The crude oil after having collapsed to multiyear lows of USD 28/bbl, at the start of 2016, the oil price has reversed, soaring to USD 80/bbl, levels that were last seen in 2014. While India derived significant economic benefits from the low oil price levels, these benefits are all set to reverse as the trajectory has taken a U-turn. The inflation battle will now be tougher to combat due to the relentless rise in crude oil prices and fiscal prudence is at stake along with the implications for Current Account Deficit (CAD) & Balance of Payments (BoP).
The OPEC-led cutback in output with higher compliance from OPEC members is shrinking Inventories & exerting upward pressure on oil prices; robust demand is further pushing prices higher. The geo-political uncertainty is adding to the surge in oil prices. The disruption in production from Venezuela and Africa is reducing oil supply and the oil market would only tighten further if Iran’s output starts to contract due to sanctions. India as a net importer of petroleum products stands to lose considerably, especially with respect to trade balance, inflation and this time around even fiscal deficit (as it levied heavy duties on fuel to mop-up extra revenue).
Macro Impact:
Oil surge just toughened India’s inflation battle: The CPI fuel index forms 15% of CPI & includes petrol, diesel, other fuels, airfare and LPG. It has started to tick higher and is only expected to inflate further in the ensuing months and contribute negatively to inflation. The likely impact on headline CPI, is estimated to be 30-40bps if oil prices surge by USD 10/bbl with a relatively stable exchange rate and assuming that the oil marketing companies or OMCs pass-through the price rise to final consumers at existing tax levies. The impact on wholesale price index is expected to be much greater pushing up input prices for firms which in turn will exert upward bias on core inflation, both core-WPI & core-CPI.
Fiscal accommodation - either by way of subsidy/excise deductions - threaten fiscal targets: While crude oil prices continue to move northwards, the spillovers of the same are now mounting as currency too has slipped. The recent weakness in the currency, further translates into higher pump prices unless the same is either absorbed by the OMCs or the govt. reduces the excise duty on fuel. Either way the govt. is likely to lose out on revenue because in case of the former, the dividend from OMCs to the govt. will fall and the latter will immediately result in loss due to reduced excise duties. A Re 2/litre reduction in excise on fuel can lead to an annual loss of ~INR 300bn or 15-20bps of GDP to fiscal deficit target, ceteris paribus. At the same time, the subsidy bill would edge higher on account of subsidized cooking gas, kerosene which could add INR 200bn in subsidies. Overall, impact of these could potentially push up fiscal deficit/GDP target of 3.3% by 20bps, which already is facing headwinds in the wake of subdued GST collections.
External Vulnerability Rising – a repeat of 2013: India’s inelasticity to oil prices due to heavy reliance on imported oil brings back the memories of FY12-FY13. As crude oil imports account for almost a third of India's imports, a USD10/bbl spurt in oil prices is likely to increase the oil import bill by USD 17bn annually and deteriorate the CAD by USD 10-12bn.A surge in crude oil prices is widening the CAD faster than envisaged, weakening the currency. The rise in crude prices is expected to sharply reduce India’s BoP surplus and perhaps even push it into a deficit. Nevertheless, the huge FX Reserves build up would prevent a repeat of 2013!
Rupee & Bonds reeling under pressure: What is fait accompli is that a higher CAD, a lower BoP surplus (or deficit) & higher inflation depreciates the purchasing power of any nation. The sharp fall in the Rupee is reminiscent of the same. History shows that the impact of crude oil on India is not so sweet after all; surge in crude oil prices puts pressure on inflation which in turn pushes up policy & borrowing rates. The reaction of bonds to oil prices is even more entrenched now because of the flexible inflation targeting framework that has been put in place.
Thus surge in crude price will have direct impact on Indian economy by way of rise in inflation, current account deficit, fiscal deficit etc.