Oil price rise: What the oil price spike could mean for India

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Madan Sabnavis

Oil price rise, oil price spike, India, Oil price, OPEC, WPI inflation, Indian economy, economy news, Oil, Oil price, Oil price rise, oil price hike, indiaA higher provision has to be made in case the government is keen to not let market prices increase for these products.

It is almost a stylised fact that a crude oil price shock is an annual feature; and this time, it has struck at the beginning of the year. The shock is always singular as it is caused more by geo-political tensions with Iran being the fulcrum of the controversy for some years now. There was a time when OPEC could move prices given the oligopolistic power wielded by them, but this is passé. With American shale-based oil entering the market and the US becoming one of the largest suppliers, the power of OPEC has gone down to an extent.

The recent imbroglio in Iran has led to the price of crude moving towards $70/barrel and stock markets getting into a tizzy with panic striking across the forex markets. Investors are searching for new havens, and the non-dollar currencies like euro and yen seem to have been preferred to begin with. In such situations, the logical thing to do is to wait and watch, and see if the disturbance is temporary or permanent. If it is the former, then time would be the healer. But, if it is the latter, there could be some implications for us as there is a lot of dependence on imports.

Just how important is oil in Indian economics? The first thing that comes to mind is inflation, as higher oil prices means higher fuel prices, which, with the exception of LPG and kerosene, would be transmitted directly to the consumer. The price of petrol and diesel have moved up immediately as there is no subsidy element and the pricing system is on a daily basis. Curiously, at the macro level, the WPI gets impacted more given the weight of these products. In case of the WPI, the weight of all crude related products is around 10.4%, which means that 10% increase in crude price can potentially lead to 1% increase in WPI inflation. And, given that it is presently moving in the negative terrain, the potential increase can make it positive. In case of CPI, the direct weight is lower at 2.4%, and hence, the inflation impact is moderate even though this would be affecting households directly. This also means that RBI would be less concerned when looking at the monetary policy as the CPI effect would be less bothersome and the WPI effect not really relevant from the point of view of monetary policy.

Oil is also important for the government on both the revenue and expenditure side. On the expenditure side, the subsidy level gets impacted and with the present targeted amount of Rs 37,000 crore, there would be an upside risk in case crude oil price remains high for a prolonged period of time. Therefore, the FY21 budget would be watchful of this phenomenon as it would be drawn on the basis of an assumption of crude oil price, which if higher than $65/barrel will enter the budgetary numbers. A higher provision has to be made in case the government is keen to not let market prices increase for these products.

On the other side, the higher crude price is good for the government as there is a lot of revenue to be earned. The effective duty/taxes levied on petrol works out to almost 100% while that on diesel is between 65-70%. These duties are outside the ambit of the GST, and consciously so, as there is a lot of revenue to be earned by the government. In FY19, the central government earned around Rs 3 lakh crore and the state government around Rs 2.3 lakh crore. Clearly, such revenue would end in case these products came under the GST, as the highest slab is 28%, which is much below what is being levied today.

In fact, even if the rate is fixed at say 67% for both the products, this would not work well with the government as the ad valorem rate would mean lower collections in case crude oil prices declined. Therefore, there is an incentive to keep these products out of the purview of GST. It has always been defended on grounds that these products are essential to the consumption basket of the common man, though diesel does enter the transportation costs of goods that are finally passed on.

The other direct impact is on the trade deficit. Crude oil has progressively become less important in the Indian trade basket with this share now being less than 30%. This is so because of various factors. There has been a movement towards alternative fuels which, though marginal today, would expand. CNG has already caught on for vehicles in some metro cities. Second, the slowdown in the economy has meant that there is less demand for fuels, which is getting reflected in the declining share in the import basket. Third, the lower demand for autos has meant that even in future there would not be exponential growth in consumption of oil products. Therefore, crude oil is not as potent a factor in distorting the trade balance, and hence, current account, and eventually the balance of payments position. The oil intensity of growth across the globe has been coming down, which in a way, is a threat to the future of countries that are fully dependent on oil.

With the impact on trade deficit unlikely to be very stark, the rupee should continue to move based on fundamentals which remain strong, mainly due to the strong capital flows witnessed so far this year. Therefore, the impact on the rupee should be muted to this extent. However, of late it has been observed that currencies move more due to sentiment and extraneous conditions, of which, the dollar as the pivot currency holds the clue. As long as the strife signals play out, the rupee would tend to get volatile, though a fair value of 71.5-72 to the dollar looks more likely once normalcy returns. However, of late, the dollar and its strength drives currencies, and as the US exercises power, there would be a tendency for the dollar to strengthen globally which results in currencies weakening across the globe. This can be expected in the coming days too.

The oil crisis comes at a time when the Indian economy is weathering a series of challenges. Stable oil prices were one of the assumptions of monetary policy, which focused more on core inflation. This will change as the price movement becomes more permanent in nature. Fiscal policy also has assumed stable prices within a range and would require some tweaking to factor in this new reality. Hence, this episode of crude oil prices will be watched quite closely by policy makers as the implications go beyond the political overtones that are currently pervading the headlines. The crux will be as to how long does this imbroglio last, and whether it would spread to other neighbouring nations too? Prima facie it looks like being more transient in nature, though one can never tell in such cases.

Author is Chief Economist, CARE Ratings
Views are personal

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via FinancialExpress

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