Oil Price Shocks May Be Brief, But Sustained Increases Pose Risks to India's Economic Growth

Oil Price Shocks Pose Significant Risks to India's Economy

A recent Bank of Baroda Research report has highlighted the potential risks posed by prolonged periods of elevated crude oil prices to India's inflation trajectory, fiscal position, and growth. The report, written by economist Dipanwita Mazumdar, analyzed the historical impact of oil price shocks on the Indian economy.

Between February 27 and May 6, Brent crude prices rose by 39.7 percent, marking the sharpest oil price spike seen in recent years. This increase was triggered by the US and Israel's strikes on Iran on February 28, which quickly escalated into a conflict affecting oil-rich West Asia. The report noted that major oil shocks have typically been associated with geopolitical disruptions, wars, and sanctions.

The report found that over the past 54 years, crude prices rose more than 20 percent in a year on 18 out of 54 occasions. Brent prices remained above the $100 a barrel mark for 29 days until May 6, with prices touching a high of $118 during the current conflict period.

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The report noted that while crude price spikes tend to be sharp, they are usually not permanent. Most high oil price shocks historically have lasted for six to seven months on average. The report also observed that oil price volatility tends to be concentrated in specific periods rather than remaining broad-based over long durations.

The note identified FY07-FY16 as the most volatile phase for oil prices, covering the global financial crisis and sanctions-related disruptions. Statistical analysis showed a stronger relationship between oil price movements and wholesale inflation during such volatile phases. The correlation coefficient between Brent prices and WPI-Fuel inflation stood at 0.69, indicating a strong positive relationship during periods of elevated volatility.

However, the relationship between crude prices and consumer inflation remained weaker due to the government's ability to absorb part of the fuel shock through administered pricing mechanisms and tax adjustments. The report stated that there was no statistically established long-run relationship between crude price movements and India's Gross Domestic Product (GDP), Consumer Price Index (CPI) inflation, or Wholesale Price Index (WPI) inflation under its Autoregressive Distributed Lag (ARDL) model analysis.

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The report flagged that oil shocks can continue affecting broader macroeconomic variables with a lag. The Vector Autoregressive (VAR) model indicated an optimal lag length of five quarters, suggesting the impact of oil volatility on growth and inflation can persist even after prices stabilize. In the VAR model, there is a lag effect of five quarters of volatility in oil prices on macro variables.

Historically, oil shocks have largely been associated with geopolitical conflicts, including the Iran-Iraq war, Gulf war, sanctions on Iran, the Russia-Ukraine war, and the current US-Iran conflict. The report's findings come at a time when policymakers are closely tracking the impact of elevated crude on India's imported inflation, oil marketing company margins, fertilizer subsidy burden, and the current account deficit.