Financial conditions in international markets are more accommodative than in 2018.
The possibility of sustained higher crude oil prices invariably raises a number of macroeconomic concerns in India. In 2018, higher oil prices, for instance, led to significant volatility in the foreign exchange market. Further, under political pressure, the government had to lower taxes on fuel products, which raised concerns over the management of government finances. Crude oil prices are once again on the rise.
Global crude oil prices surged earlier this week, as the US decided to end the six-month waiver from Iranian sanctions to eight countries, including India and China. The Donald Trump administration last year withdrew from the 2015 multilateral agreement with Iran. The idea now is to bring crude oil exports from Iran to zero. Restrictions on Iran along with sanctions on Venezuela, disruptions in Libya, and controlled production by the Organization of the Petroleum Exporting Countries has pushed up crude oil prices in recent months. Tightening of supply with the end of the Iranian sanction waiver could further push up prices.
While at the net level, higher crude prices would affect India negatively and require policy alertness, there are at least three reasons why India should not be excessively concerned at the present level.
First, the global economy is slowing and demand is likely to remain muted, though crude oil prices have risen by over 30 percent this year, largely due to supply-side issues. Trump has said that the OPEC will make up for the shortfall. On Monday, he tweeted: “Saudi Arabia and others in OPEC will more than make up the Oil Flow difference in our now Full Sanctions on Iranian Oil.” The US would not want to be seen pushing up crude oil prices and slowing down the global economy as a consequence. It is being reported that OPEC is willing to increase production.
Second, financial conditions in global markets are more accommodative than in 2018. Problems for India mounted in 2018 because of the decline in dollar liquidity in international markets. Along with raising interest rates, the Fed was shrinking its balance sheet. Selling by foreign investors in the financial market compounded India’s problem at a time when the current account deficit was expanding due to rising crude oil prices.
But the situation has changed significantly this year. The Fed has decided to end its balance sheet reduction programme and has also signalled a more accommodative stance in terms of policy rates. Therefore, while the current account could still be under pressure, financing would be relatively easy.
Third, inflation is under control and may not warrant tightening of monetary policy in the near term. The Reserve Bank of India (RBI) does not expect inflation to go above the 4 percent mark in the current financial year. The October 2018 edition of the monetary policy report of the RBI, for instance, showed that a 10 percent increase in crude oil price is expected to push headline inflation by 20 basis points and reduce growth by 15 basis points. It is also important to note that higher crude oil prices did not lead to significantly higher inflation in 2018, possibly because inflation targeting helped anchor expectations. However, higher crude prices would put pressure on growth.
Further, one of the biggest risks at this stage could be the way the next government decides to deal with higher crude oil prices. Cutting taxes or reintroduction of subsidies to contain retail fuel prices could significantly increase macroeconomic risk.
In the currency market, the central bank would do well to allow the rupee to depreciate as it will help limit imports, push exports, and contain the current account deficit. India’s dependence on import of crude oil and volatility in its prices underline the importance of increasing exports in order to keep the current account in control. Higher current account deficit tends to increase the dependence on short term foreign capital, which raises financial stability risks.Since India is better placed to deal with higher oil prices because of favourable global financial conditions and muted domestic inflation, it should continuously work to strengthen macroeconomic fundamentals and push growth-oriented reforms.
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