The surge in oil price and Indian economy

The biggest economic impact of oil is on the fiscal deficit and current account deficit. Moreover, oil and fuel constitute a key component of CPI basket so higher oil prices would mean higher inflation.

Sep 17, 2019 10:09 IST India Infoline News Service

Over the weekend Indian markets celebrated the likely impact of the FM’s reforms package for housing and exports. However, things did take a nasty turn over the weekend. Houthi rebels allegedly carried out drone attacks on key facilities of Saudi Aramco. Not surprisingly, Brent Crude recorded the sharpest single-day gain since 1991 after Saudi Arabia announced plans to cut 50% of its output. While the impact was felt across the world, the cuts in India were deep.
 
India annual crude import volumes and crude import value since 2008 financial crisis
India annual crude import volumes
Data Source: Ministry of Commerce

As the chart above depicts India’s oil import volumes have grown from about 125 million tonnes to 225 million tonnes since 2008. However, during the same period, the oil import bill has gone up by 3.5 times. In fact, between 2016 and 2019, the oil import bill has more than doubled and the rupee import bill in 2019 is more than in 2014, although oil prices have actually halved. That is explained by the sharply higher incidence of customs duties imposed by the government. It is essential to understand this set-up because it means that any rise in oil prices will be passed on to the customer.
 
How oil impacts the twin deficits?
The biggest economic impact of oil is on the fiscal deficit and current account deficit. Both are likely to be adversely impacted.  From a fiscal deficit point of view, higher oil prices limit the government leeway to extract revenues out of oil. From a current account deficit perspective, an increase of $10/bbl increases the CAD by 50-60 bps. That is because the trade deficit gets back to above the $17 billion per month mark. Fall in oil prices contributed to lower fiscal deficit in 2014 and 2016 triggering off a major bull market rally.
 
Oil price spike and inflation
Oil and fuel constitute a key component of CPI basket so higher oil prices would mean higher inflation. For August 2019, CPI inflation is already at 3.21% and the inflation impact is estimated at 10-12 bps for every $10 rise in crude. That means the effective inflation would be closer to 3.35% and that leaves just 65 bps leeway for the RBI comfort zone of 4% inflation. This could also make the RBI wary of rate cuts, despite tepid IIP.
 
Oil spike and the rupee impact
If you have seen sharp spikes in oil prices in late 2018, you would have noticed that the rupee also weakens simultaneously. That is because, a sharp spike in oil (as we saw on Monday) makes the rupee extremely vulnerable. Not only the trade deficit and the CAD will be higher and weaken the rupee, but higher oil prices also makes importers and foreign currency borrowers rush for forward cover. That creates a sudden spike in demand for dollar and weakens the rupee.
 
How is oil likely to impact equities?
There are a number of ways oil impacts equities. Firstly, sharply higher oil prices mean that inflation goes up and that is generally negative for equities as a whole. Secondly, there are a number of specific sectors like tyres, paints, oil marketing companies, etc. that use crude oil as inputs. For them it means compression of margins due to higher input costs. Thirdly, demand for automobiles, transport services are all dependent on oil prices and a spike in oil prices could further dent demand. Auto demand has fallen over 30% consistently on a monthly basis and could exacerbate with the spike in oil prices.
 
Does oil really impact interest rates?
There may not be a direct impact but there is an indirect impact of oil on interest rates. For example, higher oil prices mean higher inflation and that would push up bond yields, hinting at RBI going slow on rate cuts. Secondly, real interest rates would come down. In the last few years, India has attracted global bond investors due to its high real rates. Spike in oil prices could mean either FPI outflows or higher rates to compensate. Quite often, the RBI has also used repo rate hikes as a strategy to protect the rupee when oil spikes.
 
In a nutshell, the spike in oil could hit a number of macros negatively. The hope is that stockpiles and global economic weakness will keep a lid on crude prices.

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