“Global
Economic Shocks and Indian Policy Response: An Analysis Using a CGE Model”
Citation: Ganesh-Kumar, A. and M. Panda. 2009.
“Global Economic Shocks and Indian Policy Response: An Analysis Using a CGE
model”. In K. S. Parikh (Ed.) Macro-Modeling for the Eleventh Five Year Plan of
India, Planning Commission, Government of India / Academic Foundation, New
Delhi.
1) The
year 2008 has been a tumultuous one in the history of the world economy
unparalleled in several decades. The first half of 2008 witnessed dramatic rise
in the global prices of crude oil and petroleum products. During the second
half of 2008, the global economy slipped into a recession triggered by the
financial meltdown in the developed economies that invoked comparisons with the
Great Depression of the 1930s. Along side commodity
prices too fell sharply. The fallout of these developments in the world economy
is already being felt in
2) In
order to study these issues we have developed a basic computable general
equilibrium (CGE) model of the Indian economy in an open economy framework with
71 sectors and 10 household classes. It is built around the social accounting
matrix (SAM) of 2003-04. In each tradable sector domestic goods and foreign
goods are treated as imperfect substitutes of each other following the
Armington specification. Along with imperfect substitutability, indirect taxes
and tariffs permit multiple price layers for each sector. Income distribution
across households depends upon the endogenous levels of (un)employment
of both labour and capital. The model determines
relative prices but does not, however, have money as a store of value. It is a
static one, particularly suitable for assessing short-run growth and
distributional impacts.
3) Two
sets of simulations are carried out in this study to assess the impact on the
Indian economy of (I) global oil price rise and the policy options for India,
and (II) global recession and the effectiveness of some of the government’s
counter measures including expansion of the National Rural Employment Guarantee
Scheme (NREGS). Towards this the basic CGE model is suitably extended to
incorporate additional features such as (a) administered pricing mechanism as exists
in the petroleum products sector in India, and (b) incorporation of the working
of the NREGS along with segmented labour markets. The
modeling of the NREGS captures the guarantee element of the Programme
by linking its size (i.e., number of jobs generated and the cost to the
government) to the endogenous levels of unemployment of rural labour. To the best of our knowledge, this is perhaps the
first ever attempt at modeling the NREGS.
4) The
first set of simulations evaluates the impacts of a 70% rise in crude oil
prices and 50% rise in petroleum products prices (a) when the domestic prices
of petroleum products are administratively kept unchanged by the government,
(b) when the government administratively raises the price of petroleum products
by 10%, and (c) when administered pricing mechanism is replaced with market
determined pricing for petroleum products.
5) The
main results of these simulations are the following:
a)
In
the short-run, GDP falls by about half a percentage point over the base levels
and real exchange rate depreciates by about 20%, due to international price
rise in crude oil and petroleum products sector, irrespective of the pricing
mechanism prevailing in the domestic petroleum products sector.
b)
The
rise in world prices results in a 1% rise in aggregate domestic price index
even when the government keeps the domestic price of petroleum products
unchanged. Domestic prices rise by 1.9% following a 10% hike in the
administered price of petroleum products, and by 4.7% when the administered
pricing mechanism is replaced with market determined pricing system.
c)
Under
a market determined price regime global oil price rise unambiguously hurts all
households across both rural and urban areas, with the urban households in each
class suffering a greater loss in real incomes than their counterparts in rural
areas. Administered pricing benefits or mutes the real income losses for most
households.
d)
Government’s
subsidy bill due to administered pricing works out to Rs.851 billions when the
price of petroleum products is left unchanged at the base level. The subsidy
bill reduces by Rs.316 billions following a 10% hike in the administered price.
In contrast under market determined prices, government get a
larger tax revenue compared to the base.
e)
Under
administered pricing, the subsidy provided to the petroleum products sector
benefits the producers also in the form of higher net- / value-added price,
which rise by nearly 50% when the prices are not changed compared to a 70%
decline in the net-price under market determined pricing system. In other
words, market determined prices forces the producers to absorb part of the
global price rise.
f)
The
rise in government subsidy for petroleum products has adverse effects on the
government’s savings, and hence national savings and investment. Government’s
dis-savings nearly doubles when the administered price
is kept unchanged, while a 10% hike in the price reduces the government’s
dis-savings by 25%. In contrast, government dis-savings rise by just 13% under
free market regime compared to base.
g)
The
main cost of global oil price rise is the fall in real investments, by 14.3%
under no change in administered price, by 11.5% after a 10% hike in
administered prices, and by 5.1% when the pricing in the petroleum products
sector is market determined.
6) The
second set of simulations examine the effects of three external developments: (i) a 10% fall in Indian exports due to falling external
demand, (ii) a 29% reduction in the foreign inflows into
7) The
results from these simulations show that,
a) Of
the three external developments, exports fall alone results in a loss in GDP by
about 3.3%, while fall in capital inflows cause another 1.8% loss in GDP. The
fall in international crude prices mutes the GDP loss somewhat. Nevertheless
the combined effect of the external shocks potentially could be a loss in GDP
of about 4.2%.
b) About
half of this combined effect could be offset by government counter measures
examined here and overall adverse effect on GDP could be limited to fall by
2.2%.
c) Assuming
a growth rate of 9% for 2008-09 as per the XI Plan target under normal
circumstances, the external shocks together could reduce the growth rate to as low
as 3.9%, but the counter measures could help lift it up to 6.8%.
d) While
the loss in growth could be arrested somewhat in the short-run through these
counter-measures, it could be at the cost of long-term growth and fiscal
erosion. The results show that all these global developments and the counter
measures would lead to decline in real investment by 20.7% and near doubling of
government dis-savings.
e) Manufacturing
sector suffers relatively more loss in output than agriculture or services
sector in all the scenarios. In fact, two of the counter measures, viz., rise in government consumption and reduction in indirect
taxes actually hurt the manufacturing sector because of the fall in investment
demand in these scenarios.
f) About
4.3% of the total labour force could suffer
unemployment following the three external shocks. Rising government consumption
and cutting down indirect taxes could limit the unemployment to just 2.7%.
Expanding the NREGS to fully cover the bottom 70% of the rural population could
bring down the unemployment by an additional 0.5% through its direct and
indirect effects.
g) Real
income losses for households following the external shocks range between 3.6%
and 4.5%, with the urban households suffering slightly higher losses than their
rural counterparts.
h) An
expanded NREGS can actually help in rising the real
incomes of the bottom 70% of the rural population over the base levels even
under these recessionary conditions. And it would cost about Rs.331 billions or about 1.4% of the nominal GDP.
8) It
is worth reiterating at the end that CGE models are real models that consider
only relative price movements. The absence of money market in the model limits
us from examining the impact of several monetary measures adopted by government
of