The energy headwind

The surge in energy prices is a concern for growth; even if temporary, a reminder of India's strategic dependence on imported energy

Not just humans, but economies also need energy to grow: Productivity growth is strongly correlated with an increase in the use of dense forms of energy. For example, a car that burns straw to propel itself would be faster than walking, but it would be far slower than a vehicle running on dense forms like petrol or electricity. Mud bricks become sturdier when baked, which needs energy; and construction quality improves further with the use of energy-guzzling material like cement and steel. Improvements in energy efficiency have meant that India’s energy demand has grown around 2.5 per cent slower than the growth in gross domestic product (GDP) over the past few decades. However, given that India lacks most dense forms of energy (like oil, gas, metallurgical coal and uranium), imports, which account for around 40 per cent of energy supply, are growing faster than GDP.

Net energy imports, including fertilisers and palm oil, accounted for nearly 80 per cent of India’s trade deficit in the fiscal year 2019-20, and more so in the last three months. Exports of services help pay for a large part of these energy imports, and for the rest we need net capital inflows: We sell our assets (equity stakes in listed or unlisted companies) or take foreign loans. Even when crude oil prices had reached $150 per barrel in 2007, due to strong growth in IT Services exports and a surge in capital inflows from foreign portfolio investors, the economy did not feel the pain.

However, when global energy prices rise sharply due to supply constraints, like in the last two months, services exports and capital inflows do not adjust as rapidly. Annualised energy imports have risen by more than $40 billion in the last three months (more if we just take the October average prices). The increase as a share of GDP is 1.1 per cent over FY20 and 2.5 per cent over FY21. This deterioration of India’s terms-of-trade is a headwind to growth, as this additional payout to foreign suppliers limits demand for domestic products. While only around 40 per cent of crude oil products are consumed directly by households, of the remaining 60 per cent used by industries, most would pass through the higher costs to consumers over time.

Further, as dense energy becomes pricier, its usage drops, hurting productivity growth (like a trip not taken to save on fuel costs). Last week’s cuts to excise duty on petrol and diesel, and to sales taxes by some states (these states add up to around half the total sales tax collection in the country) mean a $20 billion reduction in the cost to the consumer, which is about half the extra burden.

Illustration: Binay Sinha

This decision can be viewed as the government re-routing some of its surplus receipts this year, which are in effect a cost to the economy, even if strength in collections is rightly celebrated as a sign of economic recovery. For the Centre, first-half receipts were 56 per cent of the budgeted estimates versus a normal 40 per cent: The 16 per cent “extra” is around $43 billion, and the annual number was likely to be higher. As central and state governments have struggled to increase their spending, their cash balances with the Reserve Bank of India have reached more than 2 per cent of GDP ($60 billion). Providing a fiscal cushion to the economy against the rise in energy costs is thus a reasonable step. To this, one must add an implicit increase in the fertiliser subsidy this year (urea prices are fixed in India even though global prices have risen).

One suspects the inflationary aspect of fuel price hikes may have been a stronger catalyst for the decision to cut taxes. Even though petrol and diesel are together less than 2.5 per cent of the consumer price index (CPI), the sharp price increases were adding 60 to 70 basis points (one basis point is one-hundredths of a per cent) to headline inflation. Further, second-order inflationary pressures were building up, not just in transport services. The fuel tax cuts should bring down headline CPI inflation by around 30 basis points, and more importantly, temper inflation expectations.

In the near-term, this cut may be overshadowed by the spurt in vegetable prices triggered by a delayed withdrawal of the monsoon for the third year in a row, and unseasonal rains damaging crops (many of them ready for harvest) in many states. Several of these are short-cycle crops, however, and prices should start fading again in two months as supplies resume.

Just as one hopes that the increase in vegetable prices would be short-lived, there are signs that the surge in energy prices may also unwind in a few months. Coal price increases in China have rapidly reversed as production has rebounded, and coal inventories at Indian power plants have risen. Rather than a structural shortage, which would warrant sustained higher prices for a long period so that suppliers invest, the price increases are a signal for the energy supplies mothballed for the last 18 months to be revived.

However, that is still a hope. The headwinds of expensive energy and spikes in inflation are the first major obstacles in many months for an economy where, even though several pockets are still in distress, the recovery on the whole has been stronger thus far than many feared. The stalling is a signal that the phase of steady positive surprises from the economy may be waning, warranting a shift in policymaking priorities to the next and a more normal phase of the economic cycle, particularly as the risk of the third wave of the pandemic has been steadily receding.

Strategically, if India’s economy is to grow at 7 per cent or higher for a sustained period, energy demand would rise at 4 to 5 per cent annually. It should be a priority to insulate the economy as much as possible from the vagaries of global energy markets. Perhaps more importantly, India’s role is likely to change: It is currently only buffeted by global demand-supply imbalances, and contributes only marginally to them. These are, to a large extent, someone else’s responsibility currently; that is, other countries that are badly affected too need to prioritise a reduction in energy costs. However, as India’s size continues to grow, it needs to be aware of how its rising share of incremental demand could pressure global energy markets. Particularly with emission commitments becoming an important new variable in the mix, energy-related issues need to be front-and-centre again, lest they become a sustained headwind to economic revival. 

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