International prices of crude oil have been ruling buoyant above $70 per barrel (Brent ) since April 10 due to several factors. Notable among them are: (a) broad-based recovery of the global economy; (b) extension of curbs on crude oil production by OPEC countries up to December 2018; (c) fear of US sanctions on Iran, a major oil producer; and (d) geopolitical tension in other oil-producing countries.
Production of US shale oil is yet to make an impact in boosting global crude oil stocks.
The IMF’s World Economic Outlook, April 2018 has assumed the average crude oil prices to increase by 18 per cent to $62.30 per barrel in 2018 over the previous year. According to the World Bank’s April 2018 Commodity Market Outlook, average crude oil prices are expected to rise by 22.6 per cent to $65 per barrel in 2018 compared to $53 per barrel in 2017. The spot price of Brent crude oil has already surpassed the expected average level in the second week of April.
The recent hardening of crude oil prices — a tailwind for the oil exporters — may emerge as a major headwind for oil importers such as India. It would be difficult to sustain India’s macro stability if crude oil prices rule firm on an enduring basis. As the impact of rise in crude oil prices on India’s macro-fundamentals like inflation, fiscal deficit, external current account deficit, and exchange rate has been historically pervasive, policy makers need to be careful on multiple fronts to neutralise its adverse effects.
As of now, there are mainly four major upside risks to inflation in India. These are: (a) probable hike in Minimum Support Prices (MSP) for farm products; (b) staggered implementation of hike in house rent allowance (HRA) by state governments; (c) likely slippages of 2018-19 fiscal targets, both at Central and State levels; and (d) expected rise in global crude oil prices.
The first three risks are home-grown, which provide some leeway to the authorities in handling them carefully to keep the underlying inflation under control. The buoyancy in crude oil prices is entirely outside the control of the government/RBI and therefore need special attention to sustain macro stability.
The MSP for the major crops like rice and wheat are either close to or already more than one and half times the costs. Hence, there is no compelling economic reasons to announce a sharp hike in MSP for those crops, barring political compulsion to do so to meet farmers’ expectations on the eve of an election year.
According to the RBI, the direct impact of hike in HRA by the Central government on inflation, being statistical in nature, can be seen through. Moreover, the impact has been modest, 35 basis points at the most, and being dissipated by December 2018. If all State governments hike the house rent allowance together in 2018, the direct impact is likely to be around 100 basis points (bps).
The core CPI inflation is already high in India. Input costs are rising continuously. The headline CPI inflation may quickly rise above the comfort zone due to rise in crude oil prices. It would be difficult to ignore an additional 100 bps rise in CPI inflation due to hike in house rent allowance alone by State governments on statistical ground.
External sector risk
The external current account deficit (CAD) as proportion to GDP is expected to rise from less than 1 per cent in 2016-17 to about 2 per cent in 2017-18. The CAD may rise further in 2018-19, particularly if crude oil prices remain elevated throughout 2018-19. The Rupee is already under pressure and is likely to remain so in 2018-19 due to rise in the CAD. Moreover, following rapid normalisation of the US monetary policy, the interest rate spread between India and the US would narrow down further resulting in portfolio outflow, particularly from the debt segment.
The fiscal slippage of the Central government in 2017-18 has been perceived to be modest and can be argued as growth stimulating at an early stage of the economic recovery. Another fiscal slippage in 2018-19 may impair fiscal credibility. State governments are under pressure to implement the hike in HRA besides meeting demand for farm loan waivers. The fiscal space in 2018-19 seems to be limited and therefore both Central and State governments are reluctant to reduce taxes on petroleum products.
Both high crude oil prices and high fiscal deficit are inflationary. Is there a way out to reduce the inflationary impact of high crude oil prices through adjusting taxes on petroleum products without impairing the fiscal arithmetic?
When crude oil prices crashed, the government did not pass on the full benefit to consumers by imposing several levies/duties on petroleum products. There was an understanding that government would reduce such taxes when oil prices go up. This is fine keeping in view consumption smoothing with reasonable stability in retail prices of petrol/diesel. The government targeting certain amount of revenue from this sector is also understandable.
If the revenue target is met with crude oil prices at $70 per barrel, any increase in crude oil prices above that level should be absorbed by the government by reducing taxes. Calibration of taxes on petroleum products should be done in such a manner that consumers are protected without impairing the government’s revenue target.
Time is running out to do this exercise as most of the macroeconomic parameters are at stake. Pending government decision to bring petrol and diesel under GST, a downward adjustment of petrol/diesel taxes is overdue, failing which India’s macro stability may be jeopardised on the eve of an election year.
The writer is former Principal Adviser and Head of the Monetary Policy Department, RBI