The negative correlation between global oil prices and Indian equities has for long been the basis of a profitable trade for hedge funds. The Indian stock market seems to have shrugged off this uncomfortable fact for now, rising to a two-year high even as global oil prices touched an 18-month high on Tuesday.
The tendency of the Indian economy to get hurt by rising crude oil prices is well documented. A 2004 study done by the International Energy Agency and the International Monetary Fund said that the vulnerability of an economy to an oil price shock depends on the degree of dependence on oil imports and its oil intensity. The result is lower growth, higher inflation and a wider current account deficit.
Illustration: Jayachandran / Mint
India carries a further risk. Consumers do not pay market prices for petroleum products and the losses that oil marketing companies make by selling at subsidized prices are met either directly from the government budget (in case cash is given out to the oil companies) or as an off-budget expense (when bonds are given instead of cash).
The Union Budget presented by finance minister Pranab Mukherjee on 26 February has bravely assumed that there will be no petroleum subsidy in fiscal 2011. That either means that domestic fuel prices will be increased each time there is an increase in global prices or the finance ministry believes that oil prices will remain around $80 a barrel through the rest of the fiscal year. This newspaper had, in a special series published in April, identified the oil wager as one of the big bets taken in the Union Budget and added that India could suffer in terms of a higher fiscal deficit and higher inflation in case this wager backfires.
Will it? It is hard to judge the direction of global oil prices. They are currently 160% above the low of $33.87 a barrel they touched in December 2008, but 40% below the peak of $147.27 a barrel they touched earlier that year. But there is reason to believe that global oil prices will trend upwards if the global economic recovery continues and Western central banks continue to keep interest rates low for some more time.
We are not yet anywhere near the situation we saw in the middle of 2008, when galloping oil prices (and the adamant refusal of the first Manmohan Singh regime to raise domestic oil prices) had wrecked the government budget and widened the current account deficit. Along with runaway asset prices and a credit bubble, these were mild signs of an overheated economy.
But that does not mean that we should not watch oil prices very closely.
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