Friday February 24 will be the year of the Russian invasion of neighboring Ukraine. The previous months were characterized by a steady increase in tension. The invasion drove up the prices of fuel, fertilizers, grain and other essential commodities, of which Russia and Ukraine were the main suppliers. This, in turn, caused imports to soar in countries like India that depended on foreign fuels to boost their economies. As a result, inflation has risen
times, often at unprecedented levels in recent years.
Since the end of last year, the prices for fuel and other goods, which had risen sharply after the war, have fallen. However, the effects of the crisis on the Indian economy are far from over. For example, the consumer price index rose at its fastest pace in three months (6.5% yoy) in January, shattering initial hopes that falling global fuel prices would lead to a fall supported by domestic inflation. This in turn will affect how the Reserve Bank of India (RBI) decides on the future path of rate hikes in
The Russo-Ukrainian war was a major test of the resilience of the Indian economy, both short- and long-term, in the face of what economists call external “shocks”. How was it?
One of the most striking changes in the economy, although usually masked by the more visible effects of inflation, is the changing patterns of fuel imports from India (see Chart 2). After the invasion, Russia was practically excluded from the world oil market and tried to attract buyers by offering discounts on supplies.
India went all in. As a result, the share of Russia as a source of Indian crude oil supplies jumped sharply from as low as 2% in late-2021, on the eve of the crisis, to well over a quarter a year later. Russia is now among the top three suppliers of crude to India, thus reducing the traditional reliance on the Middle-East. In January, the proportion of crude imports sourced by India from Russia soared to a high of 27%.
When oil prices spike, the trade balance almost inevitably deteriorates, given the limited room to substitute crude with other forms of fuel in a primarily fossil fuel economy. But despite Russian crude being offered below global market prices, the trade balance did worsen. The overall trade deficit in goods and services between April and December 2022 — the peak months of the crisis — more than doubled to $118 billion, from $57 billion for the same period in 2021.
What of the future? As the war shows little sign of resolution, the West has actually ratcheted up attempts to economically isolate Russia. In December, for instance, the European Union banned seaborne imports of Russian crude and the G7 countries imposed a price cap on Russian crude imports.
This implies that Russia will be more eager than ever to sell its crude elsewhere, and its share of Indian crude supplies could increase even further. Indeed, while the effective price at which India imports crude still closely tracks the international price (Chart 2), in January, when Russian crude imports of India soared to their highest level ever, the Indian price of crude decoupled from the global price to a sharp extent. If this trend continues, the changing pattern of India’s fuel imports could well have a far bigger impact on the overall domestic inflation rate (and the trade deficit) in the longer term than most other direct attempts to tinker with either of these two indicators.
The Inflationary Aftermath
If Russia does become the mainstay of India’s fuel imports, with resulting moderating effects on the pace of inflation, it could have far-reaching effects on the economy, though the jury is still very much out on this. Upticks in fuel prices have always had a highly predictable effect on the Indian economy — on both growth and inflation.
Initial rises in global fuel prices lead to a direct impact on the consumer price index, as they account for close to 7% of the total index. While this may seem a low weightage, it is the steep jumps in the absolute price of crude and other imports of a similar type — gas, refined petroleum products, etc — that can cause a disproportionate effect on inflation. But the direct effects are only part of the picture.
The problem with any of the main fossil fuels is that they are a critical input into a range of industries. Thus, a sustained fuel price rise inevitably leads to other sectors and industries raising prices of their products. What started as a localized price rise can soon become generalized across industries, and across manufacturing and services. Thus, while there is an initial bump in so-called ‘headline’ inflation, it can soon cause ‘core’ inflation — inflation excluding highly volatile prices of commodities like food and fuel — to rise as well.
This is exactly what happened, according to a study of the inflation episode of the last year, done by Michael Patra, Asish Thomas George, G V Nadhanael and Joice John at the RBI. They write: “What started as a shock to food and fuel prices got increasingly generalized over ensuing months. This was reflected in highly elevated and sticky core inflation. Unprecedented input cost pressures got translated to…goods prices, in spite of muted demand conditions and pricing power. As the direct effects of the conflict waned and international commodity prices softened, the strengthening domestic recovery and rising demand enabled pass-through of pent-up input costs, especially in services, adding persistence to elevated inflationary pressures.”
As the authors point out, the difference between the inflationary episode after the war, and recent ones before it, lie in the fact that in earlier episodes, the bulk of inflation came from volatile components like food and fuel, which are prone to wild swings in prices. In the later months of the war, though, the inflation had spread to most categories of goods and services. In fact, those secondary effects are what we see now, with headline inflation still rising, despite fuel prices weakening in recent months.
The problem didn’t lie just with crude oil. Russia is a key exporter of fertilizer as well, and the war seriously disrupted the global fertilizer trade. By April, the International Monetary Fund (IMF)’s index of prices of key fertilizers had risen by over 16% compared with just two months earlier. This came on the back of major increases in the global price of fertilizers during the covid-19 crisis, caused by trade disruptions. Between April 2020 and early-2022, the IMF fertilizer price index had already risen by well over three times.
But it wasn’t just the price of fertilizer on the world market. Natural gas is a key ‘feedstock’, or input, into the domestic fertilizer industry. When Russia cut off gas supplies to Europe through the Nord Stream pipeline, it set off a mad scramble for other sources of natural gas, leading to a global spike in prices.
This further worsened supply conditions in the international and domestic fertilizer markets, and caused the fertilizer subsidy bill to rise by close to 50% in 2022–23, compared with a year earlier. As in crude oil, India imports a substantial volume of its natural gas requirements, and the global price increases lead to price hikes for Indian natural gas customers, such as those using piped gas for cooking or as fuel in Compressed Natural Gas (CNG) vehicles.