A prolonged Red Sea crisis could bring back inflation scare for the world and India

India uses the Red Sea route through the Suez Canal to trade with Europe, North America, North Africa, and parts of the Middle East.

Following the Russia, Ukraine war that started in 2022, the world saw a steep rise in energy and food prices, causing central banks to tighten monetary policies to keep a lid on inflation. While risks have since faded with a reduction in broader cost pressures, the recent Red Sea crisis could throw a spanner in the works.

Experts believe that global inflationary pressures may make a comeback as shipping costs soar due to relentless attacks by Yemen-based Houthi rebels on vessels passing through the Red Sea, a route that accounts for 30 percent of the world's container traffic and 12 percent of global trade.

"Escalating confrontation in the Red Sea increases the risk of renewed upward pressure on inflation, together with ongoing disruptions in the Panama Canal. The Red Sea is a key route for the transit of energy commodities (particularly oil and liquified natural gas), as well as for goods in general. Freight costs have increased as a reaction to the conflict," S&P Global said in research report on January 18.

The research report further said that although the uptick in commodity prices has remained subdued so far. Key emerging market economies that are more directly impacted due to the ongoing maritime crisis include, India, China (through energy imports), and Turkey (through supply-chain disruptions).

India's finance ministry, in a review of its economy on January 29, acknowledged the inflationary risks associated with the Red Sea crisis.

The ministry said the recent surge in shipping costs due to rerouting of commercial vehicles to
avoid security risks in international waters has the potential to trigger inflation, especially in terms of energy costs.

The Drewry World Container Index, which serves as a composite measure of container freight rates, reached $3,777 per 40-foot container in the week of January 18 2024, up 82 percent year-on-year (YoY). This figure also represents a significant rise of 148.3 percent from the rates seen on December 14 2023, reflecting an increases since the attacks on vessels started.

"The steepest rate increases have been observed on Asia to Europe trade lanes...however, despite the ongoing Red Sea crisis, the increase in overall shipping rates is still less pronounced than those seen during the peak of the pandemic over 2020-2022," BMI, a FitchSolutions company, said in its summary report for January 2024.

India's key trade body, the Federation of Indian Export Organisations (FIEO) also reiterated concerns around costs pressures on Indian exporters due to intermittent attacks on consignments routed through the Red Sea

"Freight rates have gone up unimaginably high, with further burden of various surcharge, pushing Indian exporters to hold back around 25 percent of the outbound shipments transiting through the Red Sea, adding to the sense of scepticism and nervousness among the businesses and markets across the world," FIEO said in a note on January 15.

The potential fallout of the Red Sea crisis on energy prices could play spoil sport at a time when there are expectations that central banks across the globe will start easing interest rates soon. Economists expect the Indian central bank's Monetary Policy Committee to begin cutting the policy repo rate around the middle of 2024. The US Federal Reserve's dovish hold in December 2023 and indications that it may start lowering interest rates from June 2024 will likely provide room for other emerging market (EM) economies to do the same.

"However, reaching and keeping inflation anchored around targets will be more challenging than in the recent past. This is due to higher uncertainty over the impact of climate related risks on food prices and geopolitical trends on shipping and supply chain-related costs. This is likely to add a risk premium on interest rates," S&P Global warned in the research report cited above.

For India, headline retail inflation has eased in recent months after touching a 15-month high during July 2023. In December, the rate came in at 5.55 percent, within the Reserve Bank of India's (RBI) tolerance range of 2-6 percent for the third month in a row. However, it has now been above the medium-term target of 4 percent for 50 consecutive months now.

What is at stake for India?
India uses the Red Sea route through the Suez Canal to trade with Europe, North America, North Africa
and parts of Middle East. According to Crisil Ratings, these regions accounted for around 50 percent of the South Asian nation's exports worth Rs 18 lakh crore and about 30 percent of imports amounting to Rs 17 lakh crore last fiscal.

India’s overall merchandise trade (exports and imports combined) last fiscal was Rs 94 lakh crore, with 68 percent in value terms and 95 percent in volume terms being sea-borne, Crisil said in a note on January 25.

India's exports to Europe through the Suez Canal (in the Red Sea) includes food products, apparel, and electronics, among others, and its imports primarily include crude oil. New Delhi has been worried that the attacks on cargo ships could particularly impact its agricultural exports to Europe.

Given that when it comes to agricultural commodities like Basmati rice about 30-35 percent of production is shipped to these regions, exporters are feeling the pressure as rising freight costs curbed outbound shipments and a part of their inventory is now being sold in the domestic market, leading to a moderation in realisations, Crisil added.

