The Impact of rise in fuel price on Indian Economy

A sudden surge of fuel price has raised the eyebrows of many of us. Ordinary citizens of India begin to chide and criticize the govt policies and oil companies deregulation strategy as they have to shoulder the maximum brunt in many ways. But the bottom line is we simply unaware of the facts and figures that are controlling the price of fossil fuels. So it is high time we must aware of the intricacies and delicacies of a hike of fuel price and its subsequent effect on the economy

Fuel means coal, gas or oil which burns to gives us energy or heat. But in the broader economic terms we are more concerned about crude oil; i.e. petrol or diesel. The recent rise in the prices of crude oil has drawn everyone’s attention towards the crucial role that oil plays in the economy of any nation. Crude oil is one of the most necessitated commodities in the world and India imports around 100 million tons of crude oil and other petroleum products. This, in turn, results in spending huge amounts of foreign exchange.

In the Indian Context

The increasing quantum of imports of petroleum products has a significant impact on the Indian economy, especially when crude oil prices are shooting up globally. Crude oil not only serves as a source of energy but also as a major raw material to various industries. With no major discoveries in recent years, the increasing costs of production have pushed up crude oil prices globally. Also, the high volatility in the prices of oil breaching the $100/barrel mark and rising to a high of $147/barrel could be attributed to the fact that in the recent years, many index funds have taken positions in commodities considering oil to be an asset stock in their portfolios. It has been usually observed that in India, the pricing scheme is designed in such a way that it offers a system to moderate the soaring international oil prices and thereby study the impact on growth, inflation, etc.

Reasons for the surge

There has been a sharp hike in the prices of petrol and diesel since the “dynamic” daily pricing model for these fuels was introduced in India. Before accepting the causes of the surge, we must know how the crude oil price is designed.

How is the Indian crude basket calculated?

• The Indian basket of crude oil basically represents a derived basket comprising Sour Grade and Sweet Grade of crude oil processed in Indian.
• Prices of petrol and diesel have both been made market-determined. Since then, the Public Sector Oil Marketing Companies (OMCs) are supposed to take appropriate decisions on the pricing of petrol and diesel. This is in line with international product prices and other market conditions such as the exchange rate and the demand-supply situation.
• In 2017, the new dynamic daily pricing was introduced.

What does dynamic daily pricing system mean?

• Dynamic daily pricing means the state retailers will reset the price of petrol and diesel each day, rather than wait for a fortnightly revision.
• On a broad view, this move will align the retail pricing of crude products in line with price changes in the international markets. This will bring transparency in the pricing of crude products.
• The companies will change the price of transport fuels every day based on crude price movements. Dynamic pricing is followed in many developed countries.
• We can say therefore say that the retail fuel prices are expected to be more aligned to market dynamics.

What is the positive impact of dynamic daily pricing system?

• This move is believed to crystallize the outlook for oil marketing companies marketing margin, or the difference between the cost of procurement and the price charged by retailer and therefore boost confidence over the overall sustainability of this broad deregulation initiative.
• The shorter time lag between crude purchase and products sales will collapse, thus allowing prices to reflect cost and avoid artificial distortions.
• It will enhance OMCs’ ability to pass the prices into the economy more effectively.
• Global experience shows that the current dynamic pricing of fuel has the potential to attract the participation of private players in fuel retailing and several downstream opportunities, thus exposing the downstream and marketing to best practices and modern technology in refining.
• A liberalized retailing regime may also expose the PSUs into an intensive competitive scenario.

What is the negative impact of dynamic daily pricing system?

• Consumers may be affected sometimes, especially if there is a major international event, like a war or riot. Then, the prices may fluctuate a lot. It can become expensive or cheap, depending on the nature of the incident.
• Prices of FMCG goods may also fluctuate dynamically. FMCG prices are directly related to fuel prices. Now, if the fuel prices suddenly increase, then there are chances that FMCG products pricing may also fluctuate, and sometimes daily.

What explains the divergence in the movements of the crude basket and of retail prices?

• With global crude oil prices plummeting to record lows when it took charge, the government resorted to a series of excise duty hikes in the second half of 2015 and the initial months of 2016 on both petrol and diesel to help shore up finances.
• This has helped the Centre realize higher central excise duties primarily through the increased tax on petrol and diesel, which are still outside the ambit of GST.
• In India, the share of taxes in the retail selling prices of petrol and diesel (as on July 16) was 55.5% and 47.3% respectively, with central taxes (essentially excise duty) accounting for the bulk of it.

What other variables are involved?

• The price is determined not only by the movement of crude oil price (the main raw material), but also by the rupee/dollar exchange rate and the demand-supply situation in the market.
• While a deficit of the product leads to a rise in its price, an increase in supply will lead to a decrease.
• Over the first nine months of the calendar year 2017, the global crude oil price for the Indian basket fell by 0.44% while the price of petrol (in Delhi) came down by 0.3%.
• This is despite the fact that the rupee strengthened against the dollar by nearly 7%, something that would have translated into sharply cheaper imported oil.

