ABSTRACT
Crude oil prices are a major factor
in every nation's economic development. More than 70% of India's crude oil
needs are met by imports. This article's objective is to analyze how changes in
the price of oil affect the expansion of the Indian economy, in particular the
exchange rate and foreign reserves.
Crude Oil price, Growth of
Indian economy, Inflation, Imports of crude oil, balance of trade deficit,
Exchange Rates, Foreign Reserves
INTRODUCTION
Economic growth cannot be separated from the role that
energy plays. Oil continues to be one of the most important energy sources,
along with coal, natural gas, electricity, solar, wind, and nuclear energy, in
a nation's economy, supporting things like transportation, businesses, and
households. India is similar to other countries in this sense, however oil is
the major energy source there, making up 31% of primary energy consumption.
India is the seventh-largest nation in the world, with a population of more
than 1.2 billion. It contributes 17.2% of the global population and has the
second-largest population.
As per the Monthly Ready Reckoner January, 2023 (Ministry
of Petroleum & Natural Gas), India produces 29.7 MMT( million metric tons)
in 2022 and consumed 204.7 MMT of petroleum products as compared to 194.3 MMT
in the year 2021.India imports 80% of its crude oil, whereas just 20% is
produced domestically by PSUs like ONGC, OIL, and other private entities.
Several PSU businesses including IOCL, BPCL, and HPCL as well as private
entities like Reliance and Essar refine and process crude oil in India. India
is one of the world's top importers of crude oil. India mostly imports crude
oil from the Middle East.
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| Source: www.google.com |
Due to India's substantial reliance on oil imports, which
is demonstrated in Figure 1, multiple oil price shocks that have an impact on
both the domestic economy, directly and indirectly, are most likely to occur.
Figure 1:
Share of India's Oil Import
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| Source: Handbook of Statistics of Indian Economy: Reserve Bank of India |
Note:
Share of Oil Imports= Total Oil Imports (in dollars)/ Total Oil+Non-Oil
Imports(in dollars)
WHY DO OIL PRICES FLUCTUATE?
- The Organization of Petroleum Exporting Countries, or
OPEC,
is the primary factor affecting changes in oil prices. Algeria, Angola,
Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi
Arabia, the United Arab Emirates, and Venezuela make up the group known as
OPEC, which will consist of 13 nations as of 2021. The consortium decides
on production levels to satisfy global demand and has the power to change
oil and gas prices by raising or lowering output. Prior to 2014, OPEC
promised to maintain oil prices above $100 per barrel for the foreseeable
future, but in the middle of the year, the price of oil started to
decline. It dropped from a peak of more than $100 a barrel to less than
$50 per barrel. In that case, OPEC was largely to blame for the low price
of oil since it refused to reduce oil output, which caused prices to fall.
- Supply and Demand: Oil prices fluctuate
according to the principles of supply and demand, just like they do with
any other good, stock, or bond. Prices decrease when supply outpaces
demand; the opposite is also true when demand outstrips supply. Reduced
oil demand in Europe and China, along with a consistent supply of oil from
OPEC, have been blamed for the sharp decline in oil prices in 2014. Oil
prices dropped significantly as a result of the excess supply. Oil prices
are influenced by supply and demand, but oil futures actually determine
the price. A legally binding contract known as an oil futures contract
gives the buyer the right to purchase a barrel of oil at a certain price
in the future. The buyer and seller of the oil are required to complete
the transaction on the date specified in the contract.
- Natural Disasters: Another element that may
affect oil prices is natural disasters. For instance, the price of oil
increased by $13 a barrel when Hurricane Katrina hit the southern United
States in 2005, hurting over 20% of the country's oil supply. The
Mississippi River's flooding in May 2011 also caused changes in oil
prices.
- Political Instability: Since the Middle East
produces the majority of the world's oil supply, political unrest in the
region has an impact on oil prices globally. For instance, in July 2008, a
barrel of oil cost $128 because of unrest and consumer apprehension over
the conflicts in Afghanistan and Iraq.
- Production Cost and Storage: Oil prices might fluctuate
due to production expenses as well. While it costs less to extract oil in
the Middle East, it costs more to do so in Canada's oil sands.If the only
oil left is in the tar sands, the price might theoretically increase if
the supply of cheap oil runs out. The price of oil is also directly
impacted by U.S. output. Due to the extreme overstock in the market, a
drop in output lowers total supply and raises prices.
- Interest Rates: One of the fundamental
hypotheses contends that as interest rates rise, manufacturers' and
consumers' expenditures increase, resulting in less time and money spent
driving overall. Less demand for oil results from fewer vehicles on the
road, which can lower oil costs. This is what we would refer to as an
inverse correlation. According to the same principle, when interest rates
fall, people and businesses can borrow and spend money more easily, which
increases the demand for oil. More consumers bid up the price of oil the
more it is used.
