Oil prices after reaching a recent peak of $128 a barrel in early March fell sharply below $100 and have once again climbed back to around $120. The geo-political tensions and oil's volatility have kept the market on the edge for almost three weeks now. If one were to look back in history, high oil prices are not a completely new phenomenon for the world. The 2011-2014 period witnessed sustained triple digit levels with an average of around $110 through the period. The peak of $146 came, however, in August 2008 prior to the global financial crisis.
So why is the world more worried about oil than before? Or is it the dynamics of a more interconnected world? To get some answers let us compare the macro dynamics of the earlier oil price era (2011-2014) with the situation now.
First, the earlier high oil prices were more of a demand side issue. Now it is more of a supply side problem. The earlier periods of high oil did not witness a geo-political shock but saw rising demand after the 2008 financial crisis. Note that in the present context, oil was already seeing a similar rise, before the geo-political shock aggravated the situation. The supply side shock has exacerbated the problem.
And the problem, that of inflation. While a rise in oil price does fuel inflation, and it did so (average WPI inflation between 2010 and 2012 was around 9 percent and average CPI of around 8.6 percent between 2012 and 2014) the demand side inflation was then countered with continued rate hikes by RBI. Also, this was during the period when inflation was not the nominal anchor. Now, with inflation as a nominal anchor with some leeway to look through supply side shocks, the issue becomes tricky for RBI. Adding to the dilemma is the just-recovering economy from the pandemic.
Adding some more fuel to this is the already elevated levels of commodity prices. This again due to supply side pressures partly emanating from the pandemic which is yet to ebb away.
Next comes the bearing on currency. Oil prices do have a bearing on currency in terms of foreign exchange and current account deficit as around 25 percent of India's dollar imports are oil and India imports around 85 percent of its oil requirements. The value of oil imports accounts for 80 percent of the current account deficit (CAD). Every $10 increase in oil prices annually can have 0.4 percent increase in CAD. Therefore, higher oil prices do have a direct bearing on the rupee. However, in the 2011-2014 era, India witnessed double digit depreciation in alternate years 2011 and 2013 and stability in the intermittent years. And, this appears more correlated with FII flows rather than oil. Weak flows in 2011 (equity) and 2013 (debt, taper tantrum) had a larger bearing on currency.
This time around too, we are witnessing negative flows even before the oil rise, which was driven by Fed rate hikes. In the earlier phase we did not have the strain from external rate actions. On the contrary, RBI was in hiking mode then.
So then, what is protecting our currency now? This year so far, we have seen rupee depreciate by around 2.4 percent while oil has climbed around 44 percent. The answer perhaps lies in RBI's reserves. India's dollar reserves of around $630 billion are now among the fifth largest in the world, and with over 12 months of import cover, are a dominant cushion for any currency shocks. Import cover then was 7-8 months and India FX reserves was around $300 billion and the nation had not been able to make any meaningful addition to its reserves in those years. Since 2019, RBI has been able to build its reserves meaningfully, which it is able to use to contain volatility. RBI had during the first weeks of March 2022 sold $9.6 billion in reserves to support currency volatility.
If we summarise this together, in comparison to the earlier era, this time around, the oil pressure (building up even before the geo-politics) is coupled with pressures of global rate hikes and outflows particularly from the equity side, a rising dollar and high commodity prices. High inflation and oil driven impact on imports are likely to impact growth as well which is already fragile. Even if the political crisis simmers down, the lingering effects in the form of elevated crude prices will likely continue.
Against that backdrop, we could see currency pressures sustain until external inflows (FII flows) resume later in FY23 once Fed rate hike trajectory is absorbed. It is interesting to note that, in the past, we have seen FII flows resume once the “risk-on” scenario is back as seen in 2009-2010 and 2012-2014. FII outflows currently are more from the equity side versus debt. Prospect of resumption of FII flows from equity is strong as the stress is largely from external risk-off factors rather than domestic headwinds. Once the dust settles, recall there is LIC IPO impending which will act as a confidence booster to domestic equities and bring in much needed dollar inflows. In addition, attractive valuations could drive inflows both from domestic and external side. Subsequently at some point one can also expect RBI to raise rates to counter inflation which may also act as an anchor for FII inflows.
While “what goes up has to eventually come down” (in the context of oil) it is a question of timing. The longer the escalation, the longer will be the uncertainty and volatility. While crisis is not new to the world and India and we have seen recovery after the crisis, this time too there seems to be a middle ground. One can believe that policy makers in India are active in working a middle path, be it oil, currency, trade or external dependencies. The hope for growth and recovery is very much alive!
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