How has the government justified the excise hikes?

• The government has defended the higher duty and said that increased revenue was going into welfare activities of building more roads and providing irrigation and drinking water facilities.
• Government has said that oil companies would continue to have pricing freedom.
• The government says that one part of the fall in oil prices as a part of proper economic and fiscal planning goes to the consumer.
• The second part is going to developmental activities, particularly national highways and rural roads, because those who consume petrol and diesel drive vehicles on these roads, and they must pay for it.
• The third part is consumed by the states by way of VAT.
• Of what the central government gets, 42% is being passed on to the states.
• And for the fourth and final part, it goes to the oil companies for the reason that when oil companies make international purchases against future purchases, they suffer a huge loss.

Why the prices have increased/Causes

• Variation in supply
• Stronger dollar
• Import-dependent
• Sanctions on Iran

Oil and Iran

• India purchases 10% of its requirement from Iran
• It is also 3rd largest supplier to India
• It provides a credit of 60 days
• Iran supplies 2.4 MN barrels per day of crude to the international market
• The value of import bill for oil increased by 76% in July from a year earlier to $10.2 bn, which pushed up the trade deficit to more than $18 bn (the highest in five years). The increasing crude oil prices will ensure that the CAD will reach 2.6% of GDP in this financial year from 1.5% a year ago

According to the recent World Economic Outlook (WEO) by the IMF, roughly 80% of the recent oil price increase was caused by deterioration in supply conditions. This, however, is not the only study on the factors leading to higher crude prices.3. The “Oil Price Dynamics” report published by the Federal Reserve Bank of New York finds that less than two-fifths of the rise in oil prices since the beginning of 2018 was on account of supply-side factors.4These contrasting studies lead to uncertainty regarding the sustainability of higher crude prices

Impacts on Indian economy: The unbearable effects –

Impact on national income

According to RBI sources, for every unit dollar increase in crude oil price, WPI inflation rises by 30 basis points. India, the world’s seventh-largest economy, was a key beneficiary of falling crude oil prices between 2013 and 2015. An analysis by this newspaper, more than a year ago, had indicated that almost the entire reduction of about 0.6% of the gross domestic product (GDP) in India’s fiscal deficit between FY14 and FY16 could be attributed to the sharp fall in crude prices. Lower crude prices also contributed to the narrower current account deficit. The biggest benefit of the fall in oil prices was evident in narrower twin deficits. Since the pass-through of the fall in crude prices to retail consumers was limited (the government retained a large part of the benefits by hiking excise duty on retail fuel products), the direct impact on inflation—measured by consumer price index (CPI)—was muted.

Things, however, started reversing about two years ago and have gathered pace in the past few months. As against an average price of $46.2/barrel for the Indian basket of crude oil in FY16, it rose to $56.4/barrel in FY18 and averaged $65/barrel in the fourth quarter of FY18. With the US’ decision to walk away from the Iran nuclear deal and to re-impose sanctions on Iran, upside risks to crude prices cannot be ruled out. It is then worth understanding the impact of higher crude prices on the Indian economy.

In short, one could safely conclude that higher crude prices will adversely affect the twin deficits—fiscal and current account deficit—of the economy, which will have spillover impact on the monetary policy, and consumption and investment behavior in the economy. However, before we talk about the impact in numbers, it is important to address one tricky question: “what is driving higher crude prices?”

The question is relevant because the factors leading to change in prices will decide the sustainability of the higher prices.

If the rise can be attributed to demand-side factors, it is not necessarily adverse for economic activity or financial markets. The higher crude oil imports bill could be offset by higher oil and non-oil exports (and of course, remittances). Similarly, better domestic economic activity could help meet fiscal deficit targets. However, if oil prices are pushed up by supply factors, it would be concerning.

According to the recent World Economic Outlook (WEO) by the International Monetary Fund (IMF), roughly 80% of the recent oil price increase was caused by deterioration in supply conditions (particularly faster-than-expected deterioration in Venezuelan output). This, however, is not the only study on the factors leading to higher crude prices. The “Oil Price Dynamics” report published by the Federal Reserve Bank of New York finds that less than two-fifths of the rise in oil prices since the beginning of 2018 was on account of supply-side factors. These contrasting studies lead to uncertainty regarding the sustainability of higher crude prices.

Not surprisingly then, the majority of the forecasts for oil price remain at $65-70/barrel. An increase of 15-25% in oil prices in one year will impact the Indian economy in various ways.

