It is amusing to see how economies and markets transpire into different cycles from time to time. As they gradually transition from stage to another, lot of enthusiasm and uncertainty grows. Just two years back we pondered over how will our lives emerge during the pandemic; we had a range of speculations of our own kind. Pandemic changed our lives in many ways, and it has resulted into newer emerging trends for betterment of mankind and environment. Economic policies and geo-political situations have played a vital role in how the present has transformed. While the expansionary policies like stimulus packages, lower interest rates received tremendous applauds from the stock, bond, commodity markets, today we concerning glare at the raging inflation that is impacting our lives and those globally at a larger scale.
The inflationary signals were flaring since long, but the global central banks chose to foresee it as mere ‘transitory’. The US' & other central banks' balance sheet has ballooned by trillions of dollars after the mammoth stimulus packages announced. I recall few weeks after announcement of inflation being transitory, Fed began giving clues about forthcoming Taper and taper tantrum began in mid-2021, which I had written about a year back in this article. Now, the previously undermined situation has transpired into a heated inflationary mayhem, and countries across the globe are facing accelerated prices rise and India is no immune to it. Burgeoning cost of living and reducing purchasing power dented our pocket and Russia Ukraine crisis has exacerbated the situation.
US registered highest inflation in last 40 years since 1970s at rate of 8.5%.
India registered Inflation rate of 7.79% in the month of April 2022. Major contributors to rising inflation are Fuel & Light – 10.87%, Food & Beverages – 8.03%, Transport & Communication – 10.69%. (Components to India's CPI can be found in this link.)
Globally, countries are witnessing rising inflation. Below exhibit depicts country wise inflation range. Major part of the world is facing inflation in range of 3-10%. Russia is facing inflation of 17%. Other few nations are facing inflation of more than 25%, whereas China is at 2%.
There are economic and social costs of Inflation. In response, RBI recently in its unscheduled meeting announced a 40 bps of hike in repo rate, revising it to 4.4 %. This rate hike move has been reactive in nature, while past suggested that there is fair likelihood for Inflation to rise, in conjunction with low interest rates and GDP. Equity Markets across the globe have responded severely to the rate hikes. RBI is further expected to increase rates in its June meeting to fight inflation. US Fed has planned for 6 rate hikes this year and increased the interest rates by 50 bps, to 0.75 % - 1%.
Many unfolding events prevailing now may not have happened during our lifetime, but they have been repeating over many long-term cycles in the past. I am writing this article to outline the macro factors and situation of the economy. While I am no expert in economics, I am using my skills to look over the past events and understand how economies stood during such crisis and where do we stand now. I see two primary drivers of the current situation, first oil crisis and second, underlying gushing liquidity infused by central banks post covid outbreak.
How Oil played role in the past?
The recent surge in Oil prices have been a major contributor to accelerating Inflation, besides excess liquidity that has poured into markets by central banks’ stimulus packages to boost demand. After sharp slump of oil prices in 2020’s covid crash to as low as 21$, crude oil had surged to 84$ in November 2021, even before the Russia Ukraine crisis emerged. Once war conditions broke out, oil has been rallying and touched peak of 125$. Russia is one of major suppliers of crude oil, accounting for around 11% of global production. Increased sanctions on Russia have led the oil prices higher, not to mention about OPEC’s decision to stick with its original plan of production output, despite supply constraints.
Walking down the memory lane, Inflationary 1970s are popularly known for the Energy crisis & Stagflation where the world faced two oil shocks in a decade. First oil Shock of 1973 was caused due to oil shipping embargo imposed by OPEC against United States and Israel’s European Allies. (Embargo means an official ban on the trading activities / on a country/ Commodity). Thus, oil shipments from Middle East towards Unites States and other European states were ceased temporarily. Embargo was imposed as US supported Israel in the war against Egypt & Syria. Since the Arabs did not like US & Europe’s interference in the war, it stopped the oil supplies. Oil prices quadrupled that year and making US and Europe re-assess their dependency on OPEC for their oil needs. The embargo was removed in 1974 and led to far reaching impact on economies including demand fall, lower GDP and increased domestic production in US and increase in their energy efficiency. Below exhibit shows the movement of oil and global inflation from 1970 till date, suggesting a direct relationship of inflation with oil.
How did this impact India?
The Oil shock drove Inflation in India to 28.6% in 1974 and impacted the GDP severely. GDP fell from 3.3% in 1973 to 1.1% in 1974. As the dust settled in 1975, India’s GDP growth rallied to 9.15%. For next few years, the global growth was fueled by rise in demand for goods and services. Year 1976 registered global GDP growth of 5.3% and remained at 4.2% in 1977. However, that decade had one more oil shock to endure. Like its predecessor, the second oil shock of 1979 was again associated with Middle East. It was triggered by Iranian Revolution which reduced the oil output. Fear of further disruptions increased widespread hoarding that pushed the prices further higher. The shortage of supply, coupled with higher demand for oil, skyrocketed the prices to 35$ in 1979-80 from 12.8$ in 1978. Oil prices began to rise rapidly and most of it was estimated to be coming from booming economies and precautionary demand, besides Iran output cut. India’s scenario again turned bleak. Inflation soared to 11% in 1980 and further 13% in 1981. Year 1979 witnessed biggest slump in GDP to minus 5.24%. The decade was extremely straining for India due to increasing poverty, geopolitical issues, high population growth accompanied with global crisis. India faced painful stagflation during that decade as unemployment rose to 6% and inflation to more than 7%. Stagflation occurs when both Inflation and unemployment are at higher levels and the demand remains low for a long period.
