OIL PRICES - How vulnerable is India to high oil prices?

Higher global crude oil prices will adversely impact GDP growth rates, inflation, the fiscal deficit and the current account deficit, but the country's macroeconomic stability is unlikely to be threatened.

Rising oil prices since 1999, initially as a result of OPEC supply-management policies, and later due to geopolitical uncertainties, had driven the international crude oil prices to an unprecedented level. Though oil prices have fallen recently from their peak levels, a sudden spike, which could be caused as much by a disruption in oil supplies as by demand increases, cannot be ruled out. The geopolitical situation in west Asia may well change abruptly. Also, the International Energy Agency in its recent World Energy Outlook (2006) has stated that over 70 per cent of global primary energy demand in the future will come from developing countries, led by China and India. This means prices of oil and gas will have a crucial bearing on the prospects of these economies.

How much of a threat do high oil prices pose to the Indian economy? If we go by the performance over the last few years, then it is quite evident that high oil prices have had very little impact on the growth in the Indian economy. Is this indicative of the Indian economy’s resilience to withstand high oil prices? Perhaps, yes, so far. However, the prospect of the economy withstanding the impact of persistently high oil prices will depend how they behave in the future.

In order to test the vulnerability of the Indian economy to higher oil prices, we carried out a combination of statistical and simulation exercises to look at how different oil price outcomes (average price during the year) will impact the four macroeconomic indicators — growth rate, inflation rate, the fiscal deficit and the current account deficit. Taking a baseline scenario as an average annual price of $64 per barrel, we look at an optimistic scenario with $55 per barrel and pessimistic ones with $80 and $100 per barrel.

The statistical estimate of GDP with respect to the price of oil is a useful summary measure of the sensitivity of the economy to an increase in oil price. The estimates of the relationship between GDP and oil prices, however, depend to a degree on what oil price measure we use. Many studies simply use the international price of oil assuming full pass-through to the domestic economy — a method we know is not really applicable to the Indian economy. Therefore, in the four scenarios presented, we have not taken the international price of oil as such, but the pass-through of international oil prices to the domestic economy, which is reflected in the Wholesale Price Index (WPI) for mineral oil. Based on the mineral oil component of the WPI, we have estimated GDP growth under alternate oil price scenarios.

A hike in oil prices increases the production cost of goods and commodities as well as transportation costs. This increase in input costs is passed on to the consumers, who ultimately end up paying higher prices. In our exercise, we used elasticity measures to quantify the impact of higher oil prices on general WPI, and hence on inflation.

We have also simulated fiscal deficit scenarios using a model that takes into account the international oil prices and their impact on the government’s payment of subsidies, and tax collections through impacted GDP. The gap between international and domestic prices of cooking fuels is increasing due to stagnant domestic cooking fuel prices coupled with higher international oil prices. Therefore, it would adversely impact the government’s overall subsidy bill and hence the fiscal deficit. Beyond this, however, economic activity in general tends to slow down due to higher oil prices, and this will lead to a lower tax collection and hence a higher fiscal deficit. Thus, we see the fiscal deficit of the government impacted via two channels.

For a country like India, which is heavily dependent on imported oil, ceteris paribus, a substantial increase in the international crude oil price will also lead to an increase in the oil-import bill. However, the slowing down of GDP growth due to higher oil prices will have an offsetting impact on non-oil imports. Both these factors will determine the net effect on the current account balance. We have treated oil and non-oil imports separately to find out the impacts of higher international oil prices. For oil imports, an algebraic decomposition of oil import intensity of GDP has been made. Non-oil imports have been linked to the activity in the economy captured through impacted GDP following a change in international oil prices. These specifications allow us to generate potential current account scenarios.

Our analysis of the impact of high oil prices on the Indian economy reveals some interesting results. Under the most likely scenario (average basket price of around $64 per barrel during 2006-2007), our results show that GDP growth would be 8.3 per cent and inflation would be 5.0 per cent. The fiscal deficit as a percentage of GDP would settle at 3.9 per cent and the current account deficit is estimated to be around 1.0 per cent of potential GDP.

At the basket price of $55, the Indian economy is expected to experience GDP growth of 8.7 per cent. Our simulation shows that inflation would be around 4.2 per cent, and the fiscal deficit would become 3.9 per cent of the potential GDP. The current account deficit would come down to 0.2 per cent of India’s potential GDP.

If the price touches $80, GDP growth would drop to 7.8 per cent and the inflation would cross the 6.0 per cent mark. The fiscal deficit as a percentage of potential GDP would become 4.0 per cent. Thus, our analysis indicates that if the Indian basket touches $80/barrel, it is unlikely that the fiscal deficit target for 2006-2007 would be met. The current account deficit would rise to 2.6 per cent of potential GDP.

While $100/barrel now appears increasingly improbable, it does serve as a reasonable limiting case in the simulation exercise. Under this scenario, while the GDP growth would further shrink to 7.1 per cent, inflation would inch up to 7.7 per cent. The fiscal deficit/GDP ratio would further increase to 4.2 per cent due to both a reduction in tax revenues and the government’s additional expenditure to fund increase in subsidies. The current account deficit would bloat to 4.5 per cent of potential GDP. The significant deterioration in the current account deficit, combined with declining capital inflows because of slower growth, might push the economy to the brink of a balance of payments problem. But, as we have said, the probabilities are rather remote and within the bounds of realism, macroeconomic stability does not appear to be threatened by high or rising oil prices.

To sum up, higher global crude oil prices will adversely impact all parameters included in our analysis, but the economy appears remarkably resilient. On average, a $10/barrel price rise reduces GDP growth by around 35 basis points, increases inflation by 75 basis points and fiscal deficit/GDP and current account deficit/GDP ratio by around 7 and 97 basis points, respectively.

BS