It has become increasingly important to study the oil-macroeconomic dynamics in the context of developing nations, especially India, due to three-fold reasons:
India is one of the countries that are being projected for fastest growth in fuel consumption corresponding to their growth in GDP.
Given the drastic policy change in India with the deregulation of oil pricing, it is critical to understand the impact of oil price shocks on economic and investment activities in the country; and
Oil constitutes more than one-third of the total imports value in India so according to Nomura estimates, every $10/bbl. rise in oil price would reduce gross domestic product (GDP) growth by around 0.2 percentage point, widen the current account deficit by 0.4 per cent of GDP, widen the fiscal deficit by 0.1 per cent of GDP and add around 30 basis points (bp) to headline CPI inflation, Nomura said in its research note.
The international crude prices increased by around 12 per cent between April and September 2018. The mid-year spike in crude prices happened mainly due to spurt in demand, on the back of global growth revival, and partly due to geopolitical risks that led to supply-side shocks. This increase in crude prices was a big concern for all oil-importing countries, as their terms of trade showed signs of deterioration after a favourable stint since 2014. The Federal Reserve balance sheet normalisation has further added to the external sector vulnerability of these countries by putting pressure on their currency.
Since mid-November 2018, the crude prices have declined significantly but they remain volatile. Against this backdrop, we analyse the impact of a crude price shock on India as it is heavily dependent on oil imports for satisfying its domestic demand. We quantify the impact of crude shock on current account deficit (CAD), inflation and fiscal situation. A high crude price directly maps into a high trade deficit and in turn a high CAD. At the same time, being an important input for the aggregate economy, a crude price shock also leads to a spike in domestic inflation.
The volume of crude imports has been rising steadily at around 4.5 percent per annum for India. In value terms, crude is the single largest import contributor and has consistently accounted for more than 20 per cent of India’s imports basket. Since India imports most of its crude, it remains susceptible to global crude price shocks.
The silver lining in crude imports is that currently around one-third of these imports are re-exported after refining and other value addition. There is a complete pass-through of raw crude prices into re-exports as the demand for these exports is also inelastic. Combining the above stylized facts gives us the following trade deficit equation on account of oil:
In the worst-case scenario, when crude prices hit USD 85/barrel the deficit on account of oil balloons to USD 106.4 billion, which is 3.61 per cent of India’s GDP. So, we can infer from that every USD 10/barrel increase in crude prices leads to an additional USD 12.5 billion deficit, which is roughly 43 bps of India’s GDP. So, every USD 10/barrel increase in crude price will shoot up the CAD/GDP ratio by 43 bps.
Given the vulnerability of India’s CAD on account of global crude prices, to check whether a high GDP growth can partially cushion the adverse impact of oil price shock we look at changes in CAD/GDP ratio with respect to nominal GDP growth and find that a 100 bps increase in GDP growth rate can only shave off 2 bps in CAD/GDP ratio as shown in Figure 1 below:
To summarise, India’s external sector remains highly vulnerable to global crude price movements and it will continue to remain so in the near future.
A rise in global crude prices will increase the domestic price of crude products and increase domestic inflation as stated by Bhattacharya and Bhattacharya (2001). This impact of crude on consumer price index (CPI) comes from two channels. First, the direct channel where crude products themselves appear as constituents in the CPI. In the short run, a change in prices of crude products will affect the CPI directly due to their weighted contribution in the index. Second, over time the retail prices of all other commodities manufactured using crude as an input will also increase due to this shock and in turn affect the CPI again, which is the indirect effect. The net impact of the crude price increase on inflation is thus given by the sum of both direct and indirect effects.
The impact of an increase in crude prices on fiscal deficit would depend on several factors that include
(a) pass-through of international prices to pump prices,
(b) excise and custom duty, and
(c) petroleum subsidy (budgeted around 0.14 of GDP for FY-19).
So far, the present government has passed on the increase in international crude prices to domestic pump prices. However, going forward, if the government decides to absorb a part of the same, it could have an impact on the budget deficit.
Furthermore, in light of rising crude prices, India's petroleum subsidies are another matter of concern. According to Moody's, the surge in prices could result in India's petroleum subsidies increasing to INR 530 billion ($7.7 billion). But the Indian government budget only makes a cost allocation of INR 245 billion ($3.6 billion) in the current fiscal year. So, the effects of oil shock in Indian economy has been vividly discussed.
As India is redeveloping, its energy needs are growing at an exponential rate. This dependency on oil means that, theoretically, oil price fluctuations are bound to have far-reaching and intense impact on the Indian economy. We can suggest that the maximum impact of oil price fluctuations is felt on the price level and net exports. Given India’s high dependence on oil imports, India faces the impact of imported inflation, which is the general price level rise in a country because of rise in prices of imported commodities as stated by Kumar. R. (2013). For an expanding economy like India, such vulnerability to oil price shocks is not sustainable and thus it becomes crucial to come up with efforts to expedite the process of exploring domestic avenues and diversify its sources of oil supply. Further, there is an urgent need for development of non-conventional (including renewable) sources as a substitute for conventional sources to meet the energy needs. Energy subsidy reforms along with regulations, standards, and targets directing the efficient level of utilization of oil as a fuel are important to reduce dependence on oil imports. This applies to developed and developing nations alike.
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