Who will bear the costs of higher crude oil prices?

Crude oil is one of those external shocks for the Indian economy, the adverse impacts of which are inevitable. According to the Reserve Bank of India’s (RBI) study, a 10 percent rise in crude oil prices weakens India’s real GDP growth by around 20 basis points (bps) over the baseline. Thus, if crude oil averages $100/bbl (or $125/bbl) vis-à-vis the baseline of $75/bbl, it implies a downgrade of roughly 67bps (134bps) to FY23 growth.

Brent crude oil prices have fluctuated from $70-80/bbl in late CY21 to its peak of around $130/bbl recently before softening towards $100/bbl now on account of geopolitical uncertainties.

Accordingly, we have also revised our forecasts to $80/75 per bbl for FY23/FY24 from $70/65 per bbl earlier. This implies an increase of 15 percent in international crude oil prices, which means a downgrade of about 30bps from real GDP growth next year. Whenever there is any loss in the national output (or income), one or more of the three domestic agents — consumers, companies and/or government — bear this burden. In this note, I recommend the Government of India (GoI) to incur the additional losses, isolating the consumers as much as possible from the current shock.

A change in international crude oil price does not lead to an equal percentage change in domestic retail fuel prices. Some components of retail prices such as excise duty per litre and dealers’ commission are static. Therefore, after adjusting for these components, an RBI study finds that the pass-through of international crude prices into domestic retail prices is only around 66 percent, if Oil Marketing Companies (OMCs) pass the whole of international price increase on to the final consumers.

Thus, an increase of 15 percent in crude oil forecasts (to $80/bbl from $70/bbl) means 10 percent hike in domestic prices. Assuming full pass-through to the final consumers, a 10 percent hike in domestic fuel prices implies an increase of 45-65bp in the headline CPI-inflation in FY23. This calculation not only includes the direct and indirect impacts of higher crude oil prices, but also incorporates the domestic fuel items such as kerosene, LPG, and other fuels. Thus, this is the maximum likely impact of 15 percent/10 percent hike in international/domestic oil prices on India’s headline CPI-inflation (note: one bp is one-hundredth of a percentage point).

Since the weightage of crude oil is much higher in the wholesale price index (WPI) v/s CPI (roughly at 10 percent v/s 4.4 percent), the impact of higher crude prices on the former is more than double v/s that on the latter.

Although retail fuel prices, by definition, are market determined, the GoI does play an important role. What else could explain the unchanged petrol/diesel prices since November? It also means that the GoI decides whether the cost of higher crude prices will be borne by the consumers (through higher inflation) or not. If the GoI wants to isolate consumers from higher inflation, then it will have to incur the losses through either higher (fuel/fertilisers) subsidy spending and/or lower excise duty receipts. As a thumb rule, a hike of $10/bbl in crude oil prices implies a worsening of $12-13b (~0.4 percent of GDP) in India’s current account deficit (CAD). If the government incurs the entire cost, fiscal deficit will also widen by the same amount — Rs 1 trillion or ~0.4 percent of GDP.

It is very likely that the fiscal deficit in FY22 (ending-March 2022) will be around 6.4 percent of GDP, lower than the revised target of 6.9 percent of GDP (even after including the Third Supplementary Grants asking for additional spending of Rs 1.07 trillion). My calculations suggest that like FY22, the GoI will receive an additional gross taxes totalling Rs 1.7 trillion in FY23.

With LIC divestment postponed to next year, even with an assumption of higher devolution (31 percent of gross taxes v/s an average of 29.5 percent in last three years), the GoI’s total receipts could exceed BE by Rs 1.3 trillion in FY23E. Therefore, if the GoI incurs the entire burden of $10 per bbl hike in crude oil prices totalling 0.4 percent of GDP (or Rs 1 trillion), total spending of the GoI will increase by Rs 1 trillion to Rs 40.5 trillion in FY23E v/s the BE of Rs 39.5 trillion. Assuming an additional Rs 0.5 trillion (or 0.2 percent of GDP) on account of some other spending, the total spending of Rs 41 trillion in FY23E implies fiscal deficit of Rs 16.7 trillion next year (6.4 percent of GDP), same as the budget estimates.

Therefore, the GoI has the room to isolate consumers from roughly 15 percent hike in international crude oil prices, and take the hit on its own income first quarter of FY23.

But, what if crude oil prices remain sticky and average $90/bbl (or worse $100/bbl) in FY23? Well then, the consumers will have to share the burden. Every 10 percent hike in international crude oil prices leads to an additional 30-45 bps increase in the CPI, assuming the complete pass-through.

Nikhil Gupta is the Chief Economist, Motilal Oswal Financial Services.

Views are personal and do not represent the stand of this publication.