Skidding on oil
By causing the price of crude oil to rise, the Iran-Israel standoff and ECB’s quantitative easing programme threaten India’s economic and stock market recovery in 2012
Amar Pandit
In 2011, the single-most important factor that caused economic growth to decelerate, foreign portfolio investments to shy away, and stock markets to nosedive was high inflation (weak global growth would rank a close second). At the beginning of 2012 the outlook had improved. Inflation is expected to soften this year due to a positive base effect and lower food prices. The central bank is expected to begin cutting rates. By encouraging consumption and investment, this should lead to a revival in corporate earnings and sustain the stock market rally (driven by strong portfolio inflows at the start of the year). The unfolding of this positive script is however now threatened by rising crude oil prices.
Iran-West stand-off
The on-going stand-off between Iran on the one side and Israel and the Western powers on the other over the former’s pursuit of a nuclear programme threatens to disrupt oil supplies from OPEC’s second-largest oil exporter, and could result in a sharp escalation in oil prices. Israel has threatened to attack Iran’s nuclear installations. The US and other Western countries have imposed trade sanctions. The 27-member European Union (EU) has decided to impose an embargo on oil imports from Iran beginning July. Iran has retaliated by threatening to cut off supplies to six European nations: Italy, Spain, France, the Netherlands, Greece and Portugal. It has also said it will block traffic passing through the Strait of Hormuz, a 21-km wide (at its narrowest) waterway through which 1.7 million barrels of oil pass each day from Middle East suppliers to countries all over the world.
Owing to this sabre rattling, global oil prices have risen to their highest level since 2008: Brent Crude is now within sniffing distance of the $130 per barrel mark.
With global growth expected to be weak this year (3.25 per cent, according to the International Monetary Fund’s projection), the price of oil (and other commodities) was expected to be soft this year. But the Iranian crisis has extinguished those hopes.
India, which imports about 80 per cent of its oil requirements, will pay a price not because oil supplies from Iran will be affected. India does not support the sanctions and plans to continue importing crude from Iran. But higher prices will translate into a higher oil import bill for the country, from an already bloated $106 billion (FY11 figure) annually.
ECB’s QE may stoke inflation
Between December 2011 and February 2012, the European Central Bank (ECB) has lent about $1.2 trillion to banks in Europe (a figure comparable to the Fed’s twin quantitative easing or QE programmes). The correlation between quantitative easing and high commodity prices (especially in the case of commodities such as oil where the supply-demand dynamic is tight) is well documented. A QE programme, by making cheap money available to investors and whetting their risk appetite, causes a run-up in the stock markets – as has already been witnessed in early 2012. But once commodity prices begin to rise and inflation rears its head, the market tends to stall (especially in the case of a commodity-importing country such as India).
Negative impact on economic fundamentals
These two factors – standoff with Iran and quantitative easing by ECB – could keep oil prices on the boil and worsen India’s already weak economic fundamentals.
Current deficit. Owing to faltering exports but high imports, India is expected to end FY12 with a record high current account deficit of around 3.5 per cent (of GDP), a level not touched in the past 12 years. If the oil import bill soars, its current account deficit could widen further in FY13.
Fiscal deficit. Since the government does not allow automatic pass-through of high crude prices to consumers, rising crude prices do not affect consumers immediately. Instead they wreak havoc on the government’s finances. An increase of one dollar in the price of crude raises the country’s subsidy burden by Rs 7,000 crore a year.
In FY12 the centre’s fiscal deficit would range anywhere between 5.5-6 per cent, depending on the average price of oil for the year. A high fiscal deficit forces the government to borrow more from the market. Besides preventing interest rates from softening, high government borrowings also crowd out private borrowings. And if this happens, private investment will not revive, and industrial growth will remain low.
Interest rates. If crude prices soar, instead of the expected decline to the 6-7 per cent level, WPI could once again move up. In the face of high inflation, the central bank would find it impossible to cut interest rates despite growing growth-related concerns.
The rupee. The rupee has gained 8.31 per cent this year due to robust foreign portfolio inflows after falling about 16 per cent in 2011. When the price of crude rises, oil refiners need more dollars, and this puts pressure on the rupee. Weakening portfolio inflows would also cause the rupee to decline.
A vicious cycle could then set in: foreign portfolio inflows would peter out due to weak fundamentals, causing the rupee to decline. And a declining rupee would scare foreign investors further away since their dollar returns on investments would get negatively affected.
Corporate bottomlines. High raw materials prices and high interest costs have already dented corporate margins in 2011. If these input costs don’t decline, the expected improvement in corporate earnings will not materialise.
Stock markets. The current rally is being driven by liquidity flows from abroad and low valuations in India. But for it to sustain corporate earnings need to improve. As mentioned, high crude prices (and that of other commodities) would act as the proverbial spanner in the works.
In recent years, oil price spikes have become a recurrent feature – either due to geo-political tensions in the Middle East or due to quantitative easing by Western central banks. India needs to urgently get its energy-related policies right.