10 minute read 27 Apr 2022
Global oil price shock

India’s policy dilemmas amid the global oil price shock

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.

10 minute read 27 Apr 2022

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India’s FY23 growth prospects may get adversely affected due to the global oil price shock.

In brief

  • India’s FY23 growth prospects are getting affected by the ongoing geopolitical tensions resulting in surging global crude prices and other supply side challenges.
  • Coping with India’s multidimensional vulnerability to global crude supply and price shocks requires a reconsideration of our short and medium-term strategy.
  • The IMF has projected India’s growth at 8.2%, the highest amongst all countries, but face high inflation prospects in FY23.  
  • A high expected nominal growth in FY23 may provide suitable fiscal space to the government to deal with the emerging economic challenges.

India’s long-term vulnerability to crude price shocks emanates from three sources. First, there is a marked increase in global crude prices on trend basis over the last three decades. Second, India’s exchange rate has been depreciating on a persistent basis over this period. Third, India’s dependence on imported oil has steadily increased. Global crude prices averaged US$18/bbl. in the 1990s, US$45.6/bbl. in the 2000s and US$76.9/bbl. during 2010s. India’s exchange rate depreciated on average, at a rate of 5.3% during the 1990s, 1.1% in the 2000s, and 4.4% during 2010s.

India’s dependence on imported oil which was at 38.5% in FY1991 steadily increased to 64.4% in FY2000 and further to 82.7% in FY2010[1]. It continuously increased, reaching another peak of 88% by FY2020. On top of these long-term determinants of India’s vulnerability, there are also added layers of short-term cyclical shocks in all these three parameters. In order to assess and formulate India’s policy framework that translates global crude prices to retail sales prices in India for the consumers and the industrial users, it is important to distinguish between long-term trends and short-term cyclical shocks. Although evolving, a robust policy framework is yet to be put in place. As a result, the economy keeps getting adversely impacted, both in terms of growth and inflation as well as inducing suboptimal responses from key stakeholders such as consumers, industrial users and the central and state governments.

Ongoing geopolitical crisis and its potential economic impact

The WTO projected that the ongoing global turmoil may lower global GDP growth by 0.7-1.3% points to range between 3.1% and 3.7% in 2022. It also projected that global trade growth in 2022 could be cut almost in half, from 4.7% as forecasted earlier in October 2021 to 2.4% to 3%[2]. The UNCTAD, in its Trade and Development Report Update released in March 2022 reduced its global growth projection to an even lower level of 2.6% for 2022[3]. The World Bank in its ‘Europe and Central Asia Economic Update’, released on 10 April 2022, has assessed that in view of the ongoing global uncertainty, GDP in the Europe and Central Asia region is expected to contract by (-)4.1% in 2022. The IMF, in its April 2022 issue of the World Economic Outlook has projected global growth to decline from an estimated 6.1% in 2021 to 3.6% in 2022 and remain at the same level in 2023.

The 2022 and 2023 forecasts have been revised down by 0.8 and 0.2% points from their corresponding estimates in January 2022 owing to the ongoing geopolitical tensions. Maximum downward revisions in growth prospects have been made for the Euro area followed by the UK, apart from Russia and Ukraine. India’s FY23 growth projection has been lowered by 0.8% points to 8.2% reflecting weaker domestic demand as higher oil price is expected to weigh on private consumption and investment, and a drag from lower net exports. The FY24 growth forecast has also been marginally revised down to 6.9%. Despite these revisions, India is projected to lead global growth throughout IMF’s forecast period from FY23 to FY28.

CPI inflation in the US increased to 8.5% in March 2022, its highest since December 1981, led by an increase in prices of gas, shelter and food[4]. According to available information[5], the US Fed has signalled more aggressive rate hikes in the upcoming months. The pressure on US interest rate would eventually call for the RBI also to revise domestic interest rates upwards.

The RBI, in its first monetary policy review of FY23 held on 8 April 2022, retained the policy rate at 4%. With this, the repo rate remained unchanged since May 2020. The RBI has instituted a new facility called Standing Deposit Facility (SDF) with its rate to be placed 25 basis points below the policy rate, at 3.75%. The Liquidity Adjustment Facility (LAF) corridor has been restored to 50 basis points, ranging from 3.75% to 4.25%. The former is the SDF rate, and the latter is the Marginal Standing Facility rate. The RBI’s policy stance continues to be accommodative. However, recognizing that there is a liquidity overhang amounting to INR8.5 lakh crore in the system, the RBI indicated that there would be a calibrated withdrawal of liquidity over a multi-year timeframe to ensure that inflation remains within the target going forward, while supporting growth. The RBI revised its FY23 growth forecast downwards to 7.2% and its CPI inflation projection upwards to 5.7%.

