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Understanding the Drivers Which Are Bringing the Indian Economy Under Duress

Professor of Financial Economics and Part-time Value Investor, Transfin.
Sep 17, 2018 10:53 AM 4 min read

The Indian Economy came under intense scrutiny last week thanks to a continuously sliding Rupee and rising fuel prices, culminating into a haphazardly organized 'Economic Review' by the PM, FM, and RBI Governor over the weekend. Much political leverage was granted to the opposition. Depending on your political leanings, this may come across as a moment of reckoning for the government's flaky approach to the Economy or simply a contagion of external factors where one doesn't have much control. 


The truth as they say, is somewhere in between. A summary of drivers which brought us here:  


Indian Rupee has fallen by -13% vs. the Dollar since the start of the year. However, most Emerging market currencies have weakened in the same period.

Foreign investors are punishing emerging markets across the board, with Turkish Lira down -63%, Brazilian Real and South African Rand down -26% and -21% respectively. Russian Ruble (-18%), Chilean Peso (-12%), South Korean Won (-5%), and the Chinese Renminbi (-6%) have followed a similar fate. There is a sense that all EMs are at some risk or the other. India due to rising crude oil price and capital flight. China due to the trade war with US. Turkey due to a loose monetary policy and weakening credit. Russia because its Russia. Counter measures have commenced in Turkey where interest rates have been tightened to a record 24%!


Nevertheless, the "external" impact of increasing crude oil prices and rising US interest rates on the Indian Rupee are very real.

The Rupee had depreciated -8% before the Turkish Lira crisis began year-to-date. This is because crude oil prices rose by 16%, from $62.3 to $72.5 per bbl in the same period. India imports 80% of its oil from overseas. And most international crude oil trading is conducted in USD, being the world's sole reserve currency of choice. Thereby, our oil marketing companies have been steadily buying USD in exchange for INR to fulfill our oil needs - negatively affecting the Rupee. 


The second effect has been that of rising interest rates in the US, hiked twice this year, with the third hike expected end of this month. It means that foreign investors, who were earlier flocking towards emerging markets such as India are moving their money back to the US, which for the first time since 2008 is offering healthy yields. Capital flight means sale of Rupee and purchase of Dollars, and the Rupee suffers further. 


However, the problem with high petrol and diesel prices is more "internal" in nature i.e. over 45% of retail selling price of petrol comes from central excise duties and VAT.

The Indian Basket of crude oil was at $124 per bbl in March 2012 (when it hit its peak this decade) with petrol in Delhi selling that time at INR65 per litre. Crude oil price now is -41% lower at $72.5 per bbl, but petrol price is up 24% at INR81. Two things are happening. 


Indian Rupee has weakened by -38% during the same period, so effective fall in crude oil price (in Rupee terms) has been -21%, and not -41%. 


Secondly, central excise duty and VAT have steadily increased since now comprising 45%+ of the retail selling price of petrol. Reduce the taxes, you reduce the retail price. Another option may be to bring petrol and diesel pricing under the GST regime, thereby replacing 45% taxes by a maximum slab of 28%. However, considering petrol and diesel are significant contributors to the government coffers, it is hesitant to act in this direction, especially in a fiscally tight environment.


[Listen in from the beginning to learn more on India's fuel price woes]


PM's Economic Review has been a half hearted attempt, with no mention of reducing fuel taxes or opening of swap windows for Oil Marketing Companies.

The Economic Review over the weekend has focused mostly on boosting Dollar reserves and pushing the bond market. There is no immediate respite for the consumer which could have taken the shape of fuel tax cuts or a forex swap facility for oil marketing companies (like the one temporarily setup in 2013). Through these swap facilities, oil marketing companies would be allowed to source Dollars directly from RBI reserves to buy crude oil, instead of going in the open market, thereby protecting the Rupee against future oil-related volatility. The market keenly awaits that move.


Petrol and Diesel price inflation means the RBI may take a more hawkish stance sooner rather than later.

The Monetary Policy Committee of the Reserve Bank of India is scheduled to meet early October. Rising inflation driven by fuel costs means the Central Bank may push for another rate hike, thereby tightening the macro environment. Retail and commercial loans will become more expensive. Equity markets would continue to stay volatile. Banks stock owners should rejoice with a higher expected interest income.


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