How an Iran 'oil shock' will wallop India's economy

Pranab Mukherjee is known to be a devout man. So, if he has any faith in prayers at all, he should now be praying fervently that the crisis over Iran's nuclear programme, which has had Israel itching to launch a pre-emptive military strike, doesn't escalate any further.

For if it does, an 'oil shock' resulting from disruption of oil supply in West Asia would cause oil prices to spike in a way that renders the Indian economy, more than that of any other country, particularly vulnerable.

In particular, India faces a 'triple whammy' arising from its vulnerabilities on three counts - its current account deficits, its fuel subsidies, and budget deficits. And any escalation in Iran-Israeli tension, which has already sent crude oil prices edging up, could represent the sum of all fears for the Pranab-da, who has already complained that the spike in subsidies is causing him to lose sleep.

India faces a 'triple whammy' arising from its vulnerabilities. Reuters

"India probably faces more downside risk to growth than others in the region," warns UBS economist Duncan Wooldridge. "You need to be cautious about any economy running a current account deficit and here India stands out." In particular, rising oil prices could worsen current account balances, and an expanding current account deficit could lead to currency weakness and force domestic rates higher to fund the deficit, he adds.

Rising oil prices could also be especially bad news at a time when the RBI appeared to be about to ease up on the monetary tightening of last year, and industry and the equity markets are counting on a lowering of interest rates to revive growth.

Since the beginning of this year, Brent crude prices are up close to 20 percent - and still rising - on fears of supply disruptions, which were triggered by Iran's threat to close the Strait of Hormuz, through which nearly a fifth of the world's oil passes. That threat came in response to the imposition of sanctions, and a full-scale trade embargo that kicks in on 1 July.

India, more than other countries in Asia, is also vulnerable to a revival in inflationary pressure, given the extraordinarily high correlation between crude oil prices and India's consumer price inflation.

Indicatively, as compared to 2011, when crude prices averaged about $105 a barrel, the direct impact of rising oil price on headline CPI in 2012 is the most pronounced in India. If crude oil prices rise to $130 a barrel, for instance, the energy CPI will shoot up by 31.4 basis points (or 0.3 percentage points), in the estimation of economists. And, worse, if oil prices touch $140 a barrel, it translates into a 0.4 percentage point spike in the headline CPI.

Countries with high food weightings in their consumption baskets could be affected disproportionately by a persistent rise in fuel prices - and India tops the worry list here too.

If the Iran situation causes crude oil prices to spike, Pranab-da may be tempted to again blame an "external scenario" for India's poor destiny. But that argument won't wash.

That's because many other emerging markets are rather less vulnerable to the oil shock: in their case, although oil prices have been rising, they are not crowding out spending and growth in other areas, in the way that it does in India.

The entire universe of emerging markets has been growing - not only in real terms but also in dollar terms: the "dollar deflator", in fact, has been increasing at an annual rate of nearly 8 percent over the past two years, notes economist Jon Anderson.

Which is why although crude prices have nearly doubled since 2006, the "stress levels" are only marginally higher since then. So, although $70 a barrel was seen as scary in 2006, $120 a barrel seems rather less daunting today.

But that sanguine outlook doesn't hold for India, which is at the "high risk" end of the spectrum of emerging markets, based on its vulnerabilities arising from its overall fiscal and current account position and net fuel trade balances.

An oil shock today arising from Iran-Israeli tension would be particularly bad news for India. Perhaps it's time for our Finance Minister to send up his prayers to the God of Hydrocarbons asking Him to keep things on an even keel so that his disjointed budget arithmetics - and his overall management of the economy - doesn't go even more out of whack than it already has.