‘Elections are too far to not hike oil prices’

Chetan Ahya, managing director and India & south-east Asia economist at Morgan Stanley says the government has very few options in tackling the oil price hike and double-digit inflation in India is within the realms of probability. Excerpts from a tete-a-tete with Venkatesan Vembu, DNA Money’s deputy editor in Hong Kong:

Implications of mounting oil subsidy bill on fiscal deficit.
If the deficit widens at a time when international capital flows could slow down, it will weigh on the domestic bond market. Right now, the 10-year bond yield is climbing up, although it hasn’t yet tested 8.35%, the 6-1/2-year high.

The duration for which global oil prices stay at current high will be the key factor to watch. If global oil prices retreat significantly after touching $135, obviously it will not have as much of a bad effect. However, if it stays at these levels for even 3-4 months and domestic oil prices are not hiked, the bond markets will be concerned because the deficit levels will shoot up.

If domestic prices are unchanged, every $10 rise in global oil prices results in increase in India’s import bill, trade deficit and current account deficit by 0.5-0.6%.
The policy options, given that inflation is also a concern

There are very few options. You have to take some tough decisions - like hiking the oil prices: that’s the only fair option available, given the circumstances. From now to the general elections is too long a time gap to not to hike oil prices.

Sure, you should protect consumers: it’s not just politics, but a humanitarian consideration. But beyond a point, it starts hurting the overall interests of the country. If you don’t raise oil prices, the deficit level shots up, 10-year bond yields shoot up... it crosses the threshold limit of macro point.

On the risk of double-digit inflation
That depends on how much oil prices go up by, but sure it can hit double digits.
While RBI may keep policy rates on hold, the market-oriented rates may continue to move if oil prices aren’t hiked and subsidy burden keeps rising. Hike in oil prices could hurt the ruling coalition’s political prospects because people will still not see the compulsion, and the opposition parties will raise an issue.

However, a macroeconomic management perspective the government will have to choose the lesser of the two evils-hike in oil prices or allowing market oriented interest to rise.

The risk of GDP growth slipping below trend  On Friday night, Indonesia hiked oil prices by 28.7%. If there’s similar hike in India, definitely there’s a significant risk (to GDP growth) because that significant cost will be borne by the system. Over the last three years, we have borrowed from the future by subsidising oil and financial leveraging, both of which cannot continue beyond a point. Now the payback time has come.

On the risks of a global oil shock, and the pace of policy response India has been fairly responsive in terms of managing its monetary policy, along with Australia and the ECB. The others have not been so rhetorical in terms of managing inflation expectations.
In terms of policy response from the world, the actions from the ECB, the Fed and PBOC matter the most. 

Commodity prices are telling that the global aggregate demand (read GDP growth) is higher than what the supply-side can cope with. At the margin, somebody has to sacrifice growth.

The US already being close to recession, is resisting an immediate move towards tighter monetary policy path. And Chinese policy makers, from their actions, appear to be leaning on the argument that China’s per capita income is lower than that in the US and its unemployment is higher, so why should it sacrifice on growth in a pre-emptive
manner...

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