By Jayant Rao

Edited By Namitha Sadanand, Senior Editor, The Indian Economist

Oil has been the center of the core fiscal and political issues, be it reducing the fiscal deficit, the Current Account Deficit or inflation, or deregulating the oil prices.What is right according to the economic pundits is politically unfeasible, and solutions which are politically feasible either take time to have an impact on the economy or are insufficient for the intended impact.

For growth to kiss India’s feet, it has to have an uninterrupted supply of energy apart from other things- energy required and consumed is in the form of oil, and 75% of this requirement is met through imports. The international market for oil makes us highly susceptible to foreign exchange risks and price rise risks. The market for global crude oil is not a perfectly competitive market, where the buyers command the price; but an oligopolistic one, wherein the buyers do not have much say in the price discovery. The prices are dependent on factors such as demand for oil globally, for instance- if the aggregate world economy is doing well, it leads to more demand, which in turn leads to an increase in prices, keeping the other factors constant. One more important factor is the regulated production/extraction of oil by OPEC, mainly Saudi Arabia. The OPEC generally ensures the DD-SS gap is kept so high so that the prices are always elevated.

The current decrease in oil prices will address many problems back home. Expert calculations state that every $ 10 decrease in oil prices would save India up to $ 16-17 Billion. The CAD would be in the range of 1.6%– 1.7 % of GDP( the major components of CAD are Oil imports and Gold Imports) , which would help in meeting the fiscal deficit target of 4.1% of GDP and would also help reduce inflation. They say that the decrease in oil prices is not temporary in nature and are here to stay. The decrease in oil prices is due to the softening of demand and supply side factors. The demand side factors include reduced Chinese growth expectations (one of the major consumers of oil) and the tightening of US monetary policy which reduces the flow of speculative money in crude oil; while on the supply side, Iraq’s high oil production is another factor.

It is just a matter of time before the trend reversal sets in. Then we go back to square one: the same CAD issue, the fiscal deficit problem and the troublesome inflation. Dependence on the international market for oil keeps us open to price shocks; it is an unhedged risk. We are virtually dependent on the international crude prices that determine the extent of deficit we run into and the extent of inflation we have to suffer. An implementable and achievable economic policy is that which has less assumptions and exogenous factors built into it. If we look at the policy framework, outlooks and predictions about the Indian economy by various institutions, all of them carve their conclusions based on some or the other assumption about the oil price trajectory. If these assumptions go wrong, so does the model. In any successful model, there should be fewer exogenous factors, and more endogenous factors that can be controlled.

How do we do away with this exogenous factor of oil price?

The fiscal deficit issue can be resolved by completely deregulating diesel prices. The previous government had laid out a good roadmap to do away with the subsidies by partially deregulating the petrol prices. Now it is on the Modi government to take forward this initiative by doing the same and letting the price of the fuel be market driven. This move will ensure a reduction in fiscal deficit, and to some extent, have an indirect effect on reducing inflation.
To eliminate the CAD issue the government can start talks of bilateral agreements with oil exporting nations, to exchange the oil exports with either of the country’s currencies. It can also think of making a tri-lateral agreement with the oil exporter and another country where the trades co-mingle. For example, if India, Iran and Japan enter into a tri-lateral agreement in which India agrees to pay Iran in INR for oil imports, Iran to pay Japan in INR for their imports and Japan would pay in INR to India for their import from India. This kind of agreement has 2 major benefits; the risk of foreign exchange exhaustion gets eliminated thereby keeping the Forex reserves intact and the trade balance with different countries are also kept in check.

I believe this can be achieved in the short to medium run; it is just a matter of time before we try and find trade opportunities with different oil exporting countries or create a maze of countries as explained above and this will ensure we depend less on USD and trade more in different countries, after all currencies are just a medium of exchange.
The third issue of Oil price instability which directly hits inflation can be tackled only in the long run; we either move away from oil to other indigenous sources of energy or buy over oil reserves as China does. But the acquisition, extraction and repatriation of oil and the price fixation would depend on the country in which the oil reserves are situated. China, for example, has the highest overseas investments in the energy sector; it is trying to ensure uninterrupted supply of energy to its fast growing economy. The best way to do away with the price issue would be to become less and less dependent on oil, and to move away from it as the primary source of energy to unconventional sources of energy.
The three issues can be tacked over the short (fiscal deficit), medium (CAD) and long term (eliminating oil dependence) in a phased out manner. This government has got the golden opportunity, in the form of complete majority in the Lok Sabha and the willingness to get the economy on track, to address all the issues and lay out a clear roadmap to achieve them.

Jayant Rao is currently working as an analyst with D E Shaw & Co and has a penchant love for Economics. He feels economics is an inseparable part of philosophy which has to be read in conjunction to get a better sense of it. He is a big time foodie and a coffee lover and never steps back in trying various cuisines. He likes to read Indian philosophical books and enjoys listening to music.

Posted by The Indian Economist | For the Curious Mind