• Why oil can spoil India’s budget math

    One of the biggest drivers of India’s superlative macro-economic performance in the recent past has been a relatively under-appreciated element: oil. Since 2014, the dramatic fall in crude oil prices has helped India contain her twin deficits, and tame inflation. But with oil exporting countries planning to curtail oil supply, raising the possibility of a rise in oil prices, the Indian economy might soon have to deal with another pain point besides demonetisation.

    The extent of the gains from lower oil prices since mid-2014 is under-appreciated as the benefits have not been evident in the retail prices of petrol or diesel. However, the government did improve its finances, using the opportunity to increase the amount of taxes collected on petroleum products, as the charts below illustrate. The excise duty collected by the Union government on petrol and diesel has been hiked nine times since November 2014. The Union government’s tax collection from petrol and diesel has increased from 0.4% of GDP in 2013-14 to 1.1% in 2015-16, i.e. an increase of 70 basis points (bps) in two years. To put this in perspective, this is more than the 60 bps reduction achieved in gross fiscal deficit (from 4.5% of GDP to 3.9% of GDP) over the same period. One basis point is one-hundredth of a percentage point.

    In other words, the entire reduction in India’s fiscal deficit could be attributed to the increase in Centre’s tax revenue from petrol and diesel alone. Hence, it is fair to say that falling crude oil prices have driven the improvements in India’s public finances over the past couple of years. Looking at more recent data for the first half of the fiscal year ending March 2017 (April-September 2016), and combining taxes with other oil-linked receipts such as dividends from public sector petroleum companies and states’ VAT collection on petroleum products, we find that the total receipts of the Centre and state governments’ from the petroleum sector have risen by about 50 bps since fiscal 2015 to 3.14%.

    Even the above-mentioned gains from the petroleum sector might be an underestimate because besides the increase in taxes, the Centre also gained from reduced subsidy burden owing to the fall in crude prices. Diesel prices were deregulated in 2014 and the diesel subsidy was eliminated in the last fiscal year (2015-16) itself. Previously, subsidy on diesel would cost 0.6% of GDP (FY14), jointly borne by the government and the public sector petroleum companies. Besides, subsidies on PDS kerosene and LPG have also reduced; however these reductions could also be attributed to government initiative to reform rather than a fall in petroleum prices per se.

    The upcoming Union Budget 2017 is likely to assume an average crude oil price of $55-$60 per barrel, as reported by the Hindustan Times. However, there remain risks that oil prices, which are already near $55 per barrel, could shoot up if the Organization of Petroleum Exporting Countries (Opec) and other oil exporters make good on their pledge to cut global oil supply by around 1.8%. Such a scenario, according to the International Energy Agency, would move the global oil market into deficit in the first half of 2017, i.e. demand would outstrip supply, after more than two years of comfortable surplus.

    In such a scenario, if oil rises above the government’s comfort zone to say around $70 per barrel, then the government could lose tax revenues equivalent to about 0.4% of GDP which would jeopardize the government’s plan to cut the fiscal deficit to 3% of GDP next year. To illustrate, in a hypothetical scenario where the global crude oil price is $70 per barrel in the coming fiscal year (2017-18) and the USD/INR exchange rate remains stable at 68, the government could either allow the petrol price (Delhi) to rise by another Rs10 to over Rs80 per litre, or reduce its excise tax duty from currently Rs21.48 per litre to Rs11.48 (if it wishes to keep prices same). If the government decides to reduce excise duties on petrol and diesel in similar fashion, then the Centre’s revenue from petrol and diesel could shrink to 0.7% of GDP in fiscal year 2018 compared to 1.1% in fiscal year 2016, back-of-the-envelope calculations show (assuming annual growth of 11.4% and 4.1% in demand for petrol and diesel respectively, as has been observed in the year so far).

    Thus, a spike in oil price to around $70 per barrel is enough to strain our public finances and add 0.4% to the Centre’s fiscal deficit. This would be over and above the increasing expenditure obligations on interest, salaries and pensions, compounded by Seventh Pay Commission recommendations and OROP. If the government wishes to keep petrol and diesel prices unchanged, without sacrificing its tax revenues, then it would have to resort to subsidies (or under-recoveries) as used to be the case in yesteryears. Thus, no matter the recourse adopted, government finances will most likely be hit severely if oil prices rise, unless the government allows the prices of petroleum products to rise.

    Besides posing risks for the government’s finances and stoking the fires of inflation, a rise in oil prices would also worsen the current account deficit. Assuming crude oil prices at $70/barrel and pencilling a constant pace of rise in volumes in oil imports and exports, as seen in the current fiscal year so far, and keeping all other things constant, India’s current account deficit could widen to 1.7% of GDP in fiscal 2018 compared to 1.1% of GDP in fiscal 2016.

    India’s net oil and gas import bill, i.e. adjusting for exports of petroleum products, amounts to around 2.5% of GDP, higher than India’s overall current account deficit and hence plays a big role in determining the dynamics related to the balance of payments. Thus, if there is one commodity to watch out for in 2017, it is likely to be oil. Glover Quin Authentic Jersey

    Share This