Oil shock: Entry point for deepening reform

The latest oil shock — an increase from $69 last year to $80 per barrel this week — is courtesy the American President, Donald Trump, who unilaterally pulled the United States out of the 2015 deal that Iran had reached with the UN’s Permanent Five (US, UK, Russia, France, China) plus Germany. This spooked the global financial markets, which justifiably fear renewed trade sanctions on Iran, ending five per cent of world production. The nuclear deal had ended sanctions and boosted world supply. Prices declined from $84.2 in 2014-15 to $46.2 in 2015-16. New sanctions may reverse the trend.

The gainers are the oil producers. The US President has imposed the supply constraint that Opec finds difficult. Saudi Arabia, Iran’s Sunni bête noir, is in clover. The 42 per cent increase in prices, relieves fiscal stress; is wonderful for the long-awaited listing of Aramaco, its national oil company, and avoids the unpleasantness of having to tax its citizens or reducing their benefits.  Other countries in the Gulf, Venezuela and Russia will also benefit. America’s shale oil producers, for instance, are busily removing the covers on their drills.

The big losers are China and India. For India, higher prices mean a bigger trade deficit and more stress on our foreign exchange reserves. Another outcome is rupee depreciation. Foreign hot money pulls out to “safe haven” destinations in times of trouble. The bleed made the rupee slide by around six per cent to more than Rs 68 against the US dollar from around Rs 64 earlier. But it is still overvalued.

The oil shock poses two risks for India. First, the fear that it will increase the current account deficit (CAD) — the difference between international receipts and payments, from trade and income flows — beyond the acceptable level of two per cent of GDP.

Second, it poses a conundrum of navigating conflicting objectives — preserve the market-based retail oil price mechanism whilst graduating the price shock for consumers and containing inflation.

At $80 a barrel, our additional spend on oil imports will be $9 billion this fiscal, net of the increased earnings from oil product exports. But the threat to keeping the CAD below the target of two per cent of GDP is over-hyped.  The oil shock has a silver lining. With more robust fiscal balances in the Gulf, investment and jobs will increase for Indian workers, who generously remit all their earnings. Inward remittances, higher than $69 billion last year, will dilute the impact on CAD. More petro-dollars to spend will boost our exports to the Gulf.

Second, the accompanying six per cent depreciation of the Indian rupee will make our price-sensitive exports much more competitive. Last year exports grew by 12.1 per cent to $300 billion. A three per cent growth in exports this year would generate the additional spend needed on oil imports of $9 billion.
Third, a weaker rupee discourages imports generally. Last year total imports increased by 21 per cent. Making domestic producers more competitive is in India’s interest.

Transport minister Nitin Gadkari had recently claimed that subsidising oil consumers is not aligned with a market economy. It is in a market economy that the question of targeted subsidy arises. In an old, Soviet-style economy, there are no subsidies because the government set the retail price. In our context, this is analogous to directing ONGC to absorb the cost. This is best avoided. Last year, ONGC assisted in achieving the disinvestment target by buying the government’s shareholding in HPCL. Such measures to support the government, whilst undesirable, are preferable to diluting ONGCs commercial autonomy for pricing products, which also distorts markets for the private sector.

Three options present themselves. First, intrusive Budget scrutiny can do the trick. A fiscal “surgical strike” slashing frivolous expenditure, which has crept in, can generate the Rs 0.6 trillion to sanitise consumers from a price increase. This is just six per cent of the Rs 10 trillion, which the Central government spends on schemes without including wages, pensions, interest or capital expenditure.
Second, it is not desirable to entirely sanitise customers from the oil shock. This will kill the liberalised “marked to market” regime for retail prices of oil products, introduced last year. It is also environmentally irresponsible not to have a price signal to induce lower consumption and incentivise users to switch to more efficient end-use equipment — cars, motorcycles, water pump and generators.

Mr Gadkari is right. A portion of the oil shock should be passed through. But state governments must be cajoled to give up the windfall gain accruing to them because VAT is an ad valorem rate and not a specific rate as is Central excise.   
Lastly, Budget 2018-19 projects a fiscal deficit of 3.3 per cent of GDP versus 3.5 per cent in 2017-18. The target is not credible. Capitalisation of stressed public sector banks; agriculture minimum support price revisions; and the new flagship “Ayushman Bharat” medical insurance scheme will push the deficit beyond the target. The N.K. Singh committee report on Fiscal Responsibility and Budget Management “blessed” variations in fiscal deficit capped at four per cent of GDP. Following this lead can provide Rs 1.3 trillion to the finance minister, including for partly absorbing oil price increase. But stoking inflation is a real risk here.

A further increase to the 2011-2014 level of $100+ a barrel is unlikely. Oil producers, like Venezuela, need to cash into the high price. Sanctions on Iran, even if imposed, will not bite till the end of this fiscal year. If oil spikes nevertheless, a temporary adjustment loan, from the IMF, can dilute this external shock, which can otherwise jeopardise our carbon emission targets. The continued supply of Iranian oil, but denominated in rupees, like the Russian trade earlier, is also possible. The United States may accept such necessary but limited “exceptions” for Iran to buy goods “needed by the Iranian people” to survive.

Economic stress creates reform entry points because the urgency becomes publicly visible. 1991 was an extreme event. The 2018 shock is low intensity in comparison. But it can help to push the needed third generation of reforms — deep fiscal austerity, energy security and PSU autonomy.