By Anubhuti Sahay, Head-India, Economics Research, Standard Chartered Bank
Lower crude oil prices are perceived to be positive for India’s external balances as it reduces the oil import bill, boosts net USD inflows, and bolsters foreign exchange reserves. Economists estimate the oil import bill’s sensitivity to changes in crude oil prices at 1.4-1.5 ceteris paribus. That is, every $1/bbl (barrel of oil) fall in crude oil prices reduces the import bill by $1.4-1.5 billion a year.
This simple sensitivity analysis relies heavily on the central assumption of ceteris paribus (other things being constant). But in the real world, things hardly stay constant. And thus, sensitivities change or play out only partially.
Let’s take India’s gross oil import bill and oil deficit (netted for exports) in April-October versus the year-ago period. Average crude oil prices were lower by $12/bbl. Ideally, this should have narrowed the import bill and trade deficit by $10 billion assuming the above-mentioned sensitivity. But that has not been the case. In fact, the oil deficit was marginally wider than last year, and the extent of narrowing in the oil import bill was underwhelming.
Volume Trap
This is because another dynamic came into play—lower prices led to higher demand. In fact, the rise in imported volumes of oil negated the 50-55% impact of the fall in crude oil prices. A sharp increase in imported volumes due to lower oil prices was seen in 2015 and 2016 too (crude oil prices averaged around $45-50/bbl then).
While an expanding economy like India is bound to clock positive demand for oil imports (which meet 90% of our consumption), the pace of increase in oil import volumes was peculiar this time around. Usually, higher imported volumes of crude oil reflect higher domestic demand and exported volumes and vice versa.
This time, the pace of increase in imported volumes of oil was neither correlated with growth in domestic consumption of petroleum products nor with an increase in exported volumes. In fact, petroleum ministry data shows domestic consumption of fuel products has been slowing. Similarly, export volumes of fuel products have been contracting for the second successive year. This contrasts with 2015-16, when a surge in imported volumes of crude oil at low prices was also accompanied by increased domestic fuel consumption demand and exported volumes.
So why did we import more? Was there any front-loading of oil imports from Russia? Not really. Standard Chartered’s analysis shows the increase in import volumes has been from West Asia and the US. In fact, India’s crude oil import volumes from the US during April-September almost matched its annual imports in the previous financial year. The share of oil imports from the US is expected to rise from 7.5% (4.5% last year), given the increased focus on raising energy imports from the US.
Overall, as larger oil import volumes have not been dictated by domestic and global demand, the oil balance (gross imports minus exports and domestic fuel consumption demand) is much higher than usual this time. While the possibility of increased storage cannot be ruled out, there are likely limits to it.
If the usual dynamics have not played out until now, does it mean the oil deficit will remain wide even as prices continue to fall? Possibly not. As highlighted above, while front-loading of crude oil import volumes on lower prices makes sense, with consumption and export demand staying subdued, we expect import volumes to eventually come off. The usual trend in oil import volumes—that is, larger imported volumes in H2 vs H1—is unlikely to play out. Such a correction in oil import volumes amid still-falling crude prices will help net USD flows into India, especially if it coincides with fading festive demand for gold and a seasonal decline in non-oil non-gold imports.
Rupee and Capital Flow Crisis
That said, such a decline in the oil deficit will not resolve the challenges around net USD outflows from India and pressure on the rupee. Challenges facing the balance of payments over the past couple of years have been emanating more from softer capital inflows than the current account (C/A) deficit; the latter has been well contained (at less than 1% of GDP).
However, with FDI outflows overshadowing inflows and portfolio investment shying away from emerging economies, capital flows have not been large enough to fund our narrow C/A deficit. While portfolio investment flows are fickle, the shrinking net FDI flows are a challenge. From a peak of $40 billion five years ago, reaching double-digit FDI flows appears to be a tall order (last year, it was just $1 billion). This too is surprising as India is one of the fastest-growing economies with a promising outlook; ideally, it should be a magnet for investments. But that has not been the case, and while trade uncertainty has played a role, this trend precedes Trump’s tensions. It is another area where the obvious or perceived dynamics haven’t played out, but that’s a discussion for another day.