Crisil noted that among other commodities, marine foods (predominantly shrimp and prawn) could also see a significant impact as 80-90 percent of the production is exported, with more than half of it shipped through the Red Sea. On the other hand, firms operating in certain sectors like textiles may not be immediately impacted as buyers could absorb higher freight cost, which insulates their profitability, while players in capital goods sector could be hit by sustained disruptions due to delay in deliveries.

Moneycontrol reported on January 15 that the impact of the Red Sea crisis, causing shipments to take longer routes or experience delays, is expected to have a more significant effect on India's trade starting January 2024.

Earlier this month, India's commerce ministry noted that, thus far, the impact of the Suez Canal crisis on Indian exports and imports has been limited. However, the ministry cautioned that the cumulative effect of higher freight costs, increased insurance premiums, and extended transit times could significantly raise the cost of imported goods.

India's goods exports in December 2023 entered positive territory, registering a growth of 0.96 percent compared to the same month the previous year, following a contraction in the preceding months, whereas merchandise imports fell 4.9 percent on-year.

As for imports, concerns are less daunting given that only around 10 percent of the global oil trade is facilitated by the Red Sea route, and so far prices have seen a limited impact due to the current situation. Also, India sources a major part of its oil requirement from the Middle East and Russia, largely shipped via the Persian Gulf.

But the outlook on crude oil price is not rosy. Prices are expected to remain volatile in 2024 owing to geopolitical tensions and disruptions in the Red Sea.

Bharat Petroleum Corporation Limited (BPCL) Chairman and Managing Director G Krishnakumar said on January 30 that weak demand in major economies and geopolitical issues ranging from ongoing war between Russia- Ukraine and the crisis in the Middle-East would lead to volatility in crude prices.

Currently, crude oil prices are trading around $80 per barrel amid healthy inventory in the US and weak demand, majorly from China.

Given that India imports around 84 percent of its crude oil requirement, any price shocks in the commodity would directly impact the country's domestic inflation levels. Take, for instance, the period right after the war broke out in Ukraine. At the time, global commodity prices shot up substantially and cost of crude oil jumped to a 10-year high in June 2022. This spurred inflation globally, impacting India’s external account and price situation.

Cheaper oil imports help India keep a lid on its trade deficit as well, thereby keeping its external balances in check. Resilient service exports and lower oil import costs resulted in lowering the country's current account deficit to 1 percent of GDP in the first half of FY24.

The Indian government is already grappling with the idea of going for alternative routes for inbound shipments of crude oil if the Suez Canal crisis spreads. The country plans to rely more on nations like Iraq that ships the commodity through a safer route such as the Strait of Hormuz, located between Oman and Iran. There are also concerns that the flow of Russian oil from the Black Sea region may get delayed or disrupted given the recent spate of attacks.

After the outbreak of the Russia-Ukraine war, India had stepped up oil imports from Moscow since they were offering heavy discounts. Given the cheaper supply, Moscow is now the top supplier of crude oil to the South Asian nation, followed by Iraq and Saudi Arabia.

As S&P Global noted, the Red Sea route is particularly important for commodities exports to EM economies in Asia. According to data from the US Energy Information Administration, oil shipments from Russia accounted for around 75 percent of the Suez Canal southbound oil traffic in the first half of 2023, most of which were destined for India and China.

Back in December, Emkay Global's Lead Economist Madhavi Arora said that for India, since bulk of the crude and LNG comes through the Persian Gulf, the Red Sea issue is unlikely to hamper flows much. But Russian oil flows from the Black Sea may be affected and re-routed.

"This could also lead to a higher premium for Middle East crude. Overall, there may be some impact for crude-importing refiners (and oil marketing companies — OMCs), but an outsized impact is unlikely unless issues prolong," Arora added.

Following the outbreak of the Israel-Hamas war, the Red Sea has been in the news for periodic attacks on commercial vessels since December. This has forced major freight companies to opt for the longer route around Africa to reach the west or wait at nearby ports to ensure safe passage though the Suez Canal.

Whether the attacks will escalate or not is anybody's guess, but India is betting on its recent resilient track record to beat the pessimistic global trends.

As the finance ministry noted on January 29, some shocks for the global economy, such as supply chain disruptions, have returned in 2024. "If they persist, they will impact trade flows, transportation costs, economic output and inflation worldwide. India will not be exempt from it, but having faced and seen off COVID and the energy and commodity price shocks of 2022, India is quietly confident of weathering the emerging disturbances."