India well insulated against oil price movements

26 June 2015

Weak growth, steep inflation and large external deficits made India highly vulnerable to the 2013 ‘taper tantrum’, which hit markets when the US Federal Reserve (the Fed) signalled the end to its quantitative easing programme.

But, starting in late 2013, Indian authorities took several steps to reduce the country’s vulnerabilities. In addition, the decisive victory achieved by the Bharatiya Janata Party (BJP) during the May 2014 parliamentary elections further buoyed overall sentiment.

 The current low global oil (and commodity) prices are unquestionably also proving positive for improving growth, containing inflation and moderating current account deficits; thereby contributing to a reversal in India’s economic and financial fortunes. India is no longer viewed as one of the world’s ‘fragile five’ economies. Instead, the country’s stronger fundamentals and higher foreign exchange reserves are compelling reasons for the international community to view India as distinct and separate from other major emerging market economies. Indeed, India is now well prepared to cope with potential increases in oil prices as well as any renewed financial market volatility.

Oil prices and external imbalances

The Indian rupee came under considerable pressure following the Fed announcement on 22 May 2013 which sparked the ‘taper tantrum’ period. This was due to the fact that the country was running a high current account deficit at 5.4% of GDP in the April-June quarter; largely on the back of a surge in gold imports. The country’s foreign exchange reserves fell to US$275.5 -billion that summer, their lowest level in three years. The authorities then took steps to control gold imports and succeeded in reducing the current account deficit to less than 2% of GDP in the fourth quarter of 2013. Both the current account and the level of foreign exchange reserves have since been on an improving trajectory.

The sharp reduction in the global price  of oil has had its largest and most readily discernible impact on India’s current account deficit. With net oil imports exceeding 70% of total demand, India is the fourth-largest importer of oil, after the US, China and Japan (US Energy Information Administration, International Energy Statistics and Short-Term Energy Outlook, June 2014). But thanks to the decline in oil prices, which began in July 2014 and accelerated through to March 2015,  net oil imports fell by an estimated 16% year-on-year for full year (FY2014-15) to US$85-billion. This decline in net oil imports helped limit the FY2014-15 current account balance to -1.0% of GDP.

Looking ahead, it is nearly impossible to forecast the evolution of oil prices in the next 12 to 24 months. Hence, we undertake a scenario analysis by averaging Brent crude oil prices per barrel over the next 12 months.

Our estimates of the FY2015-16 current account deficit under these four alternatives (see Table 1) show that the external imbalance will remain quite manageable. Even if oil prices were to average US$80 per barrel in 2015-16, India’s current account deficit would stay below 2% of GDP. In addition, the substantial build-up in international reserves that has been occurring since 2012-13 would also shield the country from shocks both from within and outside, at least for a period of time.



Finally, the surge in gold imports that led to a ballooning of the current account deficit in 2012-13 is unlikely to recur now that inflation has declined sharply, thereby removing the need to use gold as a hedge against inflation.

India is the fourth-largest importer of oil, after the US, China and Japan.

Oil prices and inflation

Oil prices are known to drive the wholesale price index (WPI) in India, but less so the consumer price index (CPI). Oil products have a weight of 14.9% in the WPI versus 6.8% in the CPI. The sharply lower oil prices have moved the WPI into negative territory for the past three months. CPI, which fell below 5% in November 2014, has inched up in recent months due to a pick-up in the prices of fruits and vegetables. A gradual rise in the price of oil to US$80 per barrel
in the next 12 months is unlikely to cause a meaningful increase in the CPI.

In any case, CPI has been on a declining trajectory since Raghuram Rajan was appointed governor of the Reserve Bank of India (RBI) in September 2013. This is largely because he raised the policy interest rate three times and promoted the CPI targeting regime. We take comfort in the fact that the government and the RBI have now agreed to a new monetary policy framework which will give Rajan the mandate to keep inflation under control. Barring a disastrous monsoon season, we expect inflation to remain well behaved. That may allow the RBI to cut the policy rate further, even if oil prices were to rise moderately from their current extra- ordinarily low level.

Oil prices and growth

In addition to high inflation, lack of robust growth was another factor that raised concerns about India’s creditworthiness before last year’s parliamentary elections. Following the resounding electoral win by the BJP, the new government has, in our opinion, started on a solid footing.

Already, the government is pushing reforms on these fronts:

• Reforms aimed at making labour markets more flexible;
• A new land acquisition bill to make it easier for companies to acquire land needed to start new businesses;
• Governance and regulatory reforms to increase the ease of doing business  in India;
• Improvements in food price management to soften the impact of adverse weather conditions on the CPI; and
• Tax reform to implement a General Sales Tax (GST). This would replace the current system in which the central government taxes production and states tax consumption.

The government is looking to implement a uniform GST on all sales, including property and financial services.

The resulting unification of the Indian market, together with proposed labour and land acquisition reforms, should accelerate growth, improve margins and increase corporate creditworthiness. Stable laws would also reduce uncertainty for corporations.

In addition to these reforms, growth is also receiving support from lower interest rates which the RBI has been able to push on account of declining inflation. Low oil prices have clearly played a role in driving down inflation, thereby opening up room for the Reserve Bank to cut the policy interest rate. There are now increasing signs of a revival in the investment cycle. An increased oil price, which would lead to a small rise in inflation, is unlikely to derail the economic recovery that is under way.