Figure 2: Oil Price Fluctuations
over 2012-2022
Source: Handbook of Statistics of Indian Economy: Reserve Bank of India (Prices in Dollars)
● India has a current account deficit
because it imports more than 86% of its oil needs. India's import bill would
grow due to the increase in crude oil prices, which will cause the CAD to
worsen (difference between import and export).
● The consumer price index (CPI) is
also significantly impacted by rising crude oil prices. As a result, inflation
rises in tandem with rising crude oil prices.
● It is the discrepancy between what
the government receives in direct and indirect taxes and what it spends. The
price of gasoline won't go up if the government decides not to pass on the
increases in crude oil prices to the customer. But, somebody needs to absorb
the blow. It will be the Indian government in this instance. That will result
in a budget deficit, which is never beneficial to the economy.
● The RBI will need to raise interest
rates in order to contain inflation as a result of rising crude oil prices. It
will result in less expenditure, which will slow down the nation's growth.
● Oil import costs would increase for net oil
importers like India as the price of oil rises on the global market. A rise in
the price of oil globally will affect the trade deficit. Because of the rise in
inflation brought on by rising oil prices, actual GDP growth has been much slower.
● This connects domestic inflation to
global pricing. A typical developing nation like India that is seeing an
increase in the price of oil on the global market would see an increase in the
general price level as a result of both direct consumption of oil at the higher
price and an increase in the cost of producing final goods that utilize oil as
an input.
● If there is not a complete
pass-through, an increase in the price of oil internationally will result in a
higher oil subsidy, which will increase the government's revenue spending.
Additionally, oil prices in India are subsidized, but they also generate
significant tax revenues for the federal government and the states. Due to an
increase in ad valorem tax collections on oil and petroleum products, which must
be netted out to determine the net contribution to the government's oil
subsidy, an increase in the price of oil internationally would result in higher
revenue receipts.
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| Source: www.google.com |
IMPACT OF OIL PRICE FLUCTUATIONS ON EXCHANGE RATES
The terms of trade channel, the wealth effect channel, and the portfolio reallocation channel are three direct transmission pathways of oil prices to exchange rates that have been taken into consideration in the literature (Buetzer et al, 2016). Amano and van Norden introduced the terms of trade channel (1998a, b). The fundamental concept, according to Bénassy-Quéré et al. (2007), is to relate the price of oil to the price level that influences the real exchange rate. The output price of a country A's non-tradable sector will rise in comparison to a country B's non-tradable sector if the former uses more energy than the latter. This suggests that greater inflation causes the currency of country A to really appreciate (Chen and Chen, 2007; Buetzer et al., 2016).
If the assumption that the price of
tradable products is fixed is abandoned, effects on the nominal exchange rate
follow. In this situation, purchasing power parity serves as a link between the
fluctuations of the nominal exchange rate and inflation (PPP). We anticipate
that the tradable currencies of nations with significant oil dependence will
fall as a result of greater inflation if the price of oil rises. As the price
of the tradable (and non-tradable) commodities mentioned above changes, it will
have an effect on how the real exchange rate reacts, depending on how the
nominal exchange rate changes. Overall, depending on how prices are adjusted,
the causality encoded in the terms of trade channel may persist over various
time horizons.
Figure 3: Oil
Price and Exchange Rate Causality
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| Source: https://www.eia.gov/workingpapers/pdf/oil_exchangerates_61317.pdf |
The fundamental concept of the portfolio and wealth channel was first proposed by Krugman and Golub in 1983 and has since been reexamined by Bodenstein et al (2011). The underlying concept is that when the price of oil increases, wealth is transferred to oil-exporting nations (BénassyQuéré et al., 2007). The resulting short-run impact is reflected in the wealth channel, while the medium- and long-term effects are evaluated in the portfolio channel. When oil prices increase, wealth is transferred to oil-exporting nations (in US dollars), which is represented in an increase in exports and a positive current account balance (in local currencies). Because of this, we anticipate that with a rise in oil prices, the currencies of oil-exporting countries will strengthen and the currencies of oil-importers will depreciate effectively (Beckmann and Czudaj, 2013b). If oil-exporting nations reinvest their earnings in US dollar assets, the wealth effect may also create a short-term increase in the value of the US dollar.
According to the portfolio effect, two factors
will have an impact on the US dollar's short- and medium-term movements in
relation to the currencies of oil exporters. The first is the US's reliance on
oil imports in comparison to the percentage of US exports to nations that
produce oil. The second is the relative preference of oil exporters for US
dollar assets.
Figure 4:
Wealth and Portfolio channel
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| Source: https://www.eia.gov/workingpapers/pdf/oil_exchangerates_61317.pdf |
Oil prices have a significant impact on the Indian exchange rate, according to Hidhayathulla et al. (2014) in their study "Relationship between International Crude Oil Price and the Inflation Rate (CPI) in India from 2011 to 2014," but according to Kaushiket (2014) in his study "Oil Prices and Real Exchange Rate," there is no discernible impact of oil price change on the real exchange rate between the Indian rupee and the US dollar. Most often, as the price of crude oil rises, the cost of production inputs follows suit. As a result, prices for goods and services rise as well, which ultimately drives up the country's inflation rate. However, this process doesn't end there; it will also have an impact on consumer purchasing power, global trade, and the value of currencies. In essence, a few factors also have an impact on the price of crude oil. The number of producers, natural disasters, fresh inventories, and customer demand are some of them. In addition, the Indian government has taken several actions to lessen the effects of rising oil costs.
