both factors.

Is the world really on the throes of stagflation?

In the last few weeks, it is not just the World Bank, but even Bank of America Securities highlighted the risk of stagflation for the global economy. There are similarities with the situation in 1970s. Back then the oil prices rose due to the OPEC oil shock. This time around, oil has surged due to Russia-Ukraine war. Even in the 1970s, the government economic policies had been extremely lax, leading to surplus money supply.

Today, we have seen the US Fed balance sheet expand to $9 trillion as an aftermath to addressing the global financial crisis and COVID pandemic. The situation is the same for most other countries too. It is this combination that makes the world economy in general and the Indian economy in particular very vulnerable to stagflation. But, first, let us look at some of the interesting growth projections across the globe by the World Bank.

Growth has been downgraded sharply since January 2022

The table below has two parts to it. The first part cover the real GDP growth projections up to 2024 (calendar years). The more important data point are the last two columns that cover the revisions in GDP growth estimates between January and June 2022.

	Real GDP growth YOY — Year 2022 onwards are estimates	Revision since January 2022
Countries / Regions	2019	2020	2021	2022	2023	2024	2022	2023
World	2.6	-3.3	5.7	2.9	3.0	3.0	-1.0	0.0
Advanced economies	1.7	-4.6	5.1	2.6	2.2	1.9	-1.2	-0.1
United States	2.3	-3.4	5.7	2.5	2.4	2.0	-1.2	-0.2
Euro area	1.6	-6.4	5.4	2.5	1.9	1.9	-1.7	-0.2
Japan	-0.2	-4.6	1.7	1.7	1.3	0.6	-1.2	0.1
EM/DM	3.8	-1.6	6.6	3.4	4.2	4.4	-1.2	-0.2
East Asia and Pacific	5.8	1.2	7.2	4.4	5.2	5.1	-0.7	0.0
China	6.0	2.2	8.1	4.3	5.2	5.1	-0.8	-0.1
Indonesia	5.0	-2.1	3.7	5.1	5.3	5.3	-0.1	0.2
Thailand	2.2	-6.2	1.6	2.9	4.3	3.9	-1.0	0.0
Europe and Central Asia	2.7	-1.9	6.5	-2.9	1.5	3.3	-5.9	-1.4
Russian Federation	2.2	-2.7	4.7	-8.9	-2.0	2.2	-11.3	-3.8
Turkey	0.9	1.8	11.0	2.3	3.2	4.0	0.3	0.2
Poland	4.7	-2.2	5.9	3.9	3.6	3.7	-0.8	0.2
Latin America and the Caribbean	0.8	-6.4	6.7	2.5	1.9	2.4	-0.1	-0.8
Brazil	1.2	-3.9	4.6	1.5	0.8	2.0	0.1	-1.9
Mexico	-0.2	-8.2	4.8	1.7	1.9	2.0	-1.3	-0.3
Argentina	-2.0	-9.9	10.3	4.5	2.5	2.5	1.9	0.4
Middle East and North Africa	0.9	-3.7	3.4	5.3	3.6	3.2	0.9	0.2
Saudi Arabia	0.3	-4.1	3.2	7.0	3.8	3.0	2.1	1.5
Iran, Islamic Rep.	-6.8	3.4	4.1	3.7	2.7	2.3	1.3	0.5
Egypt, Arab Rep.	5.6	3.6	3.3	6.1	4.8	5.0	0.6	-0.7
South Asia	4.1	-4.5	7.6	6.8	5.8	6.5	-0.8	-0.2
India	3.7	-6.6	8.7	7.5	7.1	6.5	-1.2	0.3
Pakistan	3.1	-0.9	5.7	4.3	4.0	4.2	0.9	0.0
Bangladesh	7.9	3.4	6.9	6.4	6.7	6.9	0.0	-0.2
Sub-Saharan Africa	2.6	-2.0	4.2	3.7	3.8	4.0	0.1	0.0
Nigeria	2.2	-1.8	3.6	3.4	3.2	3.2	0.9	0.4
South Africa	0.1	-6.4	4.9	2.1	1.5	1.8	0.0	0.0
Angola	-0.7	-5.2	0.7	3.1	3.3	3.2	0.0	0.5

Data Source: World Bank

If you leave out the OPEC countries and Latin American mineral producers, other economies have seen downward revision in GDP growth for calendar year 2022. With the prices of crude and other minerals at multi-decadal highs, the superior performance of these economies is not surprising. However, other than these economies, the major economies like the US, EU, Japan, China and India have all seen downward revisions to GDP growth.

What about inflation? The US has been struggling with 8.6% inflation, UK with 7.5% inflation and India with over 7% inflation. For now, there are clear signs of stagflation risk in most global economies, including India. Going ahead, a lot would depend on the policy response.

Policy response to stagflation is on track

The June 2022 MPC Committee report has explicitly maintained that India did not run the risk of stagflation. However, that is more optimism than conviction. GDP growth in last 2 years in India has been engineered by a low base and high liquidity. That is unlikely to continue and that is when the pinch of stagflation will be felt. In the 1970s, central banks embarked on monetary tightening measures; entailing steep rate increases. This did not curtail inflation, but resulted in a series of bankruptcies and defaults.

India has a fiscal deficit of nearly 7% and getting worse. Tightening the liquidity taps, at this juncture, is not just a choice but an imperative. As the RBI has shown in the last 2 policies in May and June, it will resort to monetary tightening to bring down inflation to the 4% median and curtail fiscal deficit. That just means a lot of pain for the Indian economy with the clear risk of stagflation.

Let us conclude on an optimistic note. The current situation differs from the 1970s in that the dollar is much stronger today and monetary policy is a lot more synchronised. Also, as global inflation moderates by 2023, much of the stagflation risk would be automatically addressed. At least, that is the hope!