Rising oil could derail economy next fiscal

India’s problems, both in terms of cost-push inflation and fiscal deficit, will begin once crude crosses $60 a barrel

While demonetisation still dominates most of the headlines, rising crude prices could prove to be the next policy headache.

The Organisation of Petroleum Exporting Countries (OPEC) struck a deal to cut output in late-November that subsequently included non-OPEC countries last week. In the past two weeks, the price of Brent crude has risen by some 20 per cent in dollar terms. Prices of the Indian crude oil basket – a blended benchmark most relevant to national consumption patterns – has risen by a still sharp 14 per cent.

Since January 2016, the climb has been more pronounced. Brent prices are up by 77 per cent from the January average of $30.80/barrel (bbl); the Indian basket price (IBP) is up a steep 80 per cent from a January average price of $28.28/bbl.

Risks are clear and present for India; rising prices threaten to become a major policy headache.

Early signs of pass-through

In the past two years, there have been clear benefits from low oil prices. Some of these are now under threat. Thankfully, pass through is not yet a grave concern. But the problem will become onerous indeed should prices rise above $60/bbl.

Retail fuel prices did not decline in tandem with the fall in global oil prices. Two key fiscal measures were responsible for this gap: a) fuel excise duties were imposed to lift indirect tax collections; b) subsidies on petrol and diesel were lowered/removed.

On b), lower subsidies will shield the government’s balance sheet from volatile movements in global crude prices. But on a), fiscal revenues are at risk if the government is forced to consider a cut in fuel excise duties due to a rally in oil prices. A sharp jump in excise collections has helped indirect tax collections assume an important role in overall revenues. Any risk to revenues and subsequent threat to the fiscal deficit target at 3.5 per cent of GDP would require deeper spending cuts.

Secondly, the impact on inflation needs to be monitored. Admittedly, the direct impact of crude prices on CPI inflation is modest given the high weight of food and non-tradable products in the CPI. Fuel inflation has been relatively stable this year, due to a mix of subsidised and non-subsidised items. By contrast, the more responsive transport inflation quickened in November 16.

Despite this, headline inflation eased to a two-year low in November 16. This is because of a sharp correction in the heavily-weighted food prices, which overshadowed the upward move in fuel costs. This could of course reverse if firming commodity prices are accompanied by a renewed upturn in food prices and demand-led forces next year, narrowing the central bank’s scope for further rate cuts. The RBI alluded to this risk at its recent review.

Thirdly, for growth, low crude prices were a positive growth impetus through higher discretionary incomes for households and lower input costs for manufacturers and farmers. Part of this benefit is likely to be eroded as retail fuel costs rise. For corporates, expansion in gross margins due to falling commodity prices is also likely to wane, pressuring profitability.

Finally, high oil prices imply wider external deficits. The oil import bill grew by 50 per cent between October 16 and April 16. This led to a doubling in the trade deficit. This deterioration, coupled with weaker service receipts caused the Q3 current account deficit to widen to 0.6 per cent of GDP from 0.1 per cent in Q2. We have been expecting the full-year current account deficit to improve in FY17. Higher oil prices could bring a sharp U-turn in FY18.

Attention needed

In all, rising oil prices warrant close attention. India’s macro fundamentals have improved significantly, thanks to a combination of ‘good policy’ (reforms, fiscal consolidation) and ‘good luck’ by way of low commodity prices and accommodative global central banks.

With the US Fed now set to embark on rate normalisation, foreign portfolio inflows are likely to slow, weighing on the currency and interest rates. A concurrent rise in commodity prices could raise this pain further. The favourable external environment that supported the economy in recent years is fading.

The writer is an economist and vice-president of DBS Bank, Singapore

Published on December 16, 2016

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