When oil shocks the economy…

India's vulnerability to oil shocks is well known. But research firm Nomura has put a number to the impact of an oil shock on the economy. In its recent special report on Asia, it states that India's GDP growth could slip to a weak 6.2 per cent in 2012, if oil averages at $135 a barrel this year. Higher oil prices will also stoke inflation, and push the nation's consumer price index to 8.2 per cent. And this in turn could delay rate cuts by RBI, thus hurting growth. This is the worst case scenario forecasted by the research house.

Nomura has estimated the impact of oil price movements on the Asian economies under three scenarios. The first is a positive scenario, where Brent averages $110 a barrel in 2012, with potential to go down to $100 by the fourth quarter of the calendar. The second case assumes moderate oil price of $125 a barrel and the third, also the worst involves oil averaging at $135, with a peak price of $150.

This report comes after Brent crude surged 18 per cent year to date to $127.5 a barrel (Asia Pacific). This is significant as it's already touched the moderate scenario assumed by Nomura.

Demand or supply issue

The extent of impact of a rising oil price on the economy would depend on whether the rally is driven by positive demand or is accelerated by a supply shock. For instance, the oil price shock in the 1970s was a result of disruptions in oil supply in West Asia and the dollar's decline following the breaking of gold convertibility in the US. In contrast, the 2004-08 run up (when oil touched $144 a barrel in July 2008) was driven more by robust global demand, points the report.

Of these, a rally driven by supply (rather the lack of it) is likely to hurt economies more as governments and their Central banks make a bigger growth-inflation trade-off.

So, is the recent strong show by oil driven by demand or supply constraints? The report states that there is not enough evidence to believe that the rally is demand-driven. While the US may be better off than it was, the European region is still in a slump and the emerging market economies, which are the largest incremental consumers of oil, have been cooling.

The International Energy Agency's estimates too suggest demand may be easing, with world oil demand set to fall in this quarter and the next. Therefore, supply disruptions and geopolitical concerns in West Asia, together with high levels of global liquidity, may be reasons for the recent price wave.



Who is vulnerable?



Asia being a major net importer of oil (two thirds of Asia's oil needs met through imports) is naturally quite vulnerable to oil price rise. But Nomura places India, along with Korea, Thailand and the Philippines in the most vulnerable list. China, Malaysia and Singapore, on the other hand, may be less hurt by an oil spike.

Why is India vulnerable? Its existing economic condition places India in this position. It is the only large economy in Asia to run a current account deficit. A higher import bill may only worsen it. Its core industry growth is slow. Inflation still remains above comfort zone and fiscal deficit can worsen with higher fuel subsidies. While the surge in oil price in 2004-08 led to many countries in Asia reducing their fuel subsidies, countries like India and Indonesia still have a large subsidy bill, highlights the report.

In addition to this, as energy and food account for over half of the consumer price basket, the impact on inflation too would be conspicuous.

If oil hurts the economy, can equity markets be far behind? Unlike a few other nations, the report states that MSCI India index is least positively correlated to oil price rises that arise from non-demand factors. Case in point: Indian markets slipped into negative returns in the last one month, even at the hint of an oil price rise.



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