An economic policy response to the West Asia crisis

Policymakers will need to rely on both internal and external shock absorbers to guide the economy to its new equilibrium

- SAJJID Z CHINOY

The US-Iran conflict is about to enter its fourth week, with no sign of deescalation. Crude prices are up more than 50 per cent and gas prices more than 70 percent since the start of February, threatening to deliver a large, adverse supply shock to energy importers around the world.

Supply shocks are notoriously difficult to respond to, as Covid taught us, because they simultaneously impinge on growth and drive up inflation, creating difficult policy trade-offs. How then should India respond in the current environment?

A blend of Covid and Russia-Ukraine

The first thing to appreciate is the nature of this supply shock. The current situation is unlike the 2022 Russia-Ukraine conflict, which also spawned a surge in energy prices. That, too, was a supply shock but it worked largely through an adverse terms-of-trade channel by pushing up global prices.

Here, the adverse price shock is being compounded by a quantitative constraint on volumes of crude, gas and liquefied petroleum gas (LPG). Almost 50 percent of the LPG and 30 percent of the natural gas that India consumes comes from the Strait of Hormuz. If that does not open soon, physical availability of energy will become an increasing challenge. This will amplify the price shock in two pernicious ways:

First, there is a growing risk that economic activity across various sectors will be impacted, resulting in a hit to activity much larger than the sticker price of crude and gas would suggest. Hypothetically, if restaurants have to temporarily close because of a lack of LPG or auto part production is hit because of a lack of gas availability, the ‘shadow price’ that they, de facto, confront — which results in a sharp curtailment of activity — will be much higher than implied by the price of crude and gas quoted in global markets.