Oil Price Shock and Tough Policy Choices

Geetima Das Krishna

Rising crude oil prices are making policy makers jittery. Just when ground level micro data showed signs of growth pick up, the crude oil prices started its uptrend. A sharp recovery was seen in passenger car sales, tractor and two wheeler sales. Moreover, bank credit, railway traffic, industrial production, core sector, capital goods and construction growth also gained momentum by the start of the year. These indicated solid uptick in rural and urban consumption and strong cyclical recovery with better capacity utilization.

However, the crude oil basket for India that had averaged around $64 per barrel during January to March 2018, started to rise steadily from April to reach $78 by 22nd May. The government 10 year bond yield rose in tandem by almost 50 bps during the same period denoting negative sentiment. It is not surprising as India imports 82% of its total oil requirement and Brent crude oil makes up around 28% of India’s total imports. A sustained increase in oil prices is expected to have adverse macroeconomic implications – from growth, inflation and currency to fiscal deficit. India was in a sweet spot for last few years with record low oil prices that created space for the new government to push tough reforms, cut oil subsidies and make petrol-diesel prices market determined.

The question often asked is whether the situation is similar to the one in the mid 2013 when high oil prices exposed India’s macro vulnerabilities to such an extent that India was termed as the first fallen angle of the BRIC. This time too, the uncertainties are being already felt in Turkey and Argentina. However, macro-backdrop in India is quite different now. Inflation is less than half of 10 percent averaged in 2013. Similarly, fiscal deficit is 3.5 percent of GDP in FY 2017-18 compared to almost 5% in FY 2012-13 and current account deficit is only 2 percent in December 2017, nowhere near the dangerous 6.8 percent seen five years back. Foreign reserves are also at all time high.

This does not mean that continued rise in oil prices would not hurt us. Most of the macro indicators are coming under stress. Both core and headline inflations are climbing up. Trade deficit and hence Current account deficit have widened and will not be filled by FDI inflows anymore. Rupee is weakening. Globally, things have changed. Rising interest rates and bond yields in US have reduced the attractiveness of borrowing cheap in the US and investing in higher-yielding assets like Indian bonds. The incentive now is to sell other assets and take the money back to US strengthening dollar. This will keep pressure on Indian Rupee.

India will, invariably, be part of the group of Emerging economies at risk of facing selling pressure on foreign exchange and market due to twin fiscal and current account deficit. Various estimates state that a $10 per barrel increase in oil price increases India’s consumer price inflation by 0.6-0.7 percentage points, wholesale price by 1.7 percentage points, worsens current account balance by 0.4 percentage of GDP and reduces growth by 0.2-0.3 percentage points. So, this is not a time to be complacent.

The oil prices are increasing for various reasons – supply cutbacks by the OPEC (Organization of the Petroleum Exporting Countries) and non-OPEC countries, geo-political disruptions in Venezuela, fear of reduced supply from Iran after US president Trump’s decision to scrap nuclear deal along with higher than expected world demand. None of our policy makers anticipated oil prices to touch $80. It was expected that as soon as oil touches $65 per barrel, the costlier US shale oil and gas operations will be back online cooling the market. This did not materialize as expected. Only an increase in supply can cool the oil market.

The policy makers will be forced to make some tough decisions as high oil prices soften growth and push up inflation – an unacceptable combination. The RBI had already sent out mixed signals to the markets in April by their dovish policy statement and hawkish MPC minutes. Consensus expectation now is a hawkish statement in June with rising odds of a rate hike. The market has now priced in a couple of rate hikes due to expected uptrend in inflation. Higher interest rates will not only shave off growth but rising bond yields will also damage banks’ balance sheet further. The RBI will have difficulty balancing its prime mandate of inflation targeting with that of maintaining financial stability.

On the other hand, the government has been earning huge tax revenues from petro products through excise duties as the sharp fall in oil prices in previous years was not completely passed on to the consumers. But with such rapid rise in crude oil prices, there are only two options for the government to cushion the consumers. Either slash the excise duties or subsidise the oil companies for selling at a discount. According to government sources, a reduction of Rs1 per litre of excise duty on fuel results in a revenue loss of Rs 13,000 crore annually. Whether it is lower tax revenues or higher subsidy expenditure, the impact will be seen in fiscal deficit.

With general elections next year, there is precious little space for the government to maneuver. It can keep the consumers happy by reducing excise duties and thereby worsening the fiscal deficit or it can re-introduce oil price caps and reduce oil refiners’ profitability. On the other hand, it can maintain fiscal target by slashing capital expenditure which will eventually hurt growth.

Any populist measures ahead of election that will put macro-stability at risk. The lessons from 2013 are still fresh in policy makers’ minds. As Joseph Stiglitz said, ‘Macroeconomic policy can never be devoid of politics: it involves fundamental trade-offs and affects different groups differently’.

**Views are personal. The author is a research scholar at IIFT.


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