A dark oil cloud looms over India

Crude oil prices have sharply risen by almost 25 per cent in the past two months. There are several reasons for this. The latest anxiety could be due to the yet unknown impact of the purge in Saudi Arabia. Eleven members of the royal family, including the richest man in the world, four ministers and many prominent businessmen were taken into custody as part of an anti-corruption drive. The man behind this unexpectedly harsh and decisive action is the Crown Prince of Saudi Arabia. The outside world is still trying to understand the causes that led to this coup (of sorts), and the possible fallout. The Middle East even in the best of times has been a volatile region, with multiple, multi-dimensional conflicts, many of which are proxy battles between bigger powers of the world. Many of the present conflicts, whether in Syria, ISIS part of Iraq, Yemen or even Palestine are seen through the lens of rivalry between the large two powers, viz, Saudi Arabia and Iran. 

The USA which has big stakes in the Middle East, abruptly chose to take sides with the Saudis, against the Qataris. That is a completely new angle. This column is not about that regions’s geopolitics, but suffice to say, that the new Saudi development is causing oil prices to respond. In addition, there is the Venezuela factor. That oil producing country is on the brink of defaulting on its external debt obligation. Already the country has seen the rise of extreme poverty and malnutrition. It gets 90 per cent of its export revenues from oil.  So it, too, may be causing some blips in global oil prices.

Apart from conflict-disrupted supply, there are also demand factors. The Chinese economy, second largest in the world, is showing higher than expected growth. The IMF is projecting much stronger growth on both sides of the Atlantic. India, too, will grow at least 0.5 per cent higher than this year. All of this means that there will be demand pressure.

The sharp increase in oil will be watched with great anxiety in India. Back in June 2014, when Prime Minister Modi was sworn into office, oil prices were around 115 dollars a barrel (Brent crude). Within a few months, that fell to below 60 dollars, and stayed there for almost two years. The reasons for the sharp fall were four-fold. Firstly, big recession like slowdown in China. Remember this was around the time its growth rate fell below India? Secondly, the huge increase of oil output from America, thanks to the shale oil revolution. The USA became the largest oil and gas producer in the world, ahead of Saudi and Russia. Thirdly, we had increased output from troubled spots like Libya and Iraq. And fourthly, there was the breakdown of the informal cartel-like agreement among OPEC members. All these factors caused oil prices to crash and to stay low.

For the Indian economy, it was a bonanza. The benefit was between 1 to 1.5 per cent of GDP growth. The Modi government very cleverly divided this bonanza in three different ways.  Firstly, roughly a third of the fall in prices was used to keep inflation low. It was a great achievement to keep inflation below 5 per cent, after years of double digit inflation. Secondly, the lower oil prices meant lower oil subsidies. This saving was possibly more than Rs.50,000 crore. This of course gave relief to the fiscal deficit situation. The third angle was much of the oil savings were redirected as increased government spending on infrastructure and other growth initiatives.

Apart from these three ways, India’s current account deficit also came down sharply, since dollar outgo on oil imports reduced drastically. The lower CAD meant that the rupee gained strength. The stronger rupee and relatively higher interest rates attracted record foreign inflows. India’s stock of foreign exchange stands at 400 billion dollars, the highest ever. Foreign funds into India’s corporate bond market are at record highs of more than 2.5 trillion rupees. Thus, low oil prices lead to many virtuous cycles, and a string of sweet outcomes for imported oil-dependent India. And not to forget, the government deftly kept raising central excise duties on petrol and diesel, resulting in massive revenues, without much increase in retail prices at petrol pumps.

All this is likely to change as oil prices start climbing. Just as India did not cause the downward slide, similarly it is not responsible for the global spike in crude oil. But it is a vulnerable casualty. Firstly, the fiscal space will shrink, and oil subsidy burden will increase (even with substantial deregulation). Secondly, there will be an inflationary impact, possibly by as much as 0.5 per cent. Thirdly, the current account will expand, causing the rupee to weaken. Since the exchange rate was overvalued, some of this weakening may be welcome. Fourthly, with higher inflation, the scope for cuts in interest rates is gone.

Industrial credit growth is nearly zero, and needs to pick up. Lower rates would help. The bigger boost to private sector enthusiasm will come not from interest rate cuts, but from demand revival and signals from the upcoming budget. Hopefully the GST streamlining is helping.

Till the quarter ending June, we had seen six consecutive quarters of declining growth. After July, we hope to see a turnaround. That jump will be muted because of the impact of higher oil prices. India’s prospect for next year is closer to 7.5 per cent growth. But this prospect depends greatly on not-too-high oil prices, a market friendly budget, revival in private sector investments, unclogging of large projects stuck in the pipeline and lower taxes. The silver lining in the oil story is that beyond 65 dollars, the shale oil industry in the US becomes very viable and profitable. So shale output can be raised substantially at short notice. This overhang of extra supply can keep an upper limit on oil prices. India can also increase the “oil efficiency” of the economy, i.e. less oil per unit of GDP. This calls for process and energy efficiency and greater use of renewables. Dark oil clouds do carry some silver linings.

(The author is an economist and Senior Fellow, Takshashila Institution)