High oil prices and health of the economy

Since February 2021, oil prices in India have increased incessantly, reaching a sky-high level that was never witnessed before. The unprecedented hike in petrol and diesel prices have been impacting the country’s economy adversely at a time when India is reeling under the devastating Covid-19 pandemic. How the high oil prices are impacting the health of the Indian economy?

The impacts of energy price shocks are varied. Most of the developing and transition countries around the world have previously been adversely affected by the waves of oil-price shocks relatively more severely than that brought about by other exogenous crises of similar magnitudes.

However, the global recession of 1973-75, 1978-80 and 1990-1993 caused predominantly by OPEC (Organization of Petroleum Exporting Countries)-led high prices of crude oil have not recurred in the recent years despite even higher prices following the two Gulf wars.

Indeed, some of the well-known observers of the price trends for natural resources and their impacts on the economy, such as Nobel Laureate William Nordhaus, pointed out that for the post-war decades entire world’s output grew, unemployment fell and inflation remained moderate while cohabiting with oil-prices three times as high as that prevalent in the pre-war years. It is not automatic, however, that ‘all is well’ on every other front, including substantial loss of jobs faced by developing countries. Indeed, during economic downturns, which might accompany an oil price shock, the adverse impact on employment is naturally documented.

Recent petrol and diesel prices in India per litre, 2021:

But importantly, does the rather high oil price observed in the last few months affect general retail prices? Does it affect the wages and employment of formal and informal workers in a country like India, where the basic minimum for millions remain largely unattainable?

However, these are questions which one would seek to understand ex-post, while the most serious questions about why the retail prices for petrol and diesel reached unprecedented heights domestically despite a crash in the international crude oil price cannot be set aside in the first place.

The Ministry of Petroleum and Natural Gas, GoI does not offer much information or explanation for the citizen regarding the unprecedented oil price inflation, and the departmental website is instead adorned with elaborate photo galleries of the respective Minister.

So, one has to look elsewhere for the causes and effects of oil price rise which has a sweeping impact on the entire economy. First of all, since the trend in petroleum and diesel prices within India do not correspond with the international price trend, the role of taxes seems to be crucial. It has been documented in several newspaper articles and correspondences that the tax burden on a litre of petrol or diesel is nearly equal to the price of one litre of refined fuel. While the collected taxes go to both central and state exchequers in pre-defined shares, and these get expended for various social and economic support schemes in the country, what remains unexplained is why would the government impose such high tax rates?

In the case of all such commodities, taxes are proportional to prices implying that if the international price drops and the country’s price is closely aligned, tax revenue and the price per litre must also fall. This is not the case with India and the converse can happen only if the government raised the tax rate, or that the local price does not correspond to the international price. The local price at the gas stations are determined by demand and supply and for some strange relations prevailing, the prices in India are rising when the global prices are falling!

Remember, price determination for oil is not as clear as many other commodities. The blue-chip public sector oil companies cohabit with predominantly one private sector company, and there is no prior to ruling out the possibility of collusion in price formation. Indeed, when the automobile sector in India has not been doing admirably and at best growing 4-6% on average between 2014-15 and 2019-20 (see table below, vide, Society for Indian Automobile Manufacturers), with the last year showing close to 20% fall in manufacturing, the fuel prices leapfrogged.

Since petrol and diesel display low elasticity of demand higher prices are transferred readily to the consumers leading to widespread inflationary tendencies as a second-round impact. If transport costs go up due to the high price of fuel, the consignments would be dearer, leading to higher per-unit price in the retail stores, and depending on the nature of the commodity either the price rise is passed on to the buyer in full, or shared between the seller and the buyer. In the case of essential commodities the buyer ultimately pays the full rise in price, while for commodities that may be complementary in nature, the automobile included, the sharing rule works, largely.

If demand shrinks owing to rising oil prices, there would be a direct impact on the employment and earnings of millions in poor countries. A recent analysis shows that the relatively unskilled workers in 19 major states in India face lower nominal wage when the oil price rises. In effect, rising oil prices could bring about what British investors in the post-war era started calling a period of ‘stagflation’, implying a combination of stagnancy in economic activities with high inflation for a basket of goods.

It is argued that the ‘Great Moderation’ in macroeconomic shocks consequent primarily on reduced volatility is the driving force behind this unexpected non-crisis. Some suggest that the oil price shocks have a fairly limited impact on the growth and distribution in most countries, because the earlier tradition of reorienting the monetary policy to allow dollar-to-dollar pass-through of oil price shocks have of late been replaced.

In fact, the usual monetary policy response to oil price pass-through had so far been a rise in the interest rate, which in turn slowed growth. In recent times, the reactions from the central banks have been moderate in the face of oil price shocks because the monetary policy seems to be more concerned with core inflation, which excludes the energy component. Nevertheless, the possible impact in sectors directly dependent on the consumption of oil can hardly be ignored.

In fact, the impact of oil price shock as a trigger for economic crisis is much more common for countries that use lesser administrative controls internally. India, for example, practiced price control on essential items including petroleum since independence even going a few years into the economic reforms of the 1990s.

The gradualist approach to economic reforms that India adopted over a sustained period of time helped internal adjustments much better than rapid transitions into uncharted territories that disrupted economic and social circumstances in more recent times. Importantly, India also practiced managed float exchange rate system during the early reforms and had not allowed full convertibility of the capital accounts.

Both of these required continuous monitoring and intervention by the central bank. It is well-known that the economic reforms of the 1990s not only raised economic growth to an unprecedented level, but it also managed to maintain relative economic stability – of course, not without the costs that any reform brings about. In other words, India used several monetary and fiscal instruments to insulate itself from various external sources of the crisis, and even a globally spread out oil-price rise would make a limited impact owing to partial pass-through on to the local markets. But, the present experience is predominantly ‘internal’ in nature that needs strong debates in the appropriate institutions to take a corrective course.

Since the pricing of natural resources also has a strong connection with corrupt practices of the national lawmakers with India standing low in any admissible global corruption rank, the fate of oil prices and everything that depends on it may ultimately be put to dire consequences.

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(Saibal Kar is a professor of economics at the Centre for Studies in Social Sciences, Calcutta (CSSSC), and a Research Fellow of the Institute of Labor Economics (IZA) in Bonn, Germany. He is the Director of the Eastern Regional Centre of ICSSR. He has been associated with Calcutta University, Presidency University, Jadavpur University, IIT Kharagpur, Alexander von Humboldt Foundation in Germany, University of Amsterdam, Santa Fe Institute, Hamburg University, University of East Anglia, United Nations University, etc. He is the Managing Editor of the South Asian Journal of Macroeconomics and Public Finance.)

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