Moody's may have improved, but oil can spoil the party

The market celebrated India's rating upgrade by Moody's from Baa3 to Baa2 with stable outlook and the Sensex climbed 235 points the same day. The rating upgrade, after 13 long years, was prompted by continuous economic reforms that are expected to raise India's potential growth and lower government debt burden over the medium term. However, the same market was jittery prior to this as crude oil price had started to nudge upwards. Indian crude oil basket has averaged at $60 per barrel in the first two weeks of November, after remaining stable around $50 for most of 2017.

Crude oil price, which was at $100 a barrel when the Modi government came to power, crashed soon after, reaching as low as $30 per barrel by 2016. This gave the new government the required space to push politically tough reforms and cut subsidies on diesel and cooking gas. For a large oil importer like India, lower oil prices increased macro-stability. This sharp fall in international crude oil prices enabled the government to raise indirect taxes on petro-products nine times without hurting consumer sentiment. This resulted in a five-fold increase in taxes on diesel. Increased taxes on fuel products helped narrow the budget deficit through higher revenues.

An increase in oil price just when India is grappling with weak economic growth, immediately after demonetisation and a structural reform like GST, is not welcome news.   Last month, higher oil prices forced the government to cut indirect taxes on oil products that resulted in revenue loss.

India imports about 70% of its oil needs and a sustained increase in oil prices will have adverse macroeconomic implications - it will lower growth, push up inflation and widen both current account and fiscal deficit.

Due to oil subsidy cuts, any rise in crude cost will now directly punch through headline inflation much quicker than in the past, along with secondary impact in core inflation after a lag. The Consumer Price Index (CPI) has higher weightage of food and services. So, the rise in oil prices will directly impact about only 2% of CPI basket, comprising diesel and unregulated LPG segment and another 2% through Petrol in transport and communication subgroup of CPI. There will be further indirect impact through higher transportation or production cost. It is estimated that a $10 per barrel increase in crude price will push CPI inflation by about 0.5 to 0.6%.

On the other hand, WPI inflation will move up by about twice that amount due to higher weightage of around 7.3% of fuel in WPI basket in addition to other indirect impacts.

The central bank has been able to achieve its medium-term target of 4% CPI inflation ahead of time due to a virtuous cycle of inflation expectations, lower commodity prices, fiscal prudence and better food supply management by the government.
However, supply-side disruptions due to GST or narrowing of output gap on higher demand can add to inflation. In addition, if oil price, too, starts climbing, it will be a miracle if inflation does not move past 5%.  

Passing on benefits

The GST council has recently slashed tax rates on 210 items, of which about 178 items were in the highest tax bracket of 28%. This is expected to help soften inflation in coming months. However, we all know that prices are downward sticky. Prices of consumer goods and services do not easily come down. It will all depend on whether or not producers will pass through the rate cuts to the consumers.

There is hardly any policy space to accommodate an inflationary pressure. The Reserve Bank of India (RBI) will turn hawkish if the rise in oil prices feeds into core inflation and inflation expectations.  

The government might like to cushion consumers against price rise by reducing excise duties on petro-products. According to government sources, an excise duty reduction of Rs 1 per litre of fuel results in a revenue loss of Rs 13,000 crore annually. Any sharp rise might force the government to bring back the oil subsidy. Overall, this will translate to lower revenues, putting pressure on the fiscal deficit.

Moreover, the rising cost of crude oil will inflate our import bill and widen trade deficit. It is true that remittances to India from Gulf countries increase with higher oil prices but this rise will not be able to offset the rise in oil import cost. The net impact will be the worsening of the Current Account Deficit (CAD).    

We have already seen how the increase in imports shaved off about two percentage points from GDP in the first quarter. The growth will be impacted by other channels, too. Higher oil price will lower disposable incomes and hence private consumption. Increased input cost will squeeze corporate profitability, causing private investment to falter. According to RBI estimate, a $10/ barrel rise in oil price reduces our GDP growth by 0.15%.

India's fundamentals have improved significantly since 2013 to withstand this rise in oil price. However, with 14 elections coming up in the next 17 months, the government's commitment to reforms will be tested if oil prices hit $70 per barrel. On the other hand, if global growth and demand continue to be weak and OPEC fails to cut production, crude oil price may remain soft.

It is imperative for the government to ease out the constraints in the new indirect tax regime (GST) as soon as possible, for a seamless flow of input tax credit and reduction in compliance costs for SMEs. This will help enhance working capital and support the manufacturing sector. But it will be tricky for the government to handle higher oil prices and continue its reform agenda against the backdrop of upcoming elections.

(The writer is a research scholar at IIFT)