How the Crude Oil Price Spike Will Upend India's Fiscal Balancing Act

Russia’s offensive refuses to pause. Since February 24, a little over 2.3 million Ukrainians have fled seeking a safe haven while the Russian army is upping the stakes and making the war exponentially dirtier by attacking civilian enclaves, non-military infrastructure and even hospitals.

On March 10, Russia retaliated to the banking, business and commercial sanctions imposed on it by the US and the EU by firing counter-sanctions of its own. Russia’s counter-sanctions impose a ban on the export of telecom, electrical, agricultural, auto, medical and tech equipment till the end of 2022.

In this volley of sanctions and counter-sanctions, it is commodity inflation that has been roiling the global economy. On March 6, America’s Secretary of State Anthony Blinken declared that his country and their European partners are grafting together a plan to ban the import of Russian oil. As expected, this had the effect of setting off a panic in the crude oil market. Brent crude oil prices shot up to a whopping $140 a barrel triggering speculations that the oil prices per barrel could touch $200, a figure that will upend the fiscal math of many an emerging economy.

This panic is duly substantiated. Russia’s muscle in crude oil production is near unparalleled. Globally, it stands at the second position as far as export of petroleum is concerned. It produces 4.5 million barrels per day (bpd) of crude oil products and exports an additional 2.5 million barrels of oil products per day.

Larger questions loom as to whether other oil-producing countries will be able to fill the vacuum left behind by Russia’s exclusion. The US and the EU are now increasingly left with no option but to rely on reserve oil inventory to make up for the deficit. On March 1, the International Energy Agency announced that it will oversee the release of 60 million barrels from its strategic reserves. That, experts fear, is not enough to make up for the ban on Russia’s oil exports. What’s worse is that the spare production capacity of OPEC does not reach beyond 2 million bpd. Oil production of countries such as Canada and Brazil, which have been witnessing a rise in oil production, still can’t boast of a cumulative oil production exceeding 1 million bpd.

Already, problems have started surfacing. Consider, for instance, that Lebanon has run out of diesel not because it does not have crude oil to process but because its refineries have machinery equipped to process Urals crude (of Russian origin). Recalibrating these machines for other crude oil variants will take time while domestic demand sees no decline and prices keep ratcheting.

India will also have to brace itself for an inflationary shock that will only serve to bludgeon a COVID-ravaged economy.

The imminent whirlwind

India’s economic situation worsens with every passing day of the Russia-Ukraine war. Grim predictions that are threateningly close to coming true are the norm as India’s crude oil import costs skyrocket. Edelweiss Wealth Research in a note has marked out that India’s trade and current account deficit are both set to widen as crude oil prices jack up. The widening of the two deficits will drag the rupee down further.

“India’s monthly crude oil imports averaged 143 million bbl or $11.3 billion during December 2021-January 2022, when the price of the Indian crude oil basket (ICB) averaged $79/bbl. The ICB at $117/bbl (38% or $32/bbl increase in the last one month) would shore up the import bill (for stable volumes) by 48% to $16.7 billion (for the month),” the note states.

As per Edelweiss, every $10 increase in crude oil prices, potentially leads to an increase in the CAD by 0.4-0.6% of the GDP.

Impact of increase in crude oil prices on the current account deficit

There is more worrying news for the economy as fuel inflation will set the tone for inflation in other commodities. This is because crude oil prices have a direct bearing on the rise of retail and wholesale inflation.

Currently, crude oil and related products have a weight of 4.4% in retail (CPI) inflation and 10.3% in wholesale (WPI) inflation. As such, a change in crude oil prices tends to get directly reflected in the CPI and WPI reading as well as indirectly through the pass-through to other components over time.

“A $10 increase in crude oil prices can push retail inflation by 50-60 bps and wholesale inflation by 125-135 bps. The Indian crude oil basket price as of the end of February 2022 ($117/bbl) was 56% higher than the average of $75/bbl in December 2021. This could raise CPI by around 250 bps and WPI by around 580 bps. This increase would not be reflected in the inflation print for February 2022, as fuel prices have been left unchanged due to state elections since December 2021. If sustained, the increase would be seen in March 2022 after the election results,” the note states.

Impact of increased crude oil prices on inflation

Additionally, edible oils have also been on a run for the last two years, and the Russia-Ukraine war only serves to fire up the commodity upswing further given that India imports close to 60% of its requirements through Russia and Ukraine. Edible oils have a weight of 3.56% in CPI, and a 10% rise in prices will push up edible oil inflation by nearly 30 bps.

Will the fiscal math hold steady?

The rise in crude oil prices will send inflation metrics soaring in India. The Indian government can be comfortable with inflation for so long before it is, perforce, boxed into a corner where it will have to provide fiscal support by cutting back on fuel tariffs and ratcheting up food and fertilizer subsidies. It is at this critical juncture that the Indian government is hoping for a quick de-escalation of the war, failing which muted tariff income and higher social spending will disrupt the government’s budget calculations leaving it with little to no option but to to rely further on market borrowings.

“Excise duties currently stand at Rs 27.9 per litre for petrol and Rs 21.8 per litre for diesel. A Rs 1 per litre reduction in excise duty on petrol and diesel can result in lower revenues of around Rs 12,000 crore for the government. This, in turn, could have implications for the CAPEX programme for the coming fiscal, which was being relied upon for spurring economic growth and attracting private investments. For FY23, the central government has budgeted a fiscal deficit of Rs 16.61 lakh crore and market borrowings of Rs 14.95 lakh crore.”

Edelweiss has drawn up figures on the impact on the total market borrowings of the Indian government on account of fuel tariff forgone.