High oil prices can upset economic growth

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: Testing times are here. The unprecedented rise in oil prices is potentially dangerous for developing countries on a high growth path. Higher international crude oil prices result in higher domestic prices either directly through higher transportation and energy costs or indirectly through rising debt burden of a country, as higher inflation rate also leads to higher interest rates. As a consequence, high oil prices can upset the momentum of economic growth.

Increase in oil prices would also have significant impact on the external balance of payments. The most obvious impact stems from the deterioration in the terms of trade. An oil price increase would shift the terms of trade between net-importing and net-exporting economies in favour of the latter. If the crude oil price rise is not allowed to be passed through to the domestic consumers, prices would remain favourable for domestic industrial production, marginally raising the GDP. However, this situation would lead to a very large increase in the trade deficit and also the fiscal deficit could become unsustainable. On the other hand, if government expenditure is reduced in order to bring down the fiscal deficit, it would adversely affect industrial growth and hence the GDP.

If the effect of the oil price rise is passed to the domestic sector, it would increase overall price inflation by 3% points over the reigning price inflation of about 6%. The domestic overall price rise would impact industrial growth and GDP adversely, but both the trade deficit and the fiscal deficit would be controlled in this scenario. Therefore, while the effect of an oil price shock is higher domestic prices and reduction in economic growth, these adverse effects are less damaging in the long run, because both fiscal deficit and trade deficit are held at lower level.

High and volatile international petroleum prices impart an element of uncertainty in the inflation outlook not only for India but also the world economy. With increasing dependence on imported crude and growing openness, India is no longer insulated from the rest of the world. This inflation uncertainty, together with the unresolved global macroeconomic imbalances, casts its shadow on the interest rate scenario.

The decline of net profits margin has dampened the activities of new innovation and more competitive spirit of the Indian oil companies.