Will Government Share Burden Of The Oil Price Shock? CEA V Anantha Nageswaran Explains — BQ Exclusive

The rise in crude oil prices to above $100 per barrel has prompted concerns about the impact of higher fuel costs on consumers and small businesses. Petrol and diesel prices have been raised eight times in nine days by a cumulative amount of close to Rs 6 per litre. The hit could potentially be softened if the government chooses to sacrifice a part of its revenues by reducing excise duties.

Will it?

Crude prices at about $100 per barrel or below may be manageable without upsetting the current arrangement, said Chief Economic Advisor V Anantha Nageswaran in an interview with BloombergQuint. "In general, if you have persistence of oil price at $110/barrel and above, then that would require a burden sharing decision between oil marketing companies, consumers and the government," Nageswaran said.

Higher crude oil prices could upset the delicate balance in the Indian economy as it recovers from the Covid-19 pandemic. Oil at an average of $100 a barrel could mean a negative 'terms of trade' shock, shaving off close to 100 basis points from growth. The impact would be split between consumers, private enterprises and the government depending on whether taxes on fuel products are cut and if businesses pass on higher input costs to the end user.

Higher oil prices would also impact inflation, with a 10% price rise seen pushing up inflation by around 30 basis points directly. A wider current account deficit would be another consequence.

"The impact will depend not only on the level of oil price but also on its persistence. We must remember that the new financial year hasn't yet started," said Nageswaran, adding that it is possible that oil prices will settle down in a range that is tolerable for us. "Should the current state of scarcity and prices persist well into the new financial year, then there is a range of implications to think about."

According to Nageswaran, there are a number of trade-offs to consider:

• First, if a commodity were to become supply-constrained, do we want the prices to reflect its relative scarcity?

• Second, do we push the prices lower to reduce the impact on purchasing power and consumption?

• Third, what are the fiscal consequences? This would need to be assessed keeping in mind the fact that the government has taken on an additional Rs 80,000 crore in costs for extended free food transfers till September.

• Fourth, what are the implications for energy transition and focus on renewables? Higher oil prices will force increased blending of ethanol, which is a good thing, Nageswaran said.

In these volatile times, to make a policy decision that may or may not be reversible later is not the most advisable thing to do, he added.

A key trade-off is between higher inflation and its implications for consumption versus the government's fiscal deficit and level of borrowings.

For the current year, the government has projected a fiscal deficit of 6.4% of the GDP with gross borrowings pegged at over Rs 14.95 lakh crore. This pushed up government bond yields, which are currently above 6.8%. Additional spends such as increased food and fertiliser subsidies could strain government finances if it sticks to its budgeted capital expenditure plan.

A cut in excise duties could add to concerns about a wider deficit and higher borrowings.

"...if the government does provide duty relief to at least partially absorb the increase and in the process if the government's borrowing rises and the bond market reflects that, it gets passed on to everybody and not just oil users," said Nageswaran, explaining that the cost of government capital is a benchmark. "So, that is another layer of cost on the entire economy."

Another implication of higher crude oil prices is a wider current account deficit, which economists peg at 2.5-3% of the GDP if oil prices average $100 per barrel for the financial year.

"...based on some assumptions of $100-110 per barrel of oil, I think the market's appetite for funding the Indian current account deficit will remain relatively good," Nageswaran said. "So, hypothetically, if the current account deficit widens to about 2.5-2.8% of GDP, I still think, on balance, it will be a manageable situation."

Commenting on underlying economic conditions, Nageswaran acknowledged that consumption may take some more time to recover given that uncertainties on the path of the pandemic persist.

"My feeling is that the first half of the next financial year will still see subdued consumption growth because there would be the fear of a recurrence of the pandemic, given what is going on elsewhere in the world," Nageswaran said.

While exports have been strong in FY22, surpassing $400 billion, uncertainty around the global economy has increased.

As such, government spending, particularly capital expenditure, will need to do the heavy lifting. "Government capex, as has been widely discussed after the budget, is definitely doing the role it is supposed to be doing, which is to keep underlying investments going and creating the basic platform on which private capex can take over," Nageswaran said.

While skeptics question whether central and state governments will be able to spend the amounts budgeted, Nageswaran said the economy will benefit from the "positive delta" of government capital expenditure.

Nageswaran added that while private investment, on aggregate, may take some time to pick-up given subdued levels of capacity utilisation, certain industries will see investments pick up sooner.

"It is true that average level of capacity utilisation is not at a point where they would require additional capacity, but if you really look at the top four companies in key sectors like steel, cement, and chemicals, their capacity utilisation is much higher; it is 75-80%," Nageswaran said.

Emerging markets like India will also have to contend with a monetary tightening cycle underway in the U.S., where the Federal Reserve is expected to hike rates well into 2023. Alongside, the Fed may also undertake quantitative tightening, reversing years of easing.

So far, market reaction to the impending tightening of monetary conditions has not be disruptive. Will this continue?

Nageswaran, who has previously worked across investment banks like Credit Suisse and Julius Baer, said the reaction so far suggests markets do not believe the Fed will be able to go through with its signalled tightening fully.

"If they do indeed go ahead with their plan of rate hikes all the way into 2023, that would definitely have an impact on global risk appetite, stock markets, capital flows into emerging economies, etc.," Nageswaran said. "But I have my doubts as to whether economic conditions would evolve in a way that the Fed will be able to carry out its intended rate hikes to the fullest extent they have told us they will do."

Should market conditions turn volatile, India may be relatively better placed that other emerging markets, Nageswaran added.