Impact on fiscal math

As a rule of the thumb, an increase of $10 per barrel in crude prices will lead to an increase of about Rs17,000 crore (or $2.5 billion at an exchange rate of 67/$) in fuel subsidies, equivalent to 0.09% of GDP. In the Union Budget 2018-19, the government had budgeted for petroleum subsidy of Rs25,000 crore, similar to that in FY18.

Our calculations, however, suggest that fuel subsidy could be as high as Rs54,000 crore if crude price averages $65/barrel in FY19. Additionally, a cut of Re1 in excise duty for both petrol and diesel will lead to an annual revenue loss of Rs12,000-13,000 crore (or 0.065% of GDP). It remains to be seen if the excise duty cut can be resisted by the government, considering that the general election is less than a year away now.

Impact on current account deficit

As a rule of thumb, an increase of $10 per barrel in crude oil prices will lead to an adverse impact of $10-11 billion (or 0.4% of GDP) on current account deficit. There are two opposite forces at work in the current account deficit. Higher oil prices will push the import bill higher; however, it will be partly offset by higher oil exports and better remittances. The latter will materialize since more than half of India’s remittances are reported to be channeled through the Gulf countries, which are likely to witness better economic conditions with higher oil prices. If we talk in numbers, an increase of $10 per barrel in crude prices will push the merchandise imports to bill up by about $20 billion, which will be partly offset by an increase of about $6 billion in oil exports and $3-4 billion in workers’ remittances.

Impact on inflation

With a weightage of only 2.4% in headline CPI, the adverse impact will entirely depend on the extent to which higher crude oil prices are passed on to the consumers. Considering the general election next year, it is difficult to envisage a significant hike in retail fuel prices, and thus, the direct impact on CPI inflation is likely to remain muted.

Overall, the windfall gains—in terms of lower subsidy and higher revenue for the government, and lower imports—from lower crude prices are behind us.

Looking ahead

The soaring price of oil is having a major influence on India’s economy. India spends a lot of money financially supporting its citizens with fuel every year. Petrol in India is a lot cheaper than it should be. However, Oil firms in India are still buying oil at international market value. Therefore, Indian oil firms are hemorrhaging money at $100 million a day. There will be more difficulties faced if the price increases any further. It is understandable that the government is receiving complaints to raise the price of fuel by the oil companies but politically it is an unfavorable thing to do as members have to win election votes.

The political disturbances in the Middle East recently due to Iran and other countries have increased anxieties of the Finance Minister who has to smooth over conflicts for the home consumers. The question about oil production and availability has led to rising apprehensions. The minister spoke out about the situation saying they were in touch with the Petroleum Ministry and would take steps to settle the undesirable effect of high energy costs on the public. His reasoning was that when prices reached $147 a barrel that they managed the situation. Political turmoil in Egypt has resulted in crude oil prices going past 100 dollars a barrel which has led to the outcome of prince increases in all major oil importing countries like India. High global oil prices increase the government funding bill and broaden the trade decrease as India starts importing much more than it exports. India already imports three-quarters of its fuel needs. State-run firms like Indian Oil, Hindustan Petroleum and Bharat Petroleum will bear the brunt of severe revenue shortages. In 2010-11, the under-recovery of oil firms is estimated to exceed Rs. 700 billion leaving the government to pay the rest of it as a subsidy. Modi led government put in fuel reforms by deregulating petrol prices and raising prices of diesel, kerosene, and LPG to cut its subsidies and fiscal losses.

Since the past couple of years, India has maintained steady and rapid development and has infused vigor into global economic growth. The world will be a big factor in its coming improvement as India will not be able to progress without it. In approximately twenty years India will make historic inputs into the development of the global economy by the expansion of foreign trade and expansion and development in the west. It will improve its overseas investor relationships and have better business outlooks. Overseas investments will have to be guided and supported by competitive businesses and have to complete complex types of economic and technological collaboration with improved quality and benefits for both organizations. India will also have to diversity and increase its bilateral, multilateral and regional economic assistance so they can have mutual development and a global strategy in all countries and regions around the world.

India’s economy has enjoyed sustained progress in recent times. In comparison to the global economies, India’s has had a nice steady momentum with fewer fluctuations. India’s information industry has been the cause of rapid improvement with developments in language and human talent. The service industry has taken leaps and attracted many investors, therefore leading to the manufacturing industry getting less focus. India’s government has also had encouragement endeavors that have promoted growth.

There are still many hurdles to face before India’s economy can reach greater heights. Economists say that there will be great progress as well as many challenges in the future. The government especially has to start successful policies to cope with any downfalls. The most crucial problem faced by the government at the moment is current inflation due to an exponentially expanding economy. Only the passing of time can say how India’s economy will adapt to the increasingly bleak global economic climate.

Global oil prices are becoming increasingly market-oriented. Thus, dynamic fuel pricing will improve the competitiveness of the economy overall. It would also bring in transparency in fuel pricing and incentivize investments in the oil sector.