Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

India’s gains from lower oil prices at risk

Higher oil prices can affect government spending as well as private consumption

Even as the public discourse is largely focused on the economic impact of the ongoing currency exchange drive of the government, there is another important development that India needs be concerned about. The monetary policy statement of the Reserve Bank of India on Wednesday highlighted that crude oil prices may firm up in the coming months and could be a risk to the year-end inflation target. Oil prices touched a 16-month high on Monday and have gone up by about 15% since 29 November. Prices spiked after the Organization of the Petroleum Exporting Countries (Opec) on 30 November decided to cut production for the first time in eight years. It will reduce output by about 1.2 million barrels per day from January 2017. Non-Opec members, including Russia, are expected to cut production by another 600,000 barrels per day.

Opec oil deal: déjà vu?

The decision comes after two years of a supply glut and significant hardship in several oil export-dependent countries. For instance, while foreign exchange reserves of a country like Saudi Arabia have dwindled, Venezuela’s economy has virtually collapsed and it is facing severe shortage of essential commodities with high triple-digit inflation.

However, the real impact of the deal in the medium term will depend on how it is implemented and whether Opec is able to build on this agreement. Most analysts are of the view that oil prices will not sustain at higher levels because of multiple reasons. For one, global demand continues to remain weak and growth is unlikely to accelerate in the near term. Further, at higher levels, US shale oil production, which suffered because of lower prices, will once again become attractive. Also, Opec members have a tendency to cheat in order to take advantage of higher prices. Even if Opec is able to keep a watch on the production levels of its members, it will be difficult to track a non-member country like Russia.

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But what is perhaps important at this stage is the fact that Opec has actually managed to reach an agreement to cut production with the support of non-members. Until recently, Opec’s most influential member Saudi Arabia was not willing to reduce production as it didn’t want to lose market share to other producers. But a deteriorating economic situation seems to have forced a rethink. John Kemp of Reuters in a recent column highlighted another important reason behind the agreement. He noted that Saudi Arabia’s optimal strategy at this stage is to cut output and increase prices as most other Opec members are struggling to maintain current production, which limits the scope of cheating.

How things actually play out will be keenly watched all over the world. It is possible that Opec will at least be able to set a floor for oil prices—that means the days of oil at around $40 may be over for now. Some analysts who were predicting that prices will fall to $10 per barrel may have to revisit their assumptions and calculations.

India was a major gainer of the fall in crude oil prices as it depends on imports to cover over 75% of its requirement. While on the one hand, the low prices helped in containing the current account deficit and lowering inflation, on the other hand it augmented revenues—the government used the opportunity to impose higher taxes on petroleum products—which was instrumental in narrowing the fiscal deficit. In the last fiscal year, indirect tax revenue was estimated to have exceeded the target by over Rs54,000 crore. However, if oil prices sustain at present levels or manage to move up, some of those gains will be reversed. When oil prices were coming down in 2014, economists at Nomura estimated that every $10 fall in oil prices reduces inflation based on Wholesale Price Index and Consumer Price Index by 0.5 and 0.2 percentage points, respectively. The impact on current account deficit is 0.5% of the gross domestic product (GDP) and it improves fiscal balance by 0.1% of GDP. A price reversal is likely to have an opposite impact.

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If prices continue to rise, the government may have to roll back a part of the tax hike on petroleum products. This will adversely affect the fiscal math and the ability of the government to push capital expenditure. Private consumption could also get affected because of higher fuel bills. So higher oil prices can affect the two important drivers of economic growth—government spending and private consumption. Companies that benefited from lower oil prices may also see a margin erosion as passing higher input cost to the consumer could be difficult at this stage. In fact, oil prices have risen at a time when economic activity in India is expected to take a hit in the short run because of the ongoing currency crunch in the system. Higher oil prices will also widen the current account deficit while the rupee has been under pressure because of a strengthening dollar.

Although oil prices have not reached threatening levels, Indian policymakers will do well to prepare for the underlying shift in the way prices are determined.

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