India, the world’s seventh-largest economy, was a key beneficiary of falling crude oil prices between 2013 and 2015. An analysis by this newspaper, more than a year ago, had indicated that almost the entire reduction of about 0.6% of the gross domestic product (GDP) in India’s fiscal deficit between FY14 and FY16 could be attributed to the sharp fall in crude prices. Lower crude prices also contributed to the narrower current account deficit. The biggest benefit of the fall in oil prices was evident in narrower twin deficits. Since the pass-through of the fall in crude prices to retail consumers was limited (the government retained a large part of the benefits by hiking excise duty on retail fuel products), the direct impact on inflation—measured by consumer price index (CPI)—was muted.
Things, however, started reversing about two years ago and have gathered pace in the past few months. As against an average price of $46.2/barrel for the Indian basket of crude oil in FY16, it rose to $56.4/barrel in FY18 and averaged $65/barrel in the fourth quarter of FY18. With the US’ decision to walk away from the Iran nuclear deal and to re-impose sanctions on Iran, upside risks to crude prices cannot be ruled out. It is then worth understanding the impact of higher crude prices on the Indian economy.
In short, one could safely conclude that higher crude prices will adversely affect the twin deficits—fiscal and current account deficit—of the economy, which will have spillover impact on the monetary policy, and consumption and investment behaviour in the economy. However, before we talk about the impact in numbers, it is important to address one tricky question: “what is driving higher crude prices?"
The question is relevant because the factors leading to change in prices will decide the sustainability of the higher prices.
If the rise can be attributed to demand-side factors, it is not necessarily adverse for economic activity or financial markets. The higher crude oil imports bill could be offset by higher oil and non-oil exports (and of course, remittances). Similarly, better domestic economic activity could help meet fiscal deficit targets. However, if oil prices are pushed up by supply factors, it would be concerning.
According to the recent World Economic Outlook (WEO) by the International Monetary Fund (IMF), roughly 80% of the recent oil price increase was caused by deterioration in supply conditions (particularly faster-than-expected deterioration in Venezuelan output). This, however, is not the only study on the factors leading to higher crude prices. The “Oil Price Dynamics" report published by the Federal Reserve Bank of New York finds that less than two-fifth of the rise in oil prices since the beginning of 2018 was on account of supply-side factors. These contrasting studies lead to uncertainty regarding the sustainability of higher crude prices.
Not surprisingly then, the majority of the forecasts for oil price remain at $65-70/barrel. An increase of 15-25% in oil prices in one year will impact the Indian economy in various ways.
Impact on fiscal math
As a rule of the thumb, an increase of $10 per barrel in crude prices will lead to an increase of about Rs17,000 crore (or $2.5 billion at an exchange rate of 67/$) in fuel subsidies, equivalent to 0.09% of GDP. In the Union Budget 2018-19, the government had budgeted for petroleum subsidy of Rs25,000 crore, similar to that in FY18.
Our calculations, however, suggest that fuel subsidy could be as high as Rs54,000 crore if crude price averages $65/barrel in FY19. Additionally, a cut of Re1 in excise duty for both petrol and diesel will lead to an annual revenue loss of Rs12,000-13,000 crore (or 0.065% of GDP). It remains to be seen if the excise duty cut can be resisted by the government, considering that the general election is less than a year away now.
Impact on current account deficit
As a rule of thumb, an increase of $10 per barrel in crude oil prices will lead to an adverse impact of $10-11 billion (or 0.4% of GDP) on current account deficit. There are two opposite forces at work in current account deficit. Higher oil prices will push the import bill higher; however, it will be partly offset by higher oil exports and better remittances. The latter will materialize, since more than half of India’s remittances are reported to be channelled through the Gulf countries, which are likely to witness better economic conditions with higher oil prices. If we talk in numbers, an increase of $10 per barrel in crude prices will push the merchandise imports bill up by about $20 billion, which will be partly offset by an increase of about $6 billion in oil exports and $3-4 billion in workers’ remittances.
Impact on inflation
With a weightage of only 2.4% in headline CPI, the adverse impact will entirely depend on the extent to which higher crude oil prices are passed on to the consumers. Considering the general election next year, it is difficult to envisage a significant hike in retail fuel prices, and thus, the direct impact on CPI inflation is likely to remain muted.
Overall, the windfall gains—in terms of lower subsidy and higher revenue for the government, and lower imports—from lower crude prices are behind us.
Nikhil Gupta is chief economist at Motilal Oswal Securities Ltd.
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