India's twin deficit challenge resurfaces as crude heads north

Stock Market Today

With crude oil hovering near $94 a barrel, India, the world’s third biggest importer, is confronted with the return of a long-feared spectre: the twin deficit challenge.

The US Federal Reserve’s decision to hold its benchmark interest rate steady saw crude slip to around $92 per barrel on September 21. The benchmark Brent crude was trading at $94 on September 19.

Interest rate hikes usually have a bearish impact on crude, as consumer demand takes a hit with an increase in rates. The global economy, especially that of the US, plays an important role in determining the direction of crude prices.

"We do not expect a pass-through to domestic retail prices due to upcoming state and general elections, high food prices and weak rural demand. This means a limited inflationary impact but a bigger spillover on the twin deficits,” Nomura Research analysts wrote in a note to investors on September 21.

Steady domestic fuel prices will initially burden oil marketing companies (OMCs), potentially leading to a higher government subsidy and jeopardising the FY24 fiscal deficit target of 5.9 percent of the GDP.

Fatter import bill, higher inflation

Elevated oil prices will also increase the import bill, and when combined with rice export restrictions, could sequentially widen the current account deficit (CAD) from 0.2 percent of the GDP in the first quarter of 2023 to 1.1 percent in the second and an estimated 1.9 percent in the H2, Nomura said.

According to the research house, a 10 percent increase in crude prices leads to a 0.3-0.4 percentage point rise in CPI inflation, a 0.1 percentage point decrease in GDP growth, and a deterioration of the current account balance by approximately 0.4 percent of the GDP.

The government allocated Rs 30,000 crore for fuel subsidies in the FY24 budget, which Nomura believes might be used to compensate for losses incurred in FY23.

It also predicts that for every 10 percent increase in oil prices, there will be a fiscal sensitivity of 0.05 percent of the GDP.

On the revenue side, the government imposes fixed excise duties (Rs 19.90 a liter for petrol and Rs 15.80 for diesel), with the last duty cut in May 2022. However, states apply varying VAT rates based on fuel sales, so higher pump prices generally result in higher state taxes.

Nomura said government intervention in controlling fuel prices is expected to curb both direct and secondary inflation effects, making the Reserve Bank of India's efforts to control inflation more straightforward.

Long pause then a rate cut

In the near term, it anticipates a prolonged pause in policy rates and a greater emphasis on using liquidity measures if necessary.

"Looking ahead, with a forecast of slower domestic demand, ongoing core disinflation, and a global growth outlook that's not very robust, the RBI's next policy move is likely to be a rate cut. We anticipate a cumulative 100 basis points of easing throughout 2024, starting in February,” the report said.

Global crude oil prices have surged, with Brent oil rising from approximately $73 a barrel at the end of June to nearly $94 a barrel, marking a nearly 30 percent increase.

India, heavily reliant on imported oil for over 85 percent of its domestic consumption, is experiencing an adverse terms-of-trade shock due to these rising oil prices. This typically leads to unfavourable macroeconomic effects, including lower growth, higher inflation, and deteriorating twin deficits.

In 2022, following Russia’s invasion of Ukraine, oil prices surged to over $120 a barrel. India somewhat mitigated the impact by relying on cheaper Russian oil, which had discounts of up to $20 per barrel.

Russia's share in India's oil imports has risen to about 40 percent in FY24 from just 1.5-2 percent before 2022. However, this cushion is diminishing, as news agency Reuters reports that the discount has fallen to less than $5 a barrel, indicating an increased macroeconomic vulnerability to higher oil prices.