governance, political economy, institutional development and economic regulation

POTUS Saudi

The latest oil shock — an increase from $69 (average Indian import price) to $80 per barrel (Brent) this week — is courtesy the American President, Donald Trump, who unilaterally pulled the United States out of the 2015 deal between Iran and the UN’s Permanent Five (US, UK, Russia, France, China) plus Germany. This spooked the global financial markets, which justifiably fear renewed trade sanctions on Iran. Pulling out Iran’s 5 per cent contribution to world oil production has consequences. The nuclear deal which had earlier ended sanctions boosted world supply reducing oil price for India from $84.2 in 2014-15 to $46.2 in 2015-16. New sanctions may reverse the trend.

Who has POTUS benefited?

The gainers are the oil producers. The US President has imposed the supply constraint that Opec finds difficult. Saudi Arabia, Iran’s Sunni bête noir, is in clover. The 42 per cent increase in prices over last year, relieves fiscal stress; is wonderful for the long-awaited listing of Aramaco, its national oil company, and avoids the unpleasantness of having to tax its citizens or reducing their benefits.  Other countries in the Gulf, Venezuela and Russia will also benefit. America’s shale oil producers, for instance, are busily removing the covers on their drills.

Who suffers the collateral economic damage?

The big losers are China and India. For India, higher prices mean a bigger trade deficit and more stress on our foreign exchange reserves. Another outcome is rupee depreciation. Foreign hot money is pulling out to “safe haven” destinations also in expectation of an increase in US interest rates. The hot money bleed made the rupee slide by around six per cent to more than Rs 68 against the US dollar from around Rs 64 earlier. But it is still overvalued and needs to go down to Rs 70.

The risks for India

The oil shock poses two risks for India. First, the fear that it will increase the current account deficit (CAD) — the difference between international receipts and payments, from trade and income flows — beyond the acceptable level of two per cent of GDP.

Second, it poses a conundrum of navigating conflicting objectives — preserve the market-based retail oil price mechanism whilst graduating the price shock for consumers and containing inflation.

Moody had revised India’s credit rating upwards last year. Standard and Poor had not. Enhanced imbalance on the external account and missing the fiscal deficit target for 2018-19 will invite a review of India’s sovereign risk.

How serious is the risk for the CAD – red flagged at max. 2% of GDP 

At $80 a barrel, our additional spend on oil imports could be around $9 billion this fiscal, net of the increased earnings from oil product exports. But the threat to keeping the CAD below the target of two per cent of GDP is over-hyped.

The oil shock has a silver lining. With more robust fiscal balances in the Gulf, investment and jobs will increase for Indian workers, who generously remit all their earnings. Inward remittances, higher than $69 billion last year, will dilute the impact on CAD. More petro-dollars to spend, can boost our exports to the Gulf.

Second, the accompanying six per cent depreciation of the Indian rupee will make our price-sensitive exports much more competitive. Last year exports grew by 12.1 per cent to $300 billion. A three per cent growth in exports this year would generate the additional spend needed on oil imports of $9 billion.

Third, a weaker rupee discourages imports generally. Last year total imports increased by 21 per cent. Making domestic producers more competitive is in India’s interest. The risk of breaching the CAD cap is minimal.

imports

The risk of balooning the fiscal deficit

Transport minister Nitin Gadkari had recently opined that subsidizing oil consumers is not aligned with a market economy. Not quite right,sir. It is in a market economy that the question of subsidy arises – of course subsidy must be tightly targeted, which ours is not.

In an old, Soviet-style economy, there are no subsidies because the government sets the retail price for the production units which it also owns. In our context, this is analogous to directing ONGC to absorb the cost. This is best avoided.

Preserve oil PSU commercial autonomy

Last year, ONGC assisted in achieving the disinvestment target by buying the government’s shareholding in HPCL. Whilst even such nudging to support the government is undesirable. But far worse is to dilute ONGC board’s commercial autonomy for pricing products. More importantly administered pricing distorts markets and discouraged private sector investments and operations – both highly desirable in oil.

Three better options exist : They need professional effort and political capital 

Slash frivolous budget allocations for current year

swaach

Three options present themselves. First, intrusive Budget scrutiny can do the trick. A fiscal “surgical strike” slashing frivolous expenditure, which has crept in, can generate the Rs 0.6 trillion to sanitise consumers from a price increase. This is just six per cent of the Rs 10 trillion, which the Central government spends on schemes without including wages, pensions, interest or capital expenditure.

Pass through the price increase to customers @ 50 paise per litre per month  

Second, it is not desirable to entirely sanitise customers from the oil shock. This will kill the liberalised “marked to market” regime for retail prices of oil products, introduced last year.

It is also environmentally irresponsible not to have a price signal to induce lower consumption of petroleum products and incentivise users to switch to more efficient end-use equipment — cars, motorcycles, water pump and generators. Mr Gadkari is right. A portion of the oil shock should be passed through.

pollution

Invoke the GST style federalized decision mechanism for states to cut VAT equal to the windfall gains for price increase.

But state governments must be cajoled to give up the windfall gain accruing to them because VAT (their tax) is an ad valorem rate and not a specific rate as is Central excise or Customs. TERI, a New Delhi think-tank is modeling a revenue neutral taUse x realignment which would be useful. Government would do well to consult widely rather than go about taking decisions in secret as it tends to do.

Fiscal deficit 2018-19 target of 3.3% of GDP is unreal – last year we were 3.5%

Piyush Goyal

Lastly, Budget 2018-19 projects a fiscal deficit of 3.3 per cent of GDP versus 3.5 per cent in 2017-18. The target is not credible. Capitalisation of stressed public sector banks; agriculture minimum support price revisions; and the new flagship “Ayushman Bharat” medical insurance scheme will surely push the deficit beyond the target. The N.K. Singh committee report on Fiscal Responsibility and Budget Management “blessed” variations in fiscal deficit capped at 4 per cent of GDP. Following this lead can provide an additional Rs 1.3 trillion to the Finance Minister, Piyush Goyal, part of this could be used for absorbing oil price increase. But stoking inflation is a real risk here.

Oil at $100+ soon?

A further increase to the 2011-2014 level of $100+ a barrel is unlikely. Oil producers, like Venezuela, need to cash into the high price. Sanctions on Iran, now seem likely since the POTUS-Kim Jong – peace talks have collapsed and POTUS needs to look muscular.

POTUS

But even if imposed, sanctions will not bite till six months after they are imposed. If oil spikes nevertheless, a temporary adjustment loan, from the IMF, can dilute this external shock, which can otherwise jeopardise our plans for mitigating carbon emissions to meet targets to 2020.

The continued supply of Iranian oil, but denominated in rupees, like the Russian trade earlier, is also possible. The United States may accept such necessary but limited “exceptions” for Iran as a humanitarian response “needed by the Iranian people” to survive.

Economic stress creates reform entry points because the urgency becomes publicly visible. 1991 was an extreme event. The 2018 shock is low intensity in comparison. But it can help to push the needed third generation of reforms — deep fiscal austerity, energy security and PSU autonomy.

Adapted from the author’s opinion piece in The Asian Age, May 25, 2018 http://www.asianage.com/opinion/columnists/250518/oil-shock-entry-point-for-deepening-reform.html

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