High crude oil prices have come back to haunt India over the last couple of weeks, with Brent going past $120/barrel levels. While the markets have been factoring in a rate cut by the central bank from March-April, higher oil prices may put a spanner in the works.
For starters, the government may not have any choice but to increase prices of petroleum products as soon as election results are out. The last time the government increased prices was in June 2011. This will have an impact on inflation, both headline and core. It may be recalled that WPI inflation eased to 6.6 per cent in January and core inflation moderated to 6.7 per cent. If inflation goes past seven per cent levels, the central bank may not be very comfortable easing rates even if growth hovers around the six to seven per cent levels.
Taimur Baig and Kaushik Das of Deutsche Bank estimate a 10 per cent increase in fuel prices could pose a 100 basis points upside risk to inflation (first and second round impact combined), thereby, pushing headline WPI inflation back to 7.5 per cent levels. They believe, “The RBI may not be able to bring policy rates down by 100 basis points (which is our call) during the course of the year owing to renewed inflation pressure.”
Under such circumstances, investments will not pick up if inflationary pressures persist and inflationary expectations don’t come down. Consumption will also be hit as a result if prices continue to head up. Baig and Das add that in the absence of monetary accommodation, consumption and investment could suffer, with growth remaining stuck in the six to seven per cent range.
Given that oil accounts for 30 per cent of total imports, Bank of America Merrill Lynch says, a $10/barrel increase in oil prices would increase current account deficit by $8 billion (0.4 per cent of GDP). Another sensitivity analysis shows a 10 per cent increase in oil prices would result in the current account deteriorating by 0.15 per cent. According to estimates of economists, the current account deficit (CAD) is expected to touch 3.5 per cent in FY12. Given that India primarily relies on foreign inflows to fund the CAD, India’s external risks would remain elevated in case of any reversal in inflows.
