Oil price shocks affect economies around the world periodically. The once unthinkable $100 a barrel price is unrealistic no more. While swings in prices will continue to affect the sector and hence economies, effective ways to deal with such fluctuations have proven elusive. That domestic prices in India for some of the key products have remained immune to the surge in international prices does not mean that there are no consequences of rising prices. However, the ability to absorb such large price shocks without significant disruptions to the economy has been a recent experience. A large price rise in the petroleum sector immediately raises concerns on the country?s import bill, domestic fuel costs and transport costs.
Each price shock has led to re-examinations and reforms of the pricing and investment policies for the sector. However, frequent price surges have reduced the scope for ad hoc measures. One key change in the circumstances under which the analysis is conducted, as compared to previous experiences, is the transformation of India?s balance of payments position.
Also, by coincidence, the shifting composition of the economy towards services may have made it less vulnerable to energy price shocks than if the economy were more dependent on energy intensive sectors such as manufacturing. Access to alternative fuels such as coal has also meant that the impact of an oil price shock is dissipated at the economy level.
The capacity to export crude or refined products has also been a factor that has cushioned the trade balance in the context of India?s rising import bill. The boom in oil exporting countries, resulting from high oil prices, has also led to more inflows of worker remittances.
But these are unplanned circumstances that have alleviated the impact of price shocks. The more deliberate policies to reduce the immediate impact of shocks have been fiscal measures, often covering only some of the products of mass consumption. An underlying purpose of these measures is also to minimise the impact of energy price shocks on economic growth.
Given the universal application of petroleum products, the impact of changes in crude prices would also be equally widely spread. The transport and domestic sectors will be important and sensitive sources of demand for energy from crude oil. However, given that these fuels compete with other fuels as sources of energy, the longer term policy would have to consider the potential for diversification of fuel use in different sectors. The alternative sources of energy will indeed become more competitive at higher prices of petroleum products.
The economic policies in terms of taxes and subsidies on sectors such as petroleum are complex as they attempt to deal with both producer and consumer interests. In the process, both production and consumption choices may be drawn in entirely different directions than what market conditions may signal. Fears that a sudden increase in prices would affect the growth momentum and disrupt household budgets make fiscal concessions to absorb the shock more attractive than allowing the shock to be directly transmitted to consumers. But this type of response may also make oil more expensive than it could be: consumers as a group are likely to maintain their consumption at higher prices rather than reduce consumption. However, the uncertainty on how the burden of fiscal concessions would be split between domestic producers and taxpayers also influences investment decisions, probably in a manner that does not increase the profitability of investments.
High oil prices, therefore, have implications to overall economic growth, particularly since the impact is at the global level. However, the higher prices today are also a result of the acceleration of economic growth in India and elsewhere. It is clearly a force that is raising demand for energy, including energy from petroleum. The ongoing burst of economic growth in Asia?probably current as well as expected future growth?has spurred oil prices to higher levels. Remember that supply can take a long while to increase in this sector. The relatively price inelastic demand for petroleum has also meant that the price rise is all the more fast.
Does the price rise, then, also imply that further acceleration of economic growth would be limited by slower growth in fuel supplies? Unless there is unending growth in productivity, resources tend to place limits on sustainable economic growth rates.
While these are fairly standard relationships, what has kept the price shocks this time round less disastrous for India is the appreciating rupee. Fiscal measures (in terms of tax cuts) and oil bonds have been more important. But the rupee?s rise while crude prices shot up has meant that the price increase in domestic currency terms is smaller.
Yet, further crude price increases in global markets would stretch how far the rupee appreciation can cushion such pressures in the domestic context.
Clearly, a more reliable way to deal with the effects of rising demand for oil products would have to be greater efficiency in the use of energy.
?Shashanka Bhide is senior research counsellor, NCAER. These are his personal views