Risks of imported energy get real

If energy prices remain this high for a year, they could shave 3 per cent off India's GDP, weaken the currency

We ended the Tessellatum last November, The Energy Headwind, with a hope that the spike in energy prices would be short-lived, and would not derail India’s post-Covid recovery. Energy prices instead have increased sharply, as sanctions on Russia disrupt supplies.

India imports 36 per cent of its total and nearly half of its dense energy needs (biomass still accounts for a fourth of India’s energy supply). The value of India’s energy imports as a share of gross domestic product (GDP) is close to the highest among major economies. The ratio had peaked at around 8 per cent a decade ago but had thereafter eased to just 4 per cent pre-Covid and less than 3 per cent during the pandemic.

If current prices sustain, that ratio could rise again to above 7 per cent. While the 12-month rolling net imports of oil are currently 1.25 billion barrels, they were 1.4 billion before Covid restrictions curtailed demand. If economic output in the coming fiscal year is around 10 per cent higher than in the pre-Covid year, net oil imports could reach 1.5 billion barrels. Oil at $120 per barrel is $40 higher than the price in the December 2021 quarter, implying an additional burden, going forward, of $60 billion.

However, that is only part of the impact. Prices of other forms of dense energy like gas, coal, edible oil and fertilisers have risen too, not only in sympathy with crude oil, as energy is fungible, but also because Russia and Ukraine are net suppliers of these commodities too. At current prices, India’s imports of these commodities could rise by another $40 billion. Together with oil, the increase in energy imports for India could be $100 billion, close to 3 per cent of GDP.

While most of the oil-related discussion focuses on the impact on inflation and the currency, a more worrying impact is on output. This occurs via three pathways.

First, higher energy costs once passed through to consumers will displace consumption of locally produced goods and services, hurting GDP growth. Unlike price inflation in goods with a domestic supplier, where the loss for one is gain for another, here, the beneficiary is outside the country. The government may cushion this impact by cutting taxes on fuel, import duties on edible oil, and increasing fertiliser subsidies, but it may not have the fiscal room to absorb more than a quarter of the total impact.

Second, despite government fiscal interventions, a nearly 30 per cent rise in the economy’s energy costs would hurt its use: Higher prices (of petrol, diesel and LPG or of plastic products) means lower usage. Across the world and in history, economic productivity strongly correlates with the use of dense forms of energy. It is needed, for example, to move faster (a motorcycle versus a cycle), manufacture goods using machinery, to cook more efficiently (LPG versus firewood), or use higher quality materials (like using steel, cement and baked bricks instead of cast mud and thatch). A drop in energy use means lower GDP, as improvements in energy efficiency occur over a longer period.

Illustration: Binay Sinha

Third, higher energy prices as well as geopolitical uncertainty are likely to hurt global demand. The size of the global market for crude oil was $2.6 trillion per year when oil prices averaged $70 a barrel. At $120 per barrel, the market size jumps to $4.4 trillion, with oil consumers transferring an extra $1.8 trillion to oil producers. Given the suddenness of the oil price surge and the uncertainty going forward, it is unlikely that producers are going to spend this unexpected bonanza on new investments — the oil price shock is thus a drag on global demand. Even within an economy like the US, which is self-sufficient in oil, the consumers would hurt, whereas the producers would save. Together with increases in other forms of dense energy, the drag could be as much as 2 per cent of global GDP. This can put brakes on the strong momentum in India’s manufacturing exports. Given India’s low share of global manufacturing exports, share gains should keep growth positive, but the headwinds are real.

We believe energy prices are going much higher than levels that are sustainable: Supply cannot respond in the short-term, substitution with new energy forms is difficult, and even demand destruction is likely to take a few months, as higher prices need to pass through to consumers, which then eventually triggers demand weakness. However, the prevailing uncertainty on how long supplies would remain impaired (due to either sanctions or war) is also likely to delay the adjustment. Companies may be reluctant to pass through the increases, apprehensive of pushing away consumers, and suppliers may be unsure of how much to invest in new capacity. Price spikes of this magnitude should accelerate the transition to renewable energy, but that process will take many years.

The uncertainty on how long this lasts is a bigger challenge for policymakers. These changes push India’s balance of payments from a reasonable surplus to a very large deficit. Exiting foreign portfolio investors are accentuating this in the near term, but even the current account impact is so large that if energy prices were to stay elevated, say for a year, the Reserve Bank of India may have to let the rupee fall in value against the dollar. If, on the other hand, these increases were to be short-lived, say for a few weeks, it can use its substantial foreign currency reserves to keep the exchange rate steady.

For the government, no immediate active decisions may be necessary on fertiliser prices, but on whether to cut taxes on fuels (or raise subsidies), the key uncertainty is how long prices stay high. If they are to stay elevated for a year or more, it may choose to grit it out by letting petrol and diesel prices rise, slowing the economy, and accelerating electrification and a shift to a less-import-dependent energy mix. If, on the other hand, the increases last a few weeks, it may want to limit fuel price volatility and the impact on productivity by shielding the economy from these increases, using some of its fiscal resources.

In any case, the risk of a 3 per cent point growth downgrade, a sharp rise in inflation and a considerably weaker currency should strengthen policymakers’ resolve to focus on self-sufficiency in energy over the medium-term.

The writer is the co-head of APAC Strategy and India Equity Strategist for Credit Suisse