Subir Gokarn: Macroeconomics of the oil shock

By now it is pretty clear that the global oil scenario is not going to change in a hurry. Even up until a few weeks ago, many people believed that the price escalation was not likely to sustain for very long.

But, after several months of nothing but bad news, even the die-hard optimists are being forced to confront the prospect of a third oil shock, with all its implications of slower growth and higher rates of inflation.

To put the current scenario in historical perspective, today's oil prices in real terms are less than 20 per cent below their all-time high, which occurred in January 1981, at the tail-end of the second oil shock.

The peak did not sustain for very long, but prices did settle at levels comparable with today's and this pattern persisted for the next five years or so.

In 1986, a substantial downward revision took place, and with the exception of a short-lived surge during the Gulf War of 1990-91, the scenario remained relatively benign until the most recent upward movement.

From the macroeconomic perspective, over the last two decades, despite many structural changes in the world economy, one can see a correlation between the average level of oil prices and overall economic performance.

In particular, the eight-year economic boom in the US during the 1990s, while it may have had other significant drivers, was also characterised by a long spell of relatively low oil prices in real terms.

Of course, low oil prices may be necessary, but are certainly not sufficient to guarantee a healthy macroeconomy, as the Japanese experience during this decade illustrates. However, it is much more difficult to find evidence of good macroeconomic performance in a situation of high oil prices.

The third oil shock will have a disproportionate impact on emerging market economies. Over the last 30 years, these countries have garnered a significant share of global output, particularly in the manufacturing sector, and global energy consumption.

During this period, the world as a whole has become far less dependent on oil as a source of energy, driven by both technology and a changing economic structure. But, as they go through their own economic transformations, emerging market economies are typically more dependent on energy, including oil, than ever before.

India, despite its relatively weak performance in manufacturing, is no exception to this pattern. India's oil dependency (measured in terms of oil consumption per unit of GDP), in keeping with the global trend, showed a steady decline between the end of the 1980s and the end of the 1990s. From that point on, it has shown a steep increase.

Clearly, the benefits of energy-efficient technology and more effective conservation practices have been neutralised by other developments in the economy, many of which are oil-intensive.

The most visible of these is the contribution of the transportation sector to the economy's performance in recent years. The two-wheeler boom began around the late 1990s and shows no sign of abating. Cars kicked in a couple of years later.

Not only has car production grown very rapidly, an increasing proportion of the new cars are of higher engine capacity, which means lower fuel efficiency. In the last couple of years, commercial vehicles have also been on an upswing, increasing the nexus between our industrial recovery and oil dependency.

Obviously, with such a prolific increase in vehicle production and population, it is no surprise at all that oil consumption would go up in such a dramatic fashion.

Re-inforcing this relationship is the performance of the services category labelled "trade, transport, hotels and restaurants", which, in and of itself, contributes about a quarter of GDP and has been growing at double-digit rates.

We don't know what proportion of this aggregate is contributed by transport services, but it is reasonable to assume that it would not be insignificant.

This pattern suggests that the Indian economy may be particularly vulnerable to prolonged high oil prices, even if the world economy as a whole is less so than in the past. Higher domestic fuel prices will certainly induce people to economise on the use of transport.

As the utilisation rate for commercial vehicles declines, there will be that much less incentive for owners to invest in new vehicles and a slowdown in production will ensue.

It is more difficult to see a clear impact on the demand for two-wheelers and cars. People who otherwise would have decided on a larger vehicle may now reconsider and choose a smaller one instead.

The deterioration in public transport across the country was one of the major inducements for the two-wheeler and car boom in the first place. Nothing has changed for the better on that score, so the compulsion to own one's vehicle remains.

However, even if the demand for vehicles in the aggregate may not prove to be too sensitive to rising prices, short of dramatic declines in the use of vehicles, spending on other things will almost certainly go down and the overall contribution of private consumption to growth will decrease.

The simple point is that our current macroeconomic performance has been particularly closely related to oil consumption. This leaves us relatively vulnerable than otherwise to rising prices. Let us not make the mistake of underestimating the impact.

That was the gloom-and-doom part of the macroeconomic story. There is also something of a bright side. When the two previous shocks hit, they exacerbated our structural inability to generate foreign exchange. In 1981, we approached the IMF for the largest single structural adjustment facility loan the institution had provided until then.

This time around, the cumulative effects of reforms on the trade and capital market fronts have translated into a buffer of foreign exchange that will allow us to withstand an external shock of any conceivable severity.

Some, including myself, who believe that crisis is the only inducement for serious reform in India, will see this as a mixed blessing; but there is no doubt that it is a blessing.

So, assuming a persistence of oil prices at these levels for some time to come, what do we have to look forward to? Slower growth, undoubtedly, as the oil-dependent activities we have relied on for momentum start to flag.

Higher inflation, unquestionably, but this will be moderated by the slower growth. However, there are no indications of crisis and the panic that ensues, either because of actual resource constraints or because of expectations of these arising.

We shall have to bite the bullet, but with a far stronger set of teeth than we have ever had. And, finally, let's remember that the oil shock is not our problem exclusively. All our neighbours and competitors are similarly exposed and vulnerable.

(The author is Chief Economist, Crisil. The views expressed are personal)