The opposite movements in growth and inflation are likely to imply minimal changes in the nominal growth prospects. The FY23 nominal growth may be marginally revised upwards because the magnitude of increase in inflation by a margin of 1.2% points is higher than the reduction in the real growth forecast by a margin of 0.6% points. We expect that the implicit price deflator (IPD)-based inflation may be higher than the CPI inflation as the WPI inflation which has a higher weight in determining the IPD inflation, continues to be higher than the CPI inflation. During 4QFY22, CPI inflation averaged 6.3% while the WPI inflation averaged 13.8% implying an excess of 7.5% points over the CPI inflation. The expectation of a higher IPD-based inflation is also confirmed by the implied 4Q IPD-based inflation at 8.7%. In this quarter, the implied nominal GDP growth stood at 13.9%. Thus, there is a strong likelihood that nominal GDP growth may be close to 14% in FY23, which is well above the budget assumption of 11.1%. This in turn implies that there is scope for a higher than budgeted growth in Center’s gross tax revenues (GTR).

Considering a tax buoyancy of 1.1, growth in Center’s GTR may be estimated at slightly higher than 15%, which is higher than the budgeted growth at 9.6% that implied a buoyancy of less than 1. This would imply an improved fiscal space for supporting demand in the system. The RBI has also indicated an improvement in the manufacturing capacity utilization ratio to 72.4% in 3QFY22 from 68.3% in the previous quarter. If this trend continues and the government is able to support demand in the system through both, private and government final consumption expenditures, we may expect a revival of the investment cycle.

From crude oil to retail prices: role of central and state taxation

Table 1 shows that the central and state governments together accounted for 45.5% of retail price of petrol since December 2021. Both tiers of government had last reduced their tax share in November/December 2021. However, the policy option is still available for both central and state governments to give some more relief to the retail consumers and users by absorbing some of the global price pressures. It is further notable that the Center may have somewhat larger fiscal space for this purpose since the main channel of successive increases in central taxes on PoL products was through the route of non-sharable excise duty components. By 11 April 2022, petrol and diesel prices had been hiked 14 times in 21 days. Prices of both petrol and diesel have remained stable since then.

Share of central and state taxes in the RSP of petrol in Delhi

It is also notable that over time the dependence of central tax revenues on taxation of petroleum (PoL) products has significantly increased from a trough of 8.1% of GTR in FY14 to 18.9% in FY21. In comparison the dependence of state governments on tax on PoL products in their own tax revenues (OTR) has remained relatively stable in the range of 16.8% to 18.2% during the period FY12 to FY21.

It is useful to consider the share of taxes on petrol and diesel in the retail selling prices in selected major economies. This share is the lowest for the US (Chart 1). India was the second lowest for petrol and the third lowest for diesel (as on 11 April 2022). India’s position is far more comparable to the European countries. Such high shares are often defended since taxation of PoL products serve the twin purpose of revenue productivity and disincentivizing the use of polluting products.

Share of taxes in retail selling price of petrol and diesel: selected countries

Strategizing short, medium and long-term responses

Coping with India’s multidimensional vulnerability to global crude supply and price shocks requires a reconsideration of our strategy in terms of its long, medium and short-term perspectives. In the long run, as far as crude supply is concerned, there is a need to reduce India’s dependence on imported oil by accelerating the pace at which the pursuit of non-conventional energy sources is being carried on[10]. There is also a need to accelerate unexploited domestic oil and gas reserves, both offshore and on land. As far as global crude prices are concerned, there is a need to diversify sources from which crude oil is being imported into India. In the medium term, the capacity for storage of oil needs to be expanded so that more options are available for absorbing external price shocks. In the short run, consumers and industrial users need to be exposed to long term trend in global crude prices while they should also be protected against excessive volatility around this trend. Releases from strategic reserves can reduce the volatility in supply and therefore prices.

A supplementary option is reverting to the mechanism of oil pool accounts with extensive revisions. Instead of many such accounts, there is a need to have only one such account. It may now be called as ‘Oil Price Stabilization Account’. Many countries have taken recourse to such an account. Significant fiscal discipline needs to be exercised to ensure that such an account does not go into accumulated deficit. It may be ideal that the account is replenished with a steady flow every year from the central budget and periodic withdrawal from this account may be made when global prices are excessively high. This would enable the government to expose the consumers and industrial users of oil to a predetermined trend of moderate price increases while protecting them from undue volatility. This will also lead to reduction in fertilizer and petroleum subsidies which are to be provided from the budget. The released resources can be used to finance the fund. The accumulated balance in the fund, which is carried forward from year to year, may be invested in global and domestic oil related assets including oil bonds, oil exploration companies etc.

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Summary

Coping with India’s multidimensional vulnerability to global crude supply and price shocks requires a reconsideration of our short and medium-term strategy. While in FY23, the high expected nominal growth may provide suitable fiscal space for the government to deal with emerging economic challenges, in the long-term, there is a need to reduce India’s dependence on imported oil. 

About this article

By D. K. Srivastava

EY India Chief Policy Advisor

A noted economist, D.K. Srivastava is an Honorary Professor at Madras School of Economics and Member of the Advisory Council to the 15th Finance Commission.