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Posted by: Deepa Vasudevan on Fri, Apr 26th, 2019

How Rising Crude Prices could Reduce India's Investment Attractiveness

Emerging economies have fragile macro-economic systems, and India is no exception. The last few weeks have been a sobering experience for a country that is among the world’s fastest growing economies. As markets face the prospect of oil supplies from Iran drying up, India- Iran’s major consumer and a large oil importer- bore the consequences. In April so far, the price of crude has increased from $70/bbl to $75/bbl. The rupee has fallen steadily, breaching levels of 70 to a dollar by April 25. The benchmark 10-year yield is approaching 7.5%; despite massive liquidity injections by RBI through dollar swaps and open market operations (See Pic 1 below).

 Pic 1: Response of Exchange Rate and Interest Rates to Rising Crude Prices

 

The resurgence of crude prices could have serious implications for India. Estimates show that a $10 increase in the price of crude leads to a $15 billion increase in the current account deficit, roughly about 0.5% of GDP. Inflation will rise too: an RBI study showed that starting at $65/bbl, a $10 increase in the price of crude, if completely passed through, would impact inflation directly and indirectly by over 1%. Finally, if the government decides to absorb some of the fuel price hike, inflation may increase by a lesser amount, but the fiscal deficit will increase instead.  Collectively, the economy would be hit on three fronts- higher current account deficit, higher inflation and higher fiscal deficit. A simple but effective way to assess the impact is to add these three variables to create a Macroeconomic Vulnerability Index (MVI).  The higher the MVI, the greater the risk of economic instability, and the higher the country’s vulnerability.

High dependence on crude imports makes India vulnerable to crude price shocks; and it is a prime source of macroeconomic risk. At the same time, investors like to invest in India in order to participate in its current and future growth story. If the risk (measured by MVI) is matched by the reward (real economic growth), investment is likely to flow into the country on a sustained basis. The Rational Investors Ratings Index (RIRI), computed as the difference between the growth rate and MVI, measures this risk-reward trade-off (Pic 2).

 Pic 2: The Risk-Reward Trade-off

 

Note how investment attractiveness changed between FY13 and FY17. In FY13, all macro variables were flashing red: the economy faced double-digit inflation, CAD was at an all-time high, and fuel and food subsidies had pushed up the fiscal deficit. In the following years, economic vulnerability reduced due to falling crude prices, tighter fiscal management, and implementation of new reforms. As growth picked up, the risk-reward situation improved significantly. However, the first signs of deterioration can be seen in 2018-19. Even assuming that the government meets its fiscal deficit targets, the current account deficit is expected to be higher than last year, and growth has slowed down. Investing in India has become riskier. Going forward, if crude prices stay high, the risk-reward dynamic will worsen further. Unless India cuts its deficits or improves its growth, it will continue to be perceived as a risky investment.

For detailed knowledge check our course on Debt Market Indicators, Exchange Rate and External Sector

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