Who pays the price of oil? – The Financial Express

Clipped from: https://www.financialexpress.com/opinion/price-pinch-who-pays-the-price-of-oil/2214927/

The effect of higher oil prices is likely to spread widely, denting tax revenues, corporate margins, household purchasing power. We estimate that it could lower GDP growth by 0.6ppt, raise inflation by 0.7ppt and widen the trade deficit by 0.8ppt.

However, consumers and corporates will be better off compared to our base case scenario of Rs 2/litre cut in excise duties, as they split it between consumption and saving.

By Pranjul Bhandari , Aayushi Chaudhary, & Priya Mehrishi

On average, oil prices are $20/barrel (46% y-o-y) higher in the year so far, compared to the 2020 average. What if they remain elevated? Where will the impact be felt most—external balances, inflation or growth? And who will bear the cost—the government, corporates or consumers? What are the main worries, and are there any silver linings at all?

When oil prices fell quickly in 2020, the Centre was quick to raise oil tax rates so as to appropriate some of the gains. The Rs 13-16/litre rise in excise duties for petrol and diesel helped it raise revenues worth 1% of GDP, a huge help in funding the social welfare schemes during the pandemic.

But come 2021, the rise in global oil prices and its impact on domestic fuel prices has led to demand for a cut in the government’s excise duties, so as to ease consumers’ pain. We assume here that the government cuts excise duty by a token Rs 2/litre, and that works out to a loss of 0.1% of GDP in tax revenues.

The Centre will also face a higher oil subsidy bill. But since the deregulation of oil prices, that bill has shrunk (and the incremental cost is only likely to be 0.01% of GDP).

Adding up the cost of lower tax revenues and higher subsidies, we estimate that the Centre will face fiscal pressure of 0.1% of GDP.

Will this interfere with its plans to raise capital expenditure by 0.2% of GDP, one of the hallmarks of Budget FY22? Hopefully not. The government might be able to get a helping hand from elsewhere. We estimate that the government may have underestimated GST tax revenue collections by c0.4% of GDP for FY22. That could help fill some of the gap left by rising oil prices.

State governments levy an ad-valorem tax on oil, which implies that in periods when oil prices rise, so do tax revenues. Having said that, in view of the pain to final consumers due to the rise in oil prices, some states have lowered VAT rates in recent weeks. We assume that a handful of states will cut VAT rates by 5%. On aggregate, this leaves the states as beneficiaries of higher oil prices.

Multiplying state oil VAT revenues (1.1% of GDP) by the rise in domestic oil prices (c10% y-o-y), and shaving off the assumed cut in VAT rates (5% cut by one-fifth of the states), we estimate India’s states will gain 0.1% of GDP from the rise in oil prices.

This means the fiscal loss to the Centre (0.1% of GDP) will be offset by the revenue gains of the state governments (0.1% of GDP). There will be no net impact on overall government from rising oil prices under this scenario.

Before going into the pain suffered by corporates, it is worth noting that a 46% rise in global oil prices will only culminate into a 10% rise in domestic oil prices. The reason is that there are many levies and taxes added to the port price of oil before arriving to the pump price (e.g. transportation cost, commission, excise duty). Most of these add-ons (barring the state VAT) are fixed costs (per litre of oil), and as such don’t undergo any automatic increase as global oil prices rise, resulting in the percentage rise in pump prices being lower than the rise in port prices.
The pain to corporates from higher oil prices can either be absorbed in the form of lower profits, or can be passed on to consumers as higher prices, or a combination of both. In this section we tease out the likely split between the two.

From national accounts, we get the ratio of operating surplus of private companies as a percentage of GDP. We run a simple OLS regression between corporate profitability and domestic oil prices to estimate how much corporate profits can potentially fall. The sensitivity suggests that a 10% rise in domestic oil price will shave 0.25ppt from the profits-to-GDP ratio.

And how much would be passed on to consumers as higher prices? From the RBI’s database of 2,600-plus listed non-financial corporates, we find that for every 1ppt rise in input costs, profits tend to fall by 0.4ppt, and the remaining 0.6ppt tends to be passed on to consumers as higher prices.

