Some global factors that have a bearing on the domestic economy
The sharp rise in oil prices was the last straw for the market that was trying to cope with lower GDP growth, higher inflation and flight of foreign institutional investor (FII) funds. Indeed one can wonder whether the economic scenario can get any gloomier than what it is today.
Oil prices remain high
It all started with the oil prices shooting up. They touched all-time highs of $145 per barrel. Crude oil prices had corrected to $100per barrel only to go back to higher levels.
There are several theories attributed to this recent increase in the crude oil prices. Some say that cost of production has increased while others say that more speculative money is invested in crude for quick speculative returns. Usually, investors buy commodities such as oil as a hedge against inflation when the dollar falls. A weak dollar makes oil less expensive to investors dealing in other currencies. Hence, analysts are of the opinion that the dollar's protracted decline is the primary reason oil prices have doubled over the past year.
Countries heading for financial crisis
Meanwhile, high crude prices continued to threaten the macroeconomic balance of many countries. It could cause structural damage to their economies. The current account deficit of many countries is ballooning and is a matter of great concern. Countries that have sufficient foreign exchange reserves may survive while others may end up with a financial crisis. According to reports, a $10 increase in the crude oil prices may reduce India's GDP growth by about 0.3 percent and increase inflation by 1.2 percent. Hence, prolonged periods of high crude prices will be very detrimental even for India with its sufficiently large foreign exchange reserves.
But crude sustaining at these high levels for a long period of time is untenable. As the price of crude increases it will lead to a sharp decline in demand and thereafter price. Some analysts believe that the Organisation of Petroleum Exporting Countries might increase oil production, easing the supply pressure, and thus help drive down oil prices. However, the moot point here is, when will the price of oil come down. Whether the crude oil price will decline after damaging many of the global economies or will it decline a little early before irreversible damage is done in the form of contraction in growth.
Repo rate hike
The Reserve Bank of India (RBI) was hoping to control inflation by tinkering with the cash reserve ratio (CRR), but crude prices sustaining at higher levels forced the RBI's decision. Oil companies are importing oil at USD 135 per barrel and recovering it post price hike at around USD 70-75 per barrel. This difference, which is now over $10 billion a month, is funded by fiscal deficit. As dollars are required for purchase of crude, the RBI will have to dip into foreign exchange reserves to supply dollars and has to release some money out of the Market Stabilisation Scheme (MSS) to compensate the use of foreign exchange reserves. This could even cause interest rates to go up in India. Ideally, each country would like to have positive real interest rates. If inflation is between nine and 10 percent, you have to move towards a higher interest rate regime to maintain the real rates. So, the 0.25 percent repo rate hike could be a small step to further increase the interest rates.
Sacrificing growth to control inflation
An attempt to move to a higher interest rate regime in a calibrated manner could slacken growth. The RBI's focus has shifted to controlling inflation as inflation continues to remain high. Currently, the economy can absorb this 0.5 to one percent growth in interest rates, if we can still grow at 7.5 to eight percent. India's ability to grow in a high interest rate environment will be tested now. As of now there is no visible evidence of a slowdown in the growth momentum.
Investors have to wait and watch how things will pan out in the future. A cooling down of oil prices is crucial, as an increase in interest rates and its subsequent pressure on growth will all depend on it. Everything boils down to one single factor and that's the oil prices.
The sharp rise in oil prices was the last straw for the market that was trying to cope with lower GDP growth, higher inflation and flight of foreign institutional investor (FII) funds. Indeed one can wonder whether the economic scenario can get any gloomier than what it is today.
Oil prices remain high
It all started with the oil prices shooting up. They touched all-time highs of $145 per barrel. Crude oil prices had corrected to $100per barrel only to go back to higher levels.
There are several theories attributed to this recent increase in the crude oil prices. Some say that cost of production has increased while others say that more speculative money is invested in crude for quick speculative returns. Usually, investors buy commodities such as oil as a hedge against inflation when the dollar falls. A weak dollar makes oil less expensive to investors dealing in other currencies. Hence, analysts are of the opinion that the dollar's protracted decline is the primary reason oil prices have doubled over the past year.
Countries heading for financial crisis
Meanwhile, high crude prices continued to threaten the macroeconomic balance of many countries. It could cause structural damage to their economies. The current account deficit of many countries is ballooning and is a matter of great concern. Countries that have sufficient foreign exchange reserves may survive while others may end up with a financial crisis. According to reports, a $10 increase in the crude oil prices may reduce India's GDP growth by about 0.3 percent and increase inflation by 1.2 percent. Hence, prolonged periods of high crude prices will be very detrimental even for India with its sufficiently large foreign exchange reserves.
But crude sustaining at these high levels for a long period of time is untenable. As the price of crude increases it will lead to a sharp decline in demand and thereafter price. Some analysts believe that the Organisation of Petroleum Exporting Countries might increase oil production, easing the supply pressure, and thus help drive down oil prices. However, the moot point here is, when will the price of oil come down. Whether the crude oil price will decline after damaging many of the global economies or will it decline a little early before irreversible damage is done in the form of contraction in growth.
Repo rate hike
The Reserve Bank of India (RBI) was hoping to control inflation by tinkering with the cash reserve ratio (CRR), but crude prices sustaining at higher levels forced the RBI's decision. Oil companies are importing oil at USD 135 per barrel and recovering it post price hike at around USD 70-75 per barrel. This difference, which is now over $10 billion a month, is funded by fiscal deficit. As dollars are required for purchase of crude, the RBI will have to dip into foreign exchange reserves to supply dollars and has to release some money out of the Market Stabilisation Scheme (MSS) to compensate the use of foreign exchange reserves. This could even cause interest rates to go up in India. Ideally, each country would like to have positive real interest rates. If inflation is between nine and 10 percent, you have to move towards a higher interest rate regime to maintain the real rates. So, the 0.25 percent repo rate hike could be a small step to further increase the interest rates.
Sacrificing growth to control inflation
An attempt to move to a higher interest rate regime in a calibrated manner could slacken growth. The RBI's focus has shifted to controlling inflation as inflation continues to remain high. Currently, the economy can absorb this 0.5 to one percent growth in interest rates, if we can still grow at 7.5 to eight percent. India's ability to grow in a high interest rate environment will be tested now. As of now there is no visible evidence of a slowdown in the growth momentum.
Investors have to wait and watch how things will pan out in the future. A cooling down of oil prices is crucial, as an increase in interest rates and its subsequent pressure on growth will all depend on it. Everything boils down to one single factor and that's the oil prices.
