1. The saga of oil price decline

The saga of oil price decline

Declining oil prices pose greater risks of increased volatility in financial markets, especially in EMEs.

By: , and | Updated: March 28, 2015 1:23 AM

One of the most significant macroeconomic developments during 2014-15 has been the steep decline of crude oil prices in the international market. Crude oil prices have declined by more than 50% since June. The current phenomenon is predominantly supply-side driven as rising non-OPEC production (particularly US-based shale gas) and changes in OPEC policy objectives of not reducing the supply are playing major roles. Among demand-side factors, slow global economic growth has played a limited role in the current demand-supply mismatch as China and India—two major oil-importing economies and which also, to a great extent, are considered to be the drivers of global demand amongst EMEs—imported more crude oil in 2014 as compared with 2013, despite moderation in growth.

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It is being repeatedly stated that falling oil prices will have an overall positive impact on the global economy with varying implications across economies. In particular, the decline will increase disposable income in oil-importing economies and will enable the EMEs in saving on the subsidy bill, thereby creating fiscal space in these economies. However, given the deflationary scenario in advanced economies, falling oil prices would further lower inflationary expectations, making it difficult to move away from deflationary conditions and experience robust growth. Also, there would be welfare redistribution effect hurting economic growth of oil-exporting countries and benefiting that of importing countries by changing terms of trade. However, demand- and supply-side factors alone do not capture the movement in oil prices. In the current scenario, where oil is behaving like a financial asset, declining oil prices further poses greater risks of increased volatility in financial markets, especially in EMEs.

Regression results

Historically, there appears to be a strong and positive correlation between changes in crude oil prices, remittances and exchange rates in India (see graph). In fact, a regression analysis in ‘ordinary least square’ framework for data ranging from Q2-1990 to Q2-2014 gave positive and statistically significant elasticities for crude oil price (0.18) and exchange rates variables (0.51), with remittances as dependent variable. This implies that for one dollar increase in crude oil prices, remittances would increase by 0.18 dollar and vice-versa; and depreciation of the rupee by one dollar would lead to an increase in remittances by 0.51 dollar and vice-versa. The regression model is quite robust with high level of adjusted R-squared and Durbin-Watson Stat at 2.47. Augmented Dickey-Fuller test statistics derived from unit root test reveals that the equation has property of stationarity at 10% level without difference and at all levels at first level difference.

Pros and cons for the Indian economy

The World Bank data brings out the fact that in, 2012, around 47.5% of remittances were received in India from the West Asian countries, followed by North America (22.24%), Europe (9.45%) and other countries (20.81%)*. The increasing share of remittances in India from West Asia may impact the flow of remittances to India; however, partly the impact may be offset by the recovery being seen in the US economy. The time series data of oil price decline shows that there has been lagged impact on remittances. For instance, in 1997-98, when oil prices declined, the impact on remittances was seen in the following year, i.e. 1998-99. Similarly, the decline that was witnessed in oil prices in 2008 was followed by a lagged impact of one year in the flow of remittances. The data on remittances shows that this trend is likely to continue; therefore, India may witness a decline in the growth rate of remittances in 2015 though cumulative remittances may not see any decline.

Pros: The steep fall in prices of oil has provided a stimulus to the Indian economy in the form of higher fiscal space due to lower import bills. Lower petroleum product prices may also lead to a further moderation in inflationary conditions due to reduced input and transportation costs. This may also result in a marginal surplus on the current account front, making the overall macroeconomic scenario favourable. This is also an opportunity for India to create buffers to deal with any future shocks.

Cons: Apart from the positive spillovers, the Indian economy may witness some negative consequences. Declining oil prices are likely to bring down activities on the oil exploration front, thereby posing a challenge for meeting domestic energy requirements. Further, oil-exporting countries are expected to see a fall in income and employment levels, exerting a pressure on pay cuts and labour repatriation. This may worsen the employment scenario in the economy and also in the form of reduced remittances may impact the current account in the long run, as remittances feature under private transfers in the overall balance of payments.

Policy suggestions

Falling oil prices have provided an opportunity to utilise the fiscal space created by lower oil prices to look at increasing public sector investment. This would result in crowding-in private sector investments and also provide a fillip to the economy.

Financial sector players are leveraging on falling oil prices by trading and building positions (short and long) just like financial assets, which is complicating the architecture of financial markets. Financialisation of oil as an underlying asset would promote speculation, thus exposing oil-importing countries to volatility and price hike in the future. Therefore, there is a need for the regulators to timely intervene in the commodity market through forwards and options.

Even though the current account deficit is at a comfortable level, sustaining this for long may be challenging since reduced oil prices would result in a decline in the growth rate of remittances, which is expected to be zero or negative in 2015. Further, gold imports, which are now seen to be clawing upwards, may exert pressure on the current account in the medium to long run.

Given the prevailing lower oil prices, the government may also look at entering into long-term forward contracts which may provide strategic reserves, and which can act as a cushion in case oil prices start rebounding. The only risk here is if the oil prices decline below the prevailing prices of less than $50 per barrel. However, the risk appetite exists, given the potential gain. To begin with, the government may look at hedging only a fixed proportion of total oil imports.

Archana Naresh is joint director; Naveen Kumar is officer on special duty, MR, ministry of finance; Kavleen Chatwal is consultant, UNDP. Views are personal.

Author’s calculation. Data has been obtained from the Bilateral Remittance Matrix reported by the World Bank for 2012.

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