Economic Resilience: India's Strategies To Safeguard Against Israel-Gaza Conflict Effects

The outbreak of the war between Israel and Palestine has not only raised a concern about the humanitarian crisis in the Middle East but also sparked anxiety among nations about the potential disruption of world trade and the world economy. The world economy is still recovering from the impact of the Covid-19 pandemic and the Russia-Ukraine war. An extended conflict in the Middle East, especially if there is the participation of other countries like Iran, which is also a major oil producer, may wreak havoc on the global economy.

India's substantial reliance on oil imports makes it vulnerable to disruptions in the global oil supply chain. The increase in Brent crude prices since the beginning of the war has the potential to cause inflationary pressures. The higher energy costs often lead to a domino effect of increased prices for goods and services, reducing the purchasing power of the Indian rupee and exacerbating inflation challenges.

As a result, these factors could undermine the Central Bank's efforts to maintain price stability in the face of heightened inflation and external economic uncertainties. Additionally, the Indian rupee might depreciate, making imports more expensive and affecting India's trade balance. This, in turn, could pose a threat to India's overall economic stability.

However, The outlook for the Indian economy appears promising. The retail inflation in India had eased to 5.02% in September from 6.83% in August, as per the Consumer Price Index (CPI). Even though the inflation rate has come down significantly after hitting the highest of 7.79% in April 2022, the CPI reading is still above the upper tolerance target of 4% set by the Reserve Bank of India. The monetary policy committee is soon expected to take certain monetary actions to bring inflation down to the target and maintain the inflation expectation.

RBI's Tough Grip on Repo and Interbank Rate to Control Inflation

For now, expecting the rise in vegetable prices due to uneven rainfall distribution, the RBI has paused rate hikes with the repo rate at 6.50%. The decision is in the right direction if the government wants to maintain low borrowing costs for businesses and consumers, enhance financial stability, and improve the effectiveness of monetary policy transmission.

Furthermore, a lower interbank rate will facilitate cheaper interbank borrowing, enabling banks to provide loans to businesses and consumers at more attractive interest rates, ultimately boosting economic activity and growth. A reduced interbank rate can also enhance financial stability by minimizing the risk of bank runs, as banks have easier access to affordable funding. Additionally, a lower interbank rate facilitates the effective transmission of the central bank's monetary policy decisions to the wider economy, as banks are more likely to lend at lower costs when they can borrow money from each other inexpensively.

RBI Follows Lateral Approach with Sale of Bonds

The government's sale of bonds aims to align the interbank rate with the repo rate, allowing for a stable interest rate regime while managing anticipated inflation. Whenever there is an increase in the money supply within the economy, the government offers bonds with attractive interest rates and tax-free benefits to attract investors. Given the attractive interest rates and the perception of government bonds as a secure investment, a substantial number of investors gravitate towards investing in these bonds. Upon the issuance of these bonds, a significant portion of the circulating money is withdrawn from the system, leading to a reduction in liquidity and inflation rates. This approach enables the government to mitigate inflation while simultaneously providing investors with a secure investment option.

At the same time, the government's decision to sell bonds instead of increasing repo rates supports the housing and construction sectors, making it more appealing for businesses to invest in new projects, potentially leading to increased productivity and economic growth. When businesses can access credit at lower interest rates, they are more likely to invest in expansion and new projects.

This, in turn, stimulates economic growth, increasing the overall demand for housing. Low borrowing costs can also benefit construction companies directly. These companies often need financing for their projects, and when borrowing is cheaper, their costs decrease. This can make new construction more attractive and financially viable, leading to increased housing supply. Simultaneously, it can stimulate job creation by encouraging businesses to expand and hire new workers. As businesses expand and invest, they will have to hire more employees, improving the employment rates in the country.

Conclusion

As the festive season draws near, the demand for cash traditionally experiences an upsurge. This heightened need for liquidity often prompts governments and financial institutions to consider their options for managing the increased demand. On the other hand, simmering geopolitical tensions have raised the impact on the Indian economy. In this context, the decision to issue bonds typically becomes a focal point, and it is expected to materialize within the next few weeks. This decision should be regarded as a positive and proactive step in addressing the challenges associated with liquidity in the system to control inflation.

The views and opinions stated in the content belong to Mr. Sarvjeet Virk, Co-founder & MD, Finvasia.

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