Madan Sabnavis: Rising oil prices... Not to worry

Lower energy intensity and rising exports have cushioned the impact.

The rise in crude oil prices always tends to create economic trepidation as the two previous oil shocks did about three decades ago.

And why not, considering that the first oil shock of 1974 temporarily rung the knell for Keynesian Economics as stagflation debunked the theory of demand-led recoveries.

Also, while the immediate impact is felt in the shock year, the after-effects linger for a couple of years after the shock.

The second shock of 1979, did not quite threaten any economic theory but reinforced the spectre of doom in terms of both higher inflation and lower growth, besides exerting severe pressure on scarce foreign exchange resources.

The current price rise is significant because it has been on for over 18 months now and any kind of a retreat is presently not conceivable.

Geo-political relationships have been strained with few signs of the impasse being resolved. Demand has been rising, thanks to speedy growth in Asia, especially China and India, as well as the US.

The Organisation of Oil Exporting Countries (OPEC) has moved away from the $22-28 band, and a new band would be in the region of $40-50 if a reconciliation takes place.

Under these circumstances, it would be instructive to see how the Indian economy performed in the aftermath of the past shocks, and whether conditions are any different today to buffer against these repercussions.

Numerically, the current oil price rise is not that shocking compared with an increase of 252 per cent in 1974, or 111 per cent in 1979, with the price rising by 30 per cent during the first half of 2005 even after an increase of around 32 per cent in 2003-04.

In dollar terms, the price had risen by around $8 a barrel in 1974, and $17 in 1979, while in 2004, the rise was $10 a barrel, followed by another $11 in the first half of 2005. But the worry is the same.

The Indian economy witnessed a decline in GDP growth rate in 1974-75 to 1.2 per cent from 4.6 per cent in the previous year.

During the second shock, GDP actually fell by 5.2 per cent (that is, negative growth) from +5.5 per cent in FY1978-79. However, last year the growth has been buoyant at 6.9 per cent, meaning thereby that higher crude prices did not depress growth.

It is not surprising that even today we are sanguine about a 6.5 per cent growth with the monsoon being more of a concern relative to oil prices.

The inflation narrative also signals a considerable degree of moderation over the years. Overall inflation was 25.2 per cent in 1974-75 while fuel prices rose by 45.4 per cent in that year and continued at 15.4 per cent subsequently.

The 1979 story was similar with overall inflation at 18.2 per cent followed by a high rate of 9.2 per cent while fuel prices rose by 15.6 per cent and 25.3 per cent, respectively, in 1979-80 and 1980-81.

In 2004-05, inflation was moderate at 6.4 per cent despite a rise of about 10 per cent in fuel prices.

What are the two conclusions that can be drawn? The first is that India's GDP growth is no longer susceptible to crude oil price shocks.

That's because the relationship between crude oil consumption and GDP has weakened today. In 1970-71, 1 tonne of crude oil was associated with Rs 2 lakh of GDP, which came down to Rs 1.43 lakh in 2003-04, meaning thereby that the impact of oil price on GDP has been moderated despite higher consumption levels as GDP is driven by other factors such as the services sector which is less dependent on oil compared with industry and agriculture.

Inflation today is less impacted by oil prices for two reasons. The first is that the price of petroleum products is still regulated by the government through the administered price machanism (APM), which has ensured that the price increase is not commensurate with the other rise in international prices.

Besides, forward purchases by the oil companies buffers between 30-50 per cent of the increase in price in the shock year.

The second is that the two other sectors that contribute to inflation, that is agriculture and industry, have become more efficient and have countered the cost-push cycle of inflation.

The role of the Reserve Bank of India (RBI) in countering demand-pull inflation with cogent monetary policy measures also deserves mention here.

The other worrisome issue relating to high oil prices is the impact on the current account deficit. However, here too times have changed, and not only has the economy become strong in forex reserves, but there has been a structural change in the balance of payments accounts both on the current account as well as the capital inflows, with the latter redressing the lacunae in the former.

Two indicators are important here. The first is the ratio of oil imports to total imports. This ratio has declined from the region of 35-40 per cent to between 25-30 per cent, which really means that the POL bill, though dominant, tends to exert less pressure on the growth in imports.

The second factor is the growing exports of the country, both in terms of volumes and growth rate. The ratio of exports to oil imports, which describes the cover being provided on what could be called inescapable imports has been rising from the region of 1.75-2 during the crisis period to the region of 2.5-3.0 in the past few years, thereby indicating the increasing ability of the economy to absorb such shocks.

The Indian economy has certainly evolved over the past three decades to counter adverse movements of crude oil prices.

However, while this is good news, the fact remains that our consumption levels are high and alternatives are not available.

Countering the ill-effects through administered prices cannot be sustained for long, and we would really need to move towards free pricing at some later date, We need to be prepared for that "" and the process of transition needs to begin now.

The writer is Chief Economist, NCDEX Ltd. The views expressed are personal.