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Summary
India’s economy, like the world’s, is structurally less vulnerable to oil shocks than it was back in the 1970s. But with war-driven supply disruptions pushing up costs, policymakers must respond. Supply shocks are far harder to tackle than demand shocks.
The ongoing war in West Asia has cast a pall of uncertainty over the global economy. The disruptions in energy supplies have begun to ripple through supply chains across the world. In its latest monthly review of the Indian economy, the finance ministry has noted: “Recent shocks are being transmitted through higher input costs, supply constraints and pressures across sectors, with early indications of some moderation in economic activity.”
For economic policymakers, managing a disruption in supply is far more complicated than responding to a sudden shift in demand. The reason is simple. In the case of a demand shock, both output and prices move in the same direction. For example, a sudden drop in demand in an economy will lead to slower growth as well as lower inflation. The textbook solution of stimulating the economy through lower interest rates as well as higher government spending usually works well.
Supply shocks are very different. Output and prices move in different directions. For example, a shortage of supplies means that economic activity slows down while inflation moves up. The textbook solutions lose their bite in these extraordinary situations, creating tricky choices between either supporting growth or taming price increases.
A lot will depend on how long the war will last. The best strategy right now would be for the government to absorb some of the initial price increases through either tax cuts or higher subsidies, while the Reserve Bank of India waits along the sidelines. It will be less neat in case the supply shock lasts through the year.
Policymakers, companies, investors and economists will obviously be keeping a close eye on how economic growth and inflation behave in the months ahead. The general expectation is that economic activity will lose some momentum while price pressures will increase. The final effect on both fronts will be tough to assess since war disruptions are still playing out and the impact could be non-linear in case there are physical shortages of key inputs, both for industry as well as agriculture.
Does economic history offer any clues? The first major oil shock that hit the global economy was in October 1973. Oil prices quadrupled in a short span of time after West Asian petroleum exporters imposed a severe embargo on shipments after the Yom Kippur war of some Arab states with Israel.
The Indian economy went through a harrowing time. Consumer price inflation averaged 23% a year over the next two years. Economic growth was a modest 4.6% in 1973-74. It then went into negative territory the next year. Growth in nominal gross domestic product (GDP) was 22.6% that year and 17.7% in 1974-75. What this means is that the sharp rise in nominal GDP was because of higher prices rather than an increase in output. Stagflation, in other words.
The next oil shock came in 1979 after the Islamic revolution in Iran and start of the Iran-Iraq war. Nominal GDP expanded by a modest 9.1% in 1979-80 and then a sharp 19.5% the next year. India had double-digit inflation in both these years. The economy contracted by 5.2% in real terms in 1979-80. It bounced back the following year, with a real growth rate of 7.2%.
However, harsh lessons from those two oil shocks have to be tempered with one other fact. India was unlucky to face energy shortages even as droughts hit agricultural production in these two periods. So high inflation as well as muted economic growth was the result of a twin battering that the governments of the day had no direct control over.
Agriculture is now a much smaller part of the Indian economy compared to 1973 and 1979, and food stocks are far more comfortable. This is important given early warnings of an El Niño year, which signals dry conditions. However, on the other side, India uses far more fossil fuel energy than it did back then.
The other lesson comes a year closer to our times. Soaring international crude oil prices were one reason why India’s nominal growth was 18.7% in 2010-11. Consumer price inflation averaged 12.2% that year. Unlike 1973 or 1979, global oil prices were pushed up by red-hot economic growth in countries such as China and India as well speculative buying fuelled by a wave of cheap money unleashed by central banks in the aftermath of the North Atlantic Financial Crisis in 2008.
The main lesson here is that inflation was not the result of restrictions on energy supplies but also of loose macroeconomic policies.
A look at the data since 1970 shows that there is a negligible relationship between global oil prices on one hand and nominal economic growth on the other. Data points scatter, with no clear pattern. The line of best fit has a slope so gentle that it is barely meaningful. India has grown rapidly with oil at $15 a barrel and equally rapidly with oil at $110.
However, this overall benign story hides what happened during severe energy shocks—in 1973-74, 1980-81, 1990-91 and 2021-22. A lot will depend on the details. Is the world facing a supply shock or a demand shock? Are there any other exogenous blows, such as a hit to food production? How dependent are economies on oil? And how will economic policy respond to these dislocations?
The author is executive director at Artha India Research Advisors.
English (US) ·