Oil and macro economy
Considering the elevated crude prices and the strong unfavourable base effect, retail inflation in June 2018 is likely to breach the RBI's revised inflation projection of 4.8-4.9 per cent in first half of FY19
While the Indian economy was recovering from the twin shocks of demonetisation and the Goods and Services Tax roll-out, a combination of an elevated crude oil price and a weak rupee has given rise to jitters in the Indian economy. A rising crude oil price since mid-2017 and a sharp increase since April 2018 have again brought to the fore the vulnerability of the Indian economy with regard to oil imports. The situation is amplified due to a slowdown of capital inflows in the economy, originating from the strength of the US dollar and an increase in global interest rates. Higher current account deficit and lower capital inflows are affecting the value of the Indian rupee. Oil is a major commodity that affects current account deficit and currency value. Oil deficit increased to USD70.2 billion in FY18 from USD55.5 billion in FY17; the proportion of the increase in the oil deficit was 30.3 per cent of the increase in the trade deficit between FY17 and FY18.
The Indian rupee was one of the bestperforming emerging market currencies in FY18. It appreciated to 64.45/USD in FY18 from 67.07/USD in FY17. However, with the crude price strengthening and capital flows dwindling, the Indian rupee is one of the worst-performing emerging market currencies in 2018. This is similar to the situation in 2013 when taper tantrums triggered by the US Fed’s decision to wind down its bondbuying programme led to a sudden, sharp depreciation of the Indian rupee. During 2013, a free-fall of the Indian rupee also resulted in India’s inclusion in the club of Fragile 5, along with Brazil, Turkey, South Africa and Indonesia. However, India’s current macroeconomic environment is far more robust than it was in 2013. While GDP growth and foreign currency assets are higher, current account deficit, retail inflation, interest rate and fiscal deficit are lower.
The major reasons for the increase in crude prices in 2018 have been supply shortage and higher demand. The oil price situation is delicately placed. A higher crude oil price brings in shale oil in the oil supply position, indicating shale oil has the potential to increase global oil supply. The US’ oil production increased to 10.47 million barrel per day (mbpd) in March 2018 (December 2017: 10.0 mbpd) and rig count increased to 825 on 27 April 2018 (748). However, it failed to rein in the sharp increase in the global crude prices. Moreover, a gradual decline in the US stockpile of crude since March 2017 and of petroleum products since August 2017 has kept oil prices at elevated levels. Moreover, sustained high crude prices are not in the best interest of oil-producing countries, as they can jeopardise the global economic recovery, leading to declined oil demand and, thus, reducing oil prices.
Opec and non-Opec countries decided to increase crude production by 1 mbpd. It is unlikely that the proposed increase in the global oil supply would have any meaningful impact on prices until production-related issues in Venezuela, Libya, Mexico and Iran are resolved. A lot will depend on the US, on one hand, and Iran and China, on the other. If China decides to replace the US by Iran as its source of crude oil supply, Iran’s oil production will remain in the global supply situation. This would impact crude oil prices. Nonetheless, higher crude oil prices and strong demand for petroleum products have the potential to derail the Indian economic recovery, albeit to a lesser extent compared with that in the past.
The value of a currency depends on several factors, ranging from macro fundamentals (growth, inflation, deficit and others) to capital flows, and global liquidity and interest rates. Under ceteris paribus conditions, the value of a currency responds to relative growth (proxy of productivity) and relative inflation (purchasing power). The value of currency also depends on the sufficiency of capital inflows to fund current account. Capital inflows in excess of current account add to foreign currency assets and provide an appreciating bias to the currency. Within capital inflows, a larger proportion of nondebt-creating capital inflows will also give an appreciating bias. Within non-debtcreating capital inflows, a higher share of foreign direct investment compared with the portfolio investment will provide support to the currency. The prevailing situations point towards lower capital inflows (due to flight to safety and all emerging markets are experiencing this), a wobbly fiscal situation and a higher current account deficit due to high crude oil prices. All these factors would lead to the average value of the Indian rupee to depreciate 4 per cent to ~67/USD in FY19 (FY18: ~64.45/USD). During the last episode of the Indian rupee depreciation, India had mobilised NRI deposits to provide support to the currency. This was mainly responsible for the value of the Indian rupee appreciating to ~60.10/USD at end-March 2014 from ~68.34/USD as on 28 August 2013.
Petroleum products have a weight of 4.41722 in retail prices. Considering the elevated crude prices and the strong unfavourable base effect, retail inflation in June 2018 is likely to breach the Reserve Bank of India’s (RBI) revised inflation projection of 4.8-4.9 per cent in 1HFY19. However, the unfavourable base effect will start waning from July 2018. The evolving crude oil price scenario and the waning of the base effect are likely to result in the average retail price inflation for FY19 at 4.6 per cent (FY18: 3.7 per cent).
A sequential decline in the high-frequency data (index of industrial production, vehicle sales and air traffic), and a hardening of interest rates in the Indian economy will have an impact on the decision of the Monetary Policy Committee. The probability of another rate hike during the remainder of FY19 is high, while the probability of a rate hike in the August 2018 policy review is low.
The Central and state governments’ fiscal performance depends largely on revenue earned from the production and sale of petroleum products. The oil sector contributed 15.5 per cent to the gross tax revenue of the central government and 16.6 per cent to the states’ own tax revenue during FY12-FY17. Excise duty collected by central government was 62.2 per cent of central government’s total tax collection from oil sector. While central excise on petroleum products is specific in nature, the value added tax (VAT) levied by state governments is ad-valorem. Both central and state government’s collection from oil sector has increased significantly during FY12-FY17; they have grown faster for central government than state governments. While the central government has reduced excise on petroleum products (petrol and diesel) in October 2017, only four states — Maharashtra, Gujarat, Madhya Pradesh and Himachal Pradesh reduced VAT on petrol and diesel.