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Managing the Crude Price Pressure

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March 08, 2022

Why in news?

Surging oil prices constitute visible terms of trade shock and will necessitate skilled macro management.

What are the channels through which the Russia-Ukraine conflict will impact economy?

  • The negative terms of trade shock from higher commodity prices, particularly oil
  • A direct trade channel to the affected region
  • An indirect trade channel from weaker global growth
  • The tightening of financial conditions and capital flows as global risk appetite wanes

To know more about war impacts beyond oil, click here

What is the trend in crude prices?

  • Crude prices have surged well past a 110 dollar per barrel and as the conflict gets more entrenched, crude could remain elevated for much longer.
  • This would constitute a large, negative terms of trade shock to India to the tune of 1.2% of GDP.
  • The size of the commodity shock rises once higher prices for coal and gas imports are included.

What will be the implications on Indian economy?

  • The situation is similiar to an adverse supply shock to the economy that simultaneously impacts growth, inflation and the current account deficit (CAD).
  • Growth- The growth impact will manifest through
    • constraints on fiscal space
    • household purchasing power being impinged
    • firm margins coming under pressure
  • The quantum of the growth impact will depend on how the shock is distributed across the fiscal, households and firms.
  • The excise duty cuts will absorb the shock from oil and this year’s budget, therefore, forecasted lower excise duties collections and has less spending space.
  • External balances- Oil at 100 dollars will leave a tangible imprint on India’s external balances.
  • CAD- The October-December CAD is tracking 3% of GDP and the CAD is likely to stay close to those elevated levels in the coming quarters if crude is in triple digits.
  • The RBI has a war chest of foreign currency reserves, so there is no imminent threat to macroeconomic stability but the current account and balance of payments needs close monitoring.
  • Inflation- Higher commodity prices can pressure inflation.
  • Depreciation of rupee- The widening of the CAD and associated BoP pressures will create some depreciation pressures on the rupee.
  • A persistent negative term of trade shock will argue for a weaker equilibrium real effective exchange rate.

How should policy respond in the wake of terms of trade shock?

  • Allowing real depreciation of currency- Policymakers should let the rupee reach the new equilibrium in a gradual and non-disruptive manner
  • This is because it will facilitate the necessary expenditure switching to reduce imports, boost exports and help narrow an elevated CAD.
  • A real depreciation of the currency that acts as a shock absorber for the economy is the optimal response to a negative terms of trade shock.
  • While a real deprecation can be expansionary, it can also be inflationary generating an aggregate demand boost in the wake of an adverse supply shock.
  • All this will contribute to inflationary pressures, and will warrant a commensurate monetary policy response.
  • Excise duty cut- Cutting excise duties would buffer the impact on households and protect consumption, but potentially result in a larger hit to demand by shrinking fiscal space to spend.
  • If the government doesn’t cut duties, this will mean higher retail prices that can harden inflationary expectations, increasing the challenges for monetary policy.
  • Disinvestment- As soon as markets begin to stabilise, authorities must plough ahead with planned asset sales/disinvestment to create more fiscal headroom.
  • The new equilibrium will inevitably need some combination of a weaker rupee, higher rates, and judicious fiscal management.
  • Reducing import dependence- Policymakers must seriously consider systematically hedging crude price imports in global markets to protect the economy from periods of outsized volatility, apart from the medium-term objective of reducing our dependence on imported crude.

 

Reference

  1. https://indianexpress.com/article/opinion/columns/managing-the-crude-oil-price-pressure-7799847/

 

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