This gives a sharing ratio between fall in profits and higher prices to consumers of 40:60. In this case, we have already estimated that corporate profits could fall by 0.25% of GDP. The corresponding pass through of higher prices to consumers would then be 0.4% of GDP.

This then becomes a double sting to consumers/households. Not only do they have to grapple with higher price of petrol and diesel they buy (mostly for transportation), but also face higher price for non-oil products which corporates pass on to them.

Petrol and diesel make up 2.3% of the consumption basket. A 10% rise in these will lead to a 0.2ppt fall in purchasing power. Scaling this with GDP (note that consumption makes up 60% of GDP) implies a 0.1% of GDP cost to consumers.

Add to this the higher price on non-oil goods and services that corporates pass onto to consumers (i.e. 0.4% of GDP), and the total cost to consumers adds up to 0.5% of GDP.

This cost will then be divided between a cut in consumption and a cut in household savings. Assuming a 70:30 ratio, the fall in consumption could be around 0.4% of GDP, while the fall in saving will be 0.2% of GDP.

Adding it all up implies a 0.6ppt fall in GDP growth if oil prices average $20/b higher in FY22. This will be split between the weaker fiscal position of the government (0% impact, with states offsetting the Centre), weaker corporate profits (0.25ppt) and lower spending by consumers (0.4ppt). We assume here that the government and the corporates cut current spending on the back of the oil price shock while consumers spread it out between lower consumption and dissaving. To be sure, we find that household savings could fall by 0.2% of GDP in this scenario.

As such, the overall impact of higher oil prices will be 0.8% of GDP, split between lower growth (0.6ppt) and lower saving (0.2ppt).

In alternative scenarios, if the Centre does not cut excise taxes at all, domestic oil prices will be higher (14% y-o-y instead of 10% calculated in the scenario described above), and the Centre’s gain (of 0.1% of GDP) will be split between further loss for corporates and consumers.

Alternatively, if the Centre cuts excise duty by a larger quantum (say Rs 4/litre or Rs 6/litre), it will face a larger tax revenue loss, and, interestingly, so will state governments, because the lower rise in domestic oil prices due to lower excise taxes means lower VAT revenue collection for states.

However, consumers and corporates will be better off compared to our base case scenario of Rs 2/litre cut in excise duties, as they split it between consumption and saving.

Sensitivities in recent years suggest that for every $10/b rise in oil prices, the current account deficit widens by 0.4% of GDP. With a $20/b rise in oil, the consequent widening in the current account deficit could be 0.8% of GDP.

We forecast the current deficit to rise by c2% of GDP in FY22 (to a 1.1% of GDP deficit in FY22 from a 0.8% of GDP surplus in FY21), with 0.8ppt rise led by higher oil prices and the remaining c1.2ppt due to higher domestic growth.

On inflation, petrol and diesel make up 2.3% of the basket, and a 10% rise in domestic prices raise headline inflation by 0.2ppt. But this is just the direct impact on inflation. The indirect impact can be calculated via the pass through of higher prices from corporates to consumers (calculated earlier at 0.4% of GDP). Rebasing that as a percentage of purchasing power so as to calculate the indirect impact on inflation and adding the direct impact to it suggests a c0.7ppt rise in CPI inflation.

Considering the oil price impact, we forecast inflation at 5.2% in FY22, higher than the 4% target, but lower than the 6% upper tolerance limit.
The only silver lining of this negative terms-of-trade shock is that the balance-of-payment (BoP) surplus is likely to shrink with the rise in trade deficit (from $96 billion in FY21 to $15 billion in FY22 by our calculation). This means that RBI will not be forced to buy a large quantum of dollars as it had to do in 2020, to keep the rupee from appreciating amid large inflows.

That, in turn, means it will have some space open up to buy bonds to ease the pressure in the bond markets. Recall that the Centre has signed up for a higher than expected borrowing plan for FY22, inflation remains elevated, putting a lid on how much more surplus liquidity RBI would want to add to the banking sector, and global yields are on the rise.

(Edited excerpts from from HSBC Global Research’s India Economics report dated March 17, 2021)

Bhandari is chief economist (India), Chaudhary is economist, and Mehrishi is associate, HSBC Securities and Capital Markets (India) Private Limited. Views are personal

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s