Fuel prices: government faces tough choices

Rising crude oil prices are making policy-makers jittery. Just when ground-level micro data showed signs of growth picking up, crude oil price started its uptrend. A sharp recovery was seen in passenger car sales, tractor and two-wheeler sales. Moreover, bank credit, railway traffic, industrial production, core sector, capital goods and construction growth also gained momentum by the start of the year. These indicated solid uptick in rural and urban consumption and strong cyclical recovery with better capacity utilisation.

However, the crude oil basket for India that had averaged around $64 per barrel during January to March 2018, started to rise steadily from April to reach $78 by May 22. The government 10-year bond yield rose in tandem by almost 0.5% during the same period, denoting negative sentiment. It is not surprising as India imports 82% of its total oil requirement and Brent crude oil makes up around 28% of India’s total imports.

A sustained increase in oil price is expected to have adverse macroeconomic implications — from growth, inflation and currency to fiscal deficit. India was in a sweet spot for the last few years with record low oil prices that created space for the Narendra Modi government to push tough reforms, cut oil subsidies and make petrol/diesel prices market-determined.

The question often asked is, whether this situation is similar to the one in mid-2013 when high oil prices exposed India’s macro vulnerabilities to such an extent that India was termed as the first “fallen angel” among the BRIC countries. However, the macro backdrop in India is quite different now. Inflation is less than half of the 10% average in 2013. Similarly, fiscal deficit is 3.5% of GDP in FY2017-18, compared to almost 5% in FY2012-13 and current account deficit was only 2% in December 2017, nowhere near the dangerous 6.8% seen five years back. Foreign reserves are also at an all-time high.

This does not mean that continued rise in oil prices would not hurt us. Most of the macro indicators are coming under stress. Both core and headline inflations are climbing up. Trade deficit, and hence current account deficit, has widened and will not be filled by FDI inflows anymore. Rupee is weakening. Globally, things have changed.

Rising interest rates and bond yields in US have reduced the attractiveness of borrowing cheap in the US and investing in higher-yielding assets like Indian bonds. The incentive now is for selling other assets and taking the money back to the US, strengthening the dollar. This will keep up pressure on the rupee.

India will, invariably, be part of the group of emerging economies at risk of facing selling pressure on foreign exchange and markets due to the twin deficits, fiscal and current account. Various estimates state that a $10 per barrel increase in oil price increases India’s consumer price inflation by 0.6-0.7%, wholesale price by 1.7%, worsens current account balance by 0.4% of GDP and reduces growth by 0.2-0.3%. So, this is not a time to be complacent.

Oil price is increasing for various reasons — supply cutbacks by the OPEC (Organisation of Petroleum Exporting Countries) and non-OPEC countries; geopolitical disruptions in Venezuela; fear of reduced supply from Iran after US President Donald Trump’s decision to scrap nuclear deal, along with higher-than-expected world demand.

None of our policy-makers anticipated oil prices to touch $80. It was expected that as soon as oil touches $65 per barrel, the costlier US shale oil and gas operations would be back online, cooling the market. This did not materialise as expected. Only an increase in supply can cool the oil market.

Policy-makers will be forced to take some tough decisions as high oil prices soften growth and push up inflation — an unacceptable combination. The RBI had already sent out mixed signals to the markets in April by their dovish policy statement and hawkish MPC minutes.

The consensus expectation now is a hawkish statement in June with rising odds of a rate hike. The market has now priced in a couple of rate hikes due to expected uptrend in inflation. Higher interest rates will not only shave off growth, but rising bond yields will also damage banks’ balance sheets further. The RBI will have difficulty balancing its prime mandate of inflation-targeting with that of maintaining financial stability.

Petro duties

On the other hand, the government has been earning huge tax revenues from petro products through excise duties as the sharp fall in oil prices in previous years was not passed on to the consumers. But with such rapid rise in crude oil prices, there are only two options for the government to cushion the consumers.

Either slash the excise duties or subsidise the oil companies to sell at a discount. According to government sources, a reduction of Rs 1 per litre of excise duty on fuel results in a revenue loss of Rs 13,000 crore annually. Whether it is lower tax revenues or higher subsidy expenditure, the impact will be seen on the fiscal deficit either way.

With general elections next year, there is precious little space for the government to manoeuvre. It can keep consumers happy by reducing excise duties and thereby worsening the fiscal deficit, or it can reintroduce oil price caps and reduce oil refiners’ profitability. On the other hand, it can maintain fiscal target by slashing capital expenditure, which will eventually hurt growth.

Any populist measures ahead of election will put macro-stability at risk. The lessons from 2013 must be fresh in policy-makers’ minds. As Joseph Stiglitz said, ‘Macroeconomic policy can never be devoid of politics: it involves fundamental trade-offs and affects different groups differently’.

(The author is a research scholar at the Indian Institute of Foreign Trade)