Oil surge brings back twin deficit spectre; experts chart rupee’s course, RBI response

The economic damage inflicted by the COVID-19 crisis has compelled the government to delay fiscal consolidation and widen the Budget deficit in order to spend more and nurse the economy back to health.

With Russia’s decision to invade Ukraine last month pushing up crude oil prices to their highest levels in 14 years, India, which is heavily dependent on oil imports, will now see also the current account deficit widening, thereby posing a significant headwind for the rupee.

With the US and its European allies mulling a ban on Russian oil imports following Moscow’s invasion of Ukraine last month, international crude oil prices surged to their highest levels since 2008, soaring more than 6% on Monday.

Brent crude futures rose $8.46, or 7.2 per cent, to $126.57 a barrel by 0128 GMT, while US West Texas Intermediate (WTI) crude rose $7.65, or 6.6 per cent, to $123.33.

The Indian currency hit a record low of 77.0280 per dollar on Monday as against 76.1600/$1 at previous close.

The current account deficit, which is the net difference between the total value of imports and the total value of exports, has already hardened considerably and that worrisome trend is set to continue, analysts believe.

“The merchandise trade deficit widened to USD21.2bn in February from USD17.9bn in January, primarily driven by a sharp rise in oil imports and higher core imports…rising prices of oil and broader commodities, especially aggravated by the ongoing Russia-Ukraine conflict, are likely to further add to the import bill in the coming months,” economists from Nomura wrote.

“We expect the current account deficit to widen to 2.6% of GDP in FY23 (year ending March 2023) from 1.7% of GDP in FY22, assuming oil prices average USD86.6/bbl; so, if oil prices sustain at current high levels, then risks are skewed towards a much wider deficit.”

The sharp increase in the current account deficit, which had been reined in significantly during the initial phases of the pandemic due to lower import demand, is seen as a factor that could exacerbate the ongoing spree of overseas investment outflows that India is witnessing.

So far in the current calendar year, foreign institutional investors have pulled out a massive Rs 83,926 crores worth of funds from Indian equity and debt markets, with the lion’s share of sales occurring in the country’s stock markets, NSDL data showed.

With the overseas outflows exerting a toll on the rupee, traders fear a vicious cycle where further depreciation in the Indian currency could spark even more foreign selling pressure.

“Every day is a new day. Our forecast is still at 75.50/$1. Given the current environment, there is a risk that the rupee might end up weaker than what we forecasted. Every one dollar move in crude oil prices widens the CAD by around 1.4 billion dollars. If there is a 10% increase in crude oil prices, it would lead to 0.2-0.3% of GDP widening in the CAD,” Anubhuti Sahay, Head of Economic Research, South Asia, Standard Chartered Bank, said.

“We have an estimate of 1.8% of GDP for the CAD next year but with oil at such levels, the risk is that it could be wider, much wider than what we have as of now.”

Trust the RBI
The turmoil in global markets may have caused 3.5 per cent depreciation in the rupee so far in the current calendar year, but market veterans believe that India has a foundation strong enough to weather the storm.

This confidence – a far cry from earlier episodes when oil prices skyrocketed to such an extent-stems largely from the considerable war-chest of foreign exchange reserves that the RBI has built up – $631.53 billion as on February 25, latest data showed.

“The RBI has rightly stated that the accumulation of foreign exchange reserves is so as to address this exact issue – overseas outflows so that is a process that we see playing out,” Nitin Agarwal, Head of Trading, ANZ Bank said.

Meanwhile, HDFC Bank’s Chief Economist Abheek Barua is of the view that the market reaction on Monday may have been overdone.

“Today’s reaction is perhaps exaggerated and has responded to the prospect of Russia’s energy supplies being embargoed. If that probability declines, INR could move back to 76. If the likelihood remains we see 77.50 to 78 as the INR downside,” Barua said.

Another theatre where hardening crude oil prices will play out is India’s inflation and how the RBI chooses to tackle the inevitable upside pressure on consumer prices even as the external volatility poses a downside risk to growth.

While the jury is still out on when the RBI will formally tighten monetary policy, there seems to be a growing consensus that the latest developments may speed up the central bank’s approach to rate hikes, with its guidance on inflation likely to be less benign in the April policy review.

“The MPC will revise its benign inflation outlook. That’s a given,” Standard Chartered Bank’s Sahay said.

“We maintain our view that by August, they will start raising the repo rate, because risks to inflation have clearly increased and even the RBI in its past commentary has indicated that higher inflation if sustained for longer can impact medium-term growth prospects.”

ANZ Bank’s Agarwal is of the view that in the April review, the RBI is likely to opt for a path of least damage by communicating intent to shift the stance of monetary policy to neutral from accommodative rather than straightaway altering the stance and paving the way for rate hikes at the very next review.

“From a rate perspective, we see what I will refer to as baby steps because whatever is happening will also affect growth,” he said.