Next energy crisis happened in 2000s. During 2003, the price rose above $30, reached $60 by August 2005, and peaked at $147.30 in 2008. Post aftermath of Dot-com bubble, world GDP accelerated during 2000s. The world consumption of oil kept increasing faster than the production rise, due to growth in world population. This increase in oil demand could not be met with increased supply as OPEC production did not increase at same rate. On outbreak of Great Financial Crisis, demand for oil slumped bringing down the oil prices to 60$.
Below exhibits talks about impact of oil on inflation & GDP of India from 1960s till date.
From these events and above exhibits, it is evident that when the oil prices rose, inflation followed, demand getting affected and GDP slowing down. As understood from past events, demand has been one of major drivers of oil and when the demand is increasing, commodity prices increase and inflation in tandem. Fiscal and Monetary policies have other cause effect relationship with Inflation. Typically, Inflation rises when the economy is growing fast. Inflation is the highest during the boom periods and lowest during the recessionary period.
India’s unemployment rate for May 2022 is 7.1% (Source: CMIE) Unemployment rate in urban areas is 8.5% and that in rural areas is 6.5%. As compared to Jan 2022, the rate increased in Feb-22, Mar-22, April -22 to 8.11%, 7.57%, 7.83% respectively. Since covid outbreak, the unemployment rate has remained higher for last two years. Historically, urban inflation has remained higher than rural. From the below exhibit on inflation and unemployment, inflation and unemployment has moved together. Higher inflation has led to higher unemployment. Details on unemployment data can be found in this link.
Inflation & Economic Cycles
To understand where we are now, we need to know the different economic cycles. During a depression, the aggregate demand and resultant production levels are extremely low, inflation is comparatively lower, and unemployment is higher. To keep the business going, production houses resort to forced labour cuts or retrenchments.
While the economy recovers, demand and production increases, new investments become attractive, inflation shows uptick and with upturn in production, employment also increases.
In a boom period, demand is accelerated and prolonged, exceeding sustainable output levels. Economy heats up and demand-supply lag is visible. Demand-supply disequilibrium leads to Inflation moving upwards. Economy may also face structural problems like shortage of investible capital, lower savings, falling standard of living. Boom is usually followed by a price rise.
When the economy overheats, there is downturn in the demand. As demand falls, production also falls and as production levels are cut, new employment opportunities are not created in market, which increases unemployment. This takes economy to next stage of cycle, recession.
During recession, there is general fall in demand, inflation remains lower or shows signs of further lowering down, unemployment rate grows, industries resort of price cuts to sustain their business. If economy fails to recover itself from recession, depression logically follows. Inflation remains low discouraging new investments and lending.
CAD & Import Bill
Historically explained, increase in oil prices has strained the import bill and current account position (Refer Below Exhibit). Typically, when the import bill rises, current account deficit also widens. India has been usually having a deficit due to its large import bill.
Oil, electronic goods, and gold comprise of most imported goods in India. During FY 21-22, the import bill has increased heavily. Crude oil imports in quantities grew by 7% and the import value increased by 93% from 62$ billion in FY 20-21 to 120 $ billion in FY 21-22 (Source: PPAC). Additional 60$ billion of burden has widened the current account gap from 24$ billion surplus to 23$ billion deficit in Q3 FY ’22.
Forex Reserves
USD is the reserve currency acceptable at global level. A currency holds its reserve status when it is widely accepted, and global transactions are carried in that currency. This makes it very important for any economic nation to hold reserves in the reserve currency to be globally competitive and for that nation dependent on imports for running its economy. US Dollar gained its reserve currency status after decline of British Pound post world wars. For nation like India, it is important that forex reserves are higher and adequate to cover months of import bills. They act as shock absorbers against any global phenomenon. Forex reserves also include Gold reserves and special drawing rights with the IMF. After touching peak in November 2021, the reserves fell from 640$ billion to 597$ billion. Below exhibit depicts the growth of India's forex reserves from time to time.