We anticipate that Indian exports would rise as the value of the rupee falls against the major foreign currencies, making items made in India more affordable abroad. Conversely, depreciation raises the cost of imports, which could lead to a decrease in the amount of imports as domestic products and services begin to replace imports due to the rise in the relative cost of imports. In this case, a depreciation of the rupee will raise net exports and hence increase GDP.
The average price of a barrel of Indian crude oil in March
2020 was $33.36 per barrel, down from $66.74 in March 2019. Due to a drop in
demand during the pandemic era, crude oil prices have dropped by over
two-thirds since the start of the year 2020. The rupee's value has declined
against the dollar, nevertheless, offsetting this decline.
Source: Handbook of Statistics of Indian Economy: Reserve Bank of India (Prices in Dollars)
Talking about foreign reserves, all asset owners, including
citizens of oil exporting nations, will be impacted by a decline in asset
prices and dividends in countries that import oil because of an increase in the
price of crude. On the other hand, asset prices in oil-exporting nations will
rise, affecting all asset owners once more, including citizens of oil-importing
nations. Therefore, the effect of changes in oil prices on the current account
and changes in net foreign assets (NFA) may be mitigated by capital gains and
income flows. Usually, the prices of bonds, stocks, and currency rates react
considerably more quickly than the costs and quantities of things.
The country's foreign exchange reserves, which are under the
custody of the Reserve Bank of India (RBI), have decreased for a fifth week in
a row as of April 8. Over these weeks, there was a sizable $28.5 billion
decline overall. This has caused considerable anxiety, particularly given the
possibility that a protracted Russia-Ukraine crisis may reinforce the trend and
result in a significant depletion of reserves, worsening the nation's balance
of payments. Between 2019 and September 2021, the growth of India's foreign
exchange reserves, which are primarily made up of holdings of foreign currency
assets, was constant. The assets making up the remaining 35–40% of India's
foreign exchange reserves are held in other global currencies, such as the
euro, pound, and yen, albeit they are expressed in dollar terms. The component
of foreign currency assets reached $580 billion around the same time as the
Forex reserves reached their peak of $642.5 billion for the week ending
September 3. In contrast, the reserves' size on August 8 was just over $604
billion, with currency assets totalling about $537 billion. This means that the
reserves' decline was primarily the result of a valuation loss brought on by
the US dollar's appreciation against other advanced-economy currencies and the
RBI's recent sales of dollars to support the rupee. The RBI may stick with its
current approach to the currency market up till the cycle of net FPI outflows
from the Indian market turns. According to Banerjee, additional significant
depletion of the reserves might not occur if oil prices remain stable. However,
she noted that a faster depletion of India's reserves should not be ruled out
if oil rises to $140 per barrel and capital outflows pick up speed.
For the time being, FPIs won't invest in Indian assets since
they are made unattractive by high oil prices, rising US bond yields, and the
global strength of the US dollar. Because the rupee offers excellent relative
real rates compared to the US dollar, carry traders are still invested in it.
Investors can sustain their faith in the currency thanks to the RBI's
aggressive actions. The central bank had earlier stated that the market would
not determine the value of the rupee. If oil prices remain at $100, the RBI can
help to keep the rupee stable. However, if oil prices rise much from here,
there could be significant pressure on the rupee to depreciate, according to
Banerjee.
CONCLUSION
The shocks have consequential impact on the Indian economy. The RBI should therefore acknowledge the significance of macroeconomic variables in the examination of monetary policy. Oil price changes that are unfavourable have a positive long-term impact on output, while also momentarily lowering prices and short-term strengthening of the currency. To control inflation and the exchange rate, the central bank adopts an expansionary monetary policy, which can result in greater output growth. For the Indian context, it is necessary to further investigate how the economy reacts asymmetrically to positive and negative shocks to oil prices.
A medium- to long-term drop in
output, demand for money, and the price of oil globally is brought on by rupee
depreciation. It briefly increases inflation because of its tiny impact. RBI
implements a contractionary monetary policy in an effort to save the domestic
currency. The globe shouldn't disregard the global ramifications of rupee
fluctuations, which can lead to huge changes in global oil prices.
In order to raise the production potential frontier, the policy of setting an exchange rate at a very competitive level may not be advantageous and may even be quite risky for India. Instead, India should concentrate on structural reforms to address supply-side bottlenecks, particularly in the resource and energy sectors. Examples of such policies include measures to promote exports such optimal resource allocation and permitting private sector participation in the energy sector. For the development of alternative energy technologies that will lessen India's reliance on oil imports, more money must be invested in research and development.
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