Windfall from oil prices is overstated

The massive 35% year-to-date decline in global crude oil prices to a five-year low of $70 a barrel has given additional impetus to the market, which has already been running on high octane. The general line of argument is familiar: lower crude price will reduce inflation, imports, oil subsidy, fiscal deficit and interest rates. This, in turn, is seen to boost corporate earnings and market rating. Underlying these presumption is an inverse correlation between crude prices and India’s gross domestic product (GDP) growth and corporate earnings. But the facts are quite the opposite!

Contrasting the general perception, the correlation of crude oil price (year-on-year, or YoY) with India’s real GDP growth and corporate earnings is predominantly positive. GDP growth and profits rise during periods of rising crude prices. Between 1997 and 2014, the correlation for GDP growth is in the region of 0.39-0.44. Also notable is the positive correlation (0.38-0.39) with respect to corporate operating profits excluding extraordinary income. Moreover, GDP growth declined to an average of 5.5% during FY98 and FY99, when average crude price declined 43% to $12 a barrel. Likewise, the 17.4% decline in crude price during FY02 to $23.2 a barrel saw GDP growth remaining a modest 4%. In contrast, industrial GDP growth expanded from a low of 4% to an average of 8.7% during FY04 to FY08, when crude price was compounding by 20% each year.

There can be several explanations for positive correlation. One, recent decline is triggered by growth concerns in Europe, Japan and China because causality runs from the growth to commodity prices. Two, the sharp decline in demand-supply ratio to below 100%. Three, a stronger US dollar is generally accompanied by weakening in crude, other commodity prices and emerging market currencies. Four, India growth cycle has stronger convergence with global cycle, especially Europe and lower commodity prices restricts government’s ability to support domestic growth. Hence, the cost advantage from lower commodity prices is outweighed by the impact of slowing global growth on the Indian economy. Given the strong linkage within the commodity basket, it will be parochial to consider the impact of crude price.

The common perception is that India is a net importer of commodities, especially crude and hence, a decline in commodity prices should result in savings in India. This may not be entirely true as a decline in global commodity prices, which has high positive correlation with global crude prices, will lower growth of both exports and imports. Hence, the decline in current account deficit may occur during times of lower commodity prices, predominantly due to lower growth. As per our estimates, a 10% decline in commodity prices (CRB commodity index) will result in export growth and import growth decelerating roughly by similar magnitude ~800 basis points (bps). If crude prices fall by 15% on average for FY15 (-2.5% YoY for April-October 2014), net savings on oil trade account would be merely $5.4 billion. Removal of restrictions on gold imports could easily offset these savings also.

Again, while it is true that the wholesale price index (WPI) inflation could decline by 70-80 bps for every 10% fall global crude prices, the fact that the decline in commodity prices is often accompanied by weakening in Indian rupee implies that the sobering impulse on domestic inflation can be counterbalanced if rupee weakens sharply.

Perhaps the biggest misconception is the windfall for fiscal management. In reality, the government loses substantially from lower commodity prices. A decline in crude price will decrease oil subsidy (0.7% of GDP). But, it will also reduce tax collections. The contribution of the petroleum sector to the exchequer of both government of India (GoI) and state governments is ₹ 3 trillion or ~3% of GDP, apportioned equally between the GoI and States. Hence, GoI’s earning from this sector has been higher than oil subsidy. Adverse fiscal implications of loss of tax revenue and dividend payouts by public sector oil companies can outweigh reduction in oil subsidy due to lower crude prices.

But what could be giving the finance minister sleepless nights is the implication for the overall tax collections. Declining global commodity prices seem to be behind the dismal 5% growth in gross tax collection and 3.5% in net tax revenue for GoI during the current financial year (FY15 April-October). Growth in gross tax collection of GoI has a 0.76 correlation with global commodity prices (International Monetary Fund non-fuel commodity index). Every 10% decline in global commodity prices results in 600 bps decline in gross tax collection. This translates into a growth of around 5%, much lower compared to the budgeted target of 18%.

The GoI hence, is in an unenviable position given its ambitious 4.1% (of GDP) fiscal deficit target for FY15. It is not surprising that it has been forced to announce a 10% cut in non-plan expenditure, thereby compromising on growth. This explains why GDP growth declines with lower commodity prices.

Dhananjay Sinha is head, Institutional Research, Emkay Global Financial Services.

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