This fall in the forex reserves could be attributed to higher import bills and outflows of FII. Since Oct-21, FII outflows from cash segment is Rs 3 lakh crores. That is the longest period of FII outflows and highest ever withdrawal over continuous period of months since April 2007. (PS: FII poured in Rs. 2 lakh crores between May 2020 to March 2021 on QE by US and other European countries). Latest increase in US interest rates has led to money flowing back. Hike in the interest rates by US, has led to dollar gaining value. US Dollar Index touched peak of 104.9 for first time after 2017. All these factors have combined resulting to sharp depreciation of rupee. Rupee touched lows of 77-78 INR / USD, lowest ever in its lifetime. We are back to the time when in mid-2013, we were facing high inflation, depreciated rupee, and twin deficit problems. US had begun raising interest rates in year 2015 after its post subprime crisis QE program, which accelerated between year 2017-2018. FII outflows from equity segment could be seen during that time.. However, the intensity of outflows this time is much higher than before, attributable to the inflows. As US raises interest rates and emerging economies shows signs of increasing risk, foreign investors typically move towards safe-haven currencies. Below exhibits talks about FII Outflows during whenever US increased interest rates. The current period witnesses highest amount of FII outflows in last 16 years. (The below analysis is limited to data availability for FII outflows in public domain.)
External Debt
External Debt of India is 614$ billion in Q3 of FY ’22, a rise of 7% over Q1. The ratio of external debt to GDP is 20%. This ratio has remained in range of 20% - 21% over last 5 years and as against a 20-year average of 21.1% (Note: This ratio is computed in Rupees terms). US Dollar denominated debt continues to remain dominant portion of total debt. India’s debt position is much favorable when compared with other developed nations like US, UK, Japan. (Refer below Exhibit, data is limited to data availability for specific years)
Fiscal Deficit (difference between government’s total income and expenditure) of India has widened over last few years. It also indicates the borrowing that the government may need to fund the deficit. Deficit financing became quite popular with time. Fiscal deficit may impact the country’s ratings. The government in its 2022-2023 union budget sees India’s fiscal deficit to be 6.9% of GDP in 2021-2022 and 6.4% in 2022-23 as the government aims to boost spending on transport, infrastructure, and construction projects, while it proposes to trim it down to 4.5% by 2025-2026.This is an increasing trend over the past years. In today’s terms, share of indirect tax is still higher than 50%, whereas share of direct tax is around 44-46%. Increased fuel prices are further posing challenge to ex-chequer for reducing the tax burden on fuel. As the tax cuts happen, the fiscal deficit may widen.
Global Scene
History has abundant illustrations on how massive money packages have led to inflation, currency devaluation and have impacted the economies adversely. Period of Inflation that we are in now is result of excessive liquidity in the market infused by central banks through their money printing actions and the on-going oil crisis. Monetary policy induced growth and rise in demand led to inflation growing. In US, massive money printing caused inflation to spark before the prevailing conditions of war and supply chain disruptions. Over past centuries, money printing was opted for when the economy was crippled with low growth and needs stimulus and there is no other alternative available. Printing money or its modern version called “Quantitative Easing” is not bad unless the new money is going into unproductive uses. This also leads to creation of debt and increase in the burden for economies. Here, I would like to quote about Roaring 20s period post First World War and Spanish Flu. After settling from the pandemic and world war I aftermath, the 1920s-decade growth was fueled with high growth. This growth was debt levered. Eventually, the bubble busted in 1929 causing Great Depression. It took 25 years for US markets to reach the pre-crash levels.
We can draw our attention to recent frenzy in the market post covid printing of money, where large amount of funds went into asset classes like crypto currencies and meme stocks. Retail participation in financial markets has increased manifold since then and this money pouring into nothing but speculative asset classes, has led to highly inflated prices and formation of bubbles and super bubbles in multiple asset classes. Correction in some asset classes have already begun and stock markets are on the edge of bear markets.
Although the long-term outlook for India as per experts is quite positive, the present is concerning and is poised to pose challenges in future. As per recent reports, many start- ups have started laying off their employees. Funds raised by them has drastically come down this year, as compared to previous. Companies are taking time to fill in their positions. In our daily lives, what we can see is rising ‘Shrinkflation’ where the quantity of consumer goods in the packets have reduced, while prices are kept same or increased. On other hand, prices of FMCG goods have increased manifold. The FMCG sector has seen a dip in rural demand over last few months. Thus, India may face issues with higher inflation & interest burden, rising unemployment, falling demand. Days that lies ahead of us appear grim. We can nothing but, protect our portfolios, from acute losses and by investing in inflation hedged asset classes and avoid speculative bets. In my next article, I will be focusing on market’s performance during different business cycles and asset classes for investment purposes.
To end this, I would like to share an interesting quote by Henny Youngman -
Americans are getting stronger. Twenty years ago, it took two people to carry ten dollars' worth groceries. Today, a five year old can do it.
Thanks-
Ushma Zunzavadiya
(Foot Notes: In 2015, India commenced the process of ‘inflation targeting’. CPI is taken as the measure of headline inflation and RBI tracks to anchor its monetary policy and healthy range for it is annual 2-6%. Producer Price Index is a leading indicator for inflation as it denotes the prices of producers cost. Alternative to popular and widely accepted measures of Inflation like CPI & WPI, GDP Deflator can also be used to measure Inflation. GDP Deflator growth is computed as change in the ratio of nominal GDP to Real GDP).
Sources for Database:
- RBI, MOSPI, IMF, World Bank, Statista, US Fed St.Louis database, Investing.com
- Databases used are as of 19th May 2022
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