As the Indian rupee plunges, oil import costs shoot up

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The Indian rupee has been falling against the US dollar since the beginning of this year. Nevertheless, most of the fall has happened since the beginning of April, that is, in this financial year. At the beginning of April, $1 was worth 65 rupees. At this writing, $1 is worth close to 68 rupees.

So why is the rupee falling against the dollar? It needs to be mentioned here that rupee is not the only currency losing value against the dollar. Currencies of other developing countries have been losing value as well.

In the aftermath of the financial crisis that broke out in 2008, the Federal Reserve, the US central bank, initiated an easy-money policy, whereby it printed money and pumped it into the financial system to drive down interest rates. This was done in the hope that with lower interest rates people would borrow and spend more, and companies would spend and expand. This would help the overall economy recover and find its feet again.

The plan did not play out exactly as it was envisaged. Instead, what happened was that big institutional investors used this opportunity to borrow money at low interest rates and invest it in financial markets all around the world, in the hope of making a higher return, which they did.

Fed switches policy

Over the last few months, the Federal Reserve has made it clear that it now wants to start withdrawing the money it printed and pumped into the US financial system. The Fed wants to do this at a very slow pace.

With money being sucked out of the financial system, interest rates are likely to go up. In fact, the yield on the 10-year US Treasury bond has crossed 3%. The 10-year US treasury bond acts as a benchmark for other interest rates.

The big institutional investors who borrowed at low interest rates and invested in financial markets all across the world have started to take the likelihood of higher interest rates into account. This has led to money being withdrawn from the debt and equity markets in India. At higher interest rates, the difference between the interest rate at which money is borrowed in the US and the likely return available in India comes down. This has led to investors exiting India.

Since the beginning of April, a total of 303.62 billion rupees has been withdrawn by foreign institutional investors from the Indian equity and debt markets. This has put major pressure on the rupee against the dollar. When investors sell out of the equity and debt markets, they get paid in rupees. In order to repatriate this money, the rupees need to be converted into dollars.

Double whammy

When the demand for the dollar against the rupee goes up, this pushes down the value of the rupee, which is what has happened in India. Given that India imports most of the oil it consumes, there is going to be a double whammy.

The price of oil has been going up globally for a while now. With the rupee also losing value, the cost of oil imports will go up dramatically for India, if the situation continues to remain the same.

As of Wednesday, the Indian basket for crude oil cost $76.31 or 5,153.03 rupees per barrel. In April, the average price of the Indian basket of crude oil stood at $69.3 per barrel. The dollar then was worth around 65-67 rupees. Assuming that $1 averaged 66 rupees during the course of the month, the average price of the Indian basket of crude oil in April stood at 4,574 rupees per barrel.

It is likely that with sanctions on Iran, which contributes close to 4% of global oil production, and the scheduled initial public offering of Saudi Aramco, the biggest oil company in the world, oil prices will continue to go up.

This will mean that Indian oil companies will need more and more dollars to import oil. Increased demand for oil is likely to put further pressure on the value of the rupee against the dollar.

In the 2017-18 financial year, India imported 82.8% of the oil that it consumed. This has jumped from 80.6% in 2015-16. This means that as the demand for oil increases, the country has been unable to find internal sources of oil that can be used to produce gasoline, diesel and other fuels.

The fuel-tax factor

In a free market, an increase in oil prices would have been passed on to the end consumers in the form of higher prices of gasoline, diesel, kerosene, etc. The trouble is that the Indian governments (federal as well as the state) captured a significant chunk of the fall in the price of oil by increasing the taxes on gasoline and diesel. This has led to a situation where motor-fuel prices are now higher than they were in mid-2014, when oil prices were close to $110 per barrel.

Currently, the central government is struggling to raise revenues under the goods and services tax (GST). Hence it is really not in a position to cut taxes on gasoline or diesel. In this scenario, motor-fuel prices are likely to remain high in the days to come, unless a state assembly election is scheduled, during which period the oil companies are not likely to raise gasoline and diesel prices.

This happened recently in Karnataka, where motor-fuel prices weren’t raised for 19 days in a row, in the run-up to the elections that were held on May 12. Prices have been raised since then.

While imports become costlier with a weaker rupee, exports become more competitive, at least in theory. The trouble is that exports such as diamonds and jewelry, which India is good at, need inputs to be imported (raw diamonds for instance). A higher price needs to be paid for these imports, with a weaker rupee.

Labor-intensive imports also tend to benefit with a weaker currency. Typically, countries that have pulled themselves out of poverty tend to start with labor-intensive exports and gradually move toward capital-intensive exports. In India’s case, the opposite has been true for a while now. An estimate made by Jonathan Andersen of Emerging Advisors Group suggests two decades.

In a recent note, Andersen writes: “Labor-intensive manufacturing is actually India’s worst-performing export sector over the past 20 years, the only one to post an outright decline in developed market share since the mid-2000s.” If things continue along these lines, all in all, a higher oil price and a weaker rupee are not going to be good for the Indian economy.

Keep watching this space.

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