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Govt must be prepared to face oil price risks

A prolonged war and the possibility of a recession in a number of large economies have made crude oil prices more unpredictable than usual. Consider this: One of the largest US-based financial institutions believes that crude oil prices may drop to $65 per barrel in case of a recession. According to another large financial institution, oil prices can go up to $380 per barrel. Both these forecasts will result in vastly different outcomes for both the global and the Indian economy. Former Russian president Dmitry Medvedev has said capping the price of oil from his country can actually push up prices to $300-400 per barrel. The direction of oil prices will be extremely important for India. Since it is a large importer, India will benefit if oil prices are closer to the $65 per barrel forecast. However, this might happen in the case of a recession, which will affect the Indian economy in other ways.

Oil futures (West Texas Intermediate) dropped below $100 per barrel for the first time since May on Tuesday because of recession fears, but have recovered some of the lost ground. The fear of recession is also affecting other commodities. Metal prices, for instance, have corrected significantly. Global output will be under pressure because of a number of reasons. Even as the recovery from the pandemic-induced disruption was losing steam, large central banks were forced to tighten financial conditions to contain inflation. Covid-related disruption is still affecting supplies and output in some parts of the world. While lower commodity prices are generally good for India, a global recession will affect exports and growth. The outlook could worsen significantly if the global economy weakens as feared, while oil prices remain elevated because of geopolitical reasons. India’s policy establishment would do well to prepare for such an outcome.

As the West puts more pressure on Russia, either by capping the price of its oil exports or by cutting Europe’s gas imports, energy prices would remain elevated. Further, even if the Ukraine war ends in the near future, the West may not be willing to lift sanctions imposed on Russia in a hurry. Therefore, oil prices are likely to remain firm and may fall significantly only in the case of a deep global recession. India’s trade deficit widened to a record $25.63 billion in June and the current account deficit is expected to exceed 3 per cent of gross domestic product in the current fiscal year. At a time when the capital account is also witnessing large outflows, the currency would come under severe pressure.

Unfortunately, none of the possible outcomes suits India’s macroeconomic fundamentals. The challenge thus for Indian policymakers will be to minimise the global impact. One possible way is to allow the economy to adjust to global conditions in a non-disruptive manner. Sustained attempt to shield the economy could lead to financial instability. Therefore, the government should allow the oil prices to be passed on, and the Reserve Bank of India should let the currency adjust. Since the global economic condition is unlikely to improve in the foreseeable future, a delay in adjustment could create long-term distortions. To be sure, adjusting to changing global economic conditions would affect growth and inflation outcomes. They will need to be dealt with to the extent possible through  policy interventions.