How worrisome is the Iran-Israel conflict?
UNCERTAIN TIMES. The impact on the economy may not be severe, but markets may turn volatile
The Ukraine war had a major impact on the world economy through the route of commodity prices. Starting from February 2022, there was turmoil in commodity prices as well as flow of trade as various embargoes on movement of goods and payments systems were imposed.
These disruptions were however ironed out by June-July; global commodity prices corrected and the global economy bounced back.
The Israel-Hamas conflict did raise the antenna once again as countries went back to the drawing board to guess the future of the oil economy. Not surprisingly there was not much of an impact as neither Israel nor Palestine had a presence in the oil economy. More importantly the Arab nations did not take any sides.
The recent attack of Iran on Israel has once again brought to the fore the possibility of economic disruption. If a war erupts, some countries in the region would ally with Iran, even as the West has condemned the attack of Israel while clearly staying out of the conflict.
Iran is dierent from Palestine as it has control over the shipping routes which can disrupt trade. Costs will go up once alternative routes are taken. Besides it also has a share of around 4 per cent in total oil production which can upset this market unless OPEC decides to counter any disruption in supplies. This is where, we in India need to be concerned.
INFLATION IMPACT
Currently, in India inflation seems to be under control. The conjectures today are not on whether prices will rise, though the monsoon concerns remain. But it is more about when the RBI will decide to cut rates as inflation is trending downwards.
Now, a disruption in the oil economy can create problems for us. While it is true that almost a third of our oil imports are from Russia, which is cheaper, any increase in the benchmark Brent price will spook even the lower prices from Russia. The dierence between the Russian price and the global average import price has come down from 8-10 per cent to 3-4 per cent over time.
The impact of higher crude oil prices can be looked at from the point of view of both the WPI and CPI indices. An impact cannot be avoided, as long as we import oil. The CPI is still within the government’s control as prices are administered for fuel for retail consumers.
Crude oil and its products have a weight of around 7.7 per cent in the WPI. Intuitively it can be seen that 10 per cent increase in crude oil price can lead to a direct inflation impact of 0.7-0.8 per cent.
To this one can add another 0.4 per cent which would be the indirect impact as prices of other goods also move up especially transport, fertilisers, chemicals, services etc. Therefore, in the worst case scenario, the impact can be closer to 1-1.2 per cent if there is 10 per cent across the board increase in prices.
In case of the CPI, the direct impact would be around 0.3-0.4 per cent if the government decides to increase fuel prices. So far, the policy followed has been that when the crude p—rices are low, the oil marketing companies make a gain with unchanged retail prices and the government charges a windfall tax. Here the consumer subsidises the government and OMCs.
On the other side when crude oil prices increase, the losses are absorbed by OMCs. Therefore, it is possible to say that the WPI will be aected more than the CPI.
The higher crude price will have a bearing on imports and based on the imports in FY24, the bill can go up by $15-20 billion if all other variables remain unchanged. The counter-balancing eect would come from exports, where the petro-products would fetch a higher price with crude prices up by 10 per cent. Based on FY24 exports, the gain could be up to $8 billion.
Thus on balance the trade deficit will widen by $7-12 billion. This will not have a significant bearing on balance of payments considering that FPI flows are expected to be higher this year due to the flows into G-Secs following the inclusion of our bonds in the global bond indices.
RUPEE WORRIES
However, what will be a concern is the exchange rate. The rupee was stable until the Iranian attack and the consensus was that it was expected to be in the range of ₹82.50-83.50/$.
However, post the attack, there has been considerable volatility in the currency with the RBI also intervening. The rupee had crossed the mark of ₹83.50/$ in the week following the attack.
The possible escalation of the war would make the Federal Reserve defensive on cutting rates. Markets are already assuming that the first rate cut will be delayed beyond June.
The Federal Reserve will not take any chances of lowering the rate when the possibility of prices spiralling are still high. This has interestingly also spooked the domestic 10-year yield to the 7.20 per cent region from the 7.04-7.06 per cent range.
Therefore, the bond market too has felt the reverberations of the conflict and will be edgy until there is more clarity.
What can be concluded based on similar episodes in the recent past is that while there would probably not be any deep lasting impact on economies, markets would turn volatile. Starting from commodity markets where crude oil spikes, there would be similar trends in gold as it becomes a preferred investment during times of turbulence.
Bond yields would move up in consonance and currencies will get choppier as there is continuous realignment with the new price structures as well as the movement of the dollar — which can strengthen as long as the Fed defers its rate cut plans. All this will mean that the central bank has to be alert all the time.
The writer is Chief Economist, Bank of Baroda, Views expressed are personal