With crude oil prices hitting $80 dollars a barrel, and looking like it is not coming down in a hurry, India’s macroeconomics cannot but deteriorate. Even at an average price of $70-$72 for 2018, the trade gap will widen and the rupee will weaken. At a time when the output gap is starting to close, these factors will combine to drive up inflation. Moreover, should the government choose to raise MSPs for crops, it would accentuate the price increase. MSP increased 8% in 2017; typically, for every one percentage point increase, headline inflation could rise by 9 bps.
If all these factors kick in, retail inflation which averaged around 4.1% in 2017-18 could well be up to 5.1% this year, a sharp jump of 100 basis points. The government could, of course, choose to cool domestic prices of auto fuels by trimming excise duties as it did last October, taking a hit on tax collections of some `13,000 crore. A year ahead of the elections, this is not unlikely. But, unless expenditure is slashed, any hit on taxes would mean a bigger fiscal deficit—typically, a $10 increase in the price of oil expands the deficit by 0.3% of GDP.
While a weakening rupee should help exports, what is unfortunate for India Inc is that interest rates are now sure to trend up further. Indeed, if crude oil prices and inflation remain elevated, RBI will have little choice but to raise the policy rate. As per the last MPC minutes, RBI Deputy Governor Viral Acharya noted that he was “likely to shift decisively to vote for a beginning of ‘withdrawal of accommodation’ in June” contingent on growth continuing to recover.
Since the April MPC meeting, core inflation has risen further to 5.9% y-o-y in April 2018, compared with 5.1% two months ago, while the recovery seems to be stable. It would be surprising then if RBI doesn’t turn a tad hawkish next month even if doesn’t actually hike the policy rate. But even a 50 bps hike over the course of FY19 could hurt companies, especially SMEs that are just coming out of a trough.
Already, with the yield on the benchmark bond nudging 8%, most banks have been raising loan rates—the Marginal Cost of Funds Lending Rate. In fact, one reason why the off-take of non-food credit has been rising in recent months is because the banks now offer cheaper credit than the bond markets. In the fortnight to April 27, non-food credit grew at12.8% y-o-y, the highest pace in three years. Even in December and January, loan growth ranged between 10.5-11.5%. Money mopped up in the bond markets in FY18—Rs 6.44 lakh crore—was 12% lower than that picked up the previous year.
A fatter oil import bill will most certainly hit the current account deficit (CAD) which is estimated to swell to 2.3% of GDP in FY19 if oil prices average $70. For every $10 increase in the price of crude oil, the CAD typically widens by 0.4% of GDP. While exports should get a lift from the weaker rupee, India has become uncompetitive in some key sectors for other reasons.
Equally worrying is the capital account—equity flows in FY18 saw an inflow of $3.4 billion, much smaller than the inflow of $8.4 billion in FY17. Flows into the bond markets could taper off in FY19 after the strong showing of $18.7 billion in FY18. Any outflow of portfolio flows from emerging markets to safe havens, even if due to higher interest rates in the US, would hurt India as well and put pressure on the capital account, and the basic BoP—CAD minus the net FDI—will be negative. This means India will become more susceptible to volatile portfolio flows.