eco-before the model

7/29/2019 Eco-Before the Model

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Oil Price Fluctuations: Related Policies

and their Impact on India

Submitted To : Prof. Chandan Sharma

PGP28237 - Aishwarya KirthivasanPGP28239 - Bharti YadavPGP28240 - Muhammed RijasPGP28249 - Sruti Pujari

PGP28250 - Anju R. GothwalPGP28271 - Nisha BachaniPGP27276 - Pramesh Chand

GROUP-8 |Section E |IIM Lucknow, 2012-14


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I. Abstract

This project report analyses the effect of transmission of international oil prices and domestic oilprice pass-through policy on major Indian macroeconomic variables. The three prime channelsof transmission viz. import channel, price channel, and fiscal channel are explored with the help

of a structural macroeconomic framework. A macroeconomic policy simulation model is usedfor the analysis. The policy of deregulation of domestic oil prices in the premise of occurrence ofa one-time shock in international oil prices as well as no oil price shock situation is analyzedthrough its impact on growth, inflation, fiscal balances and external balances during the 12thPlan period of 2012-13 to 2016-17. The simulation results reveal that in the short run thederegulation policy would have adverse impact on the growth and inflation. But if complementedwith the policy of switching of subsidy bill to capital expenditure it might result in positivegrowth effects in the medium and long run. Given, the current pass-through policy, one-time oilshock has adverse impact on growth and inflation in the year of shock while it mitigates slowlyover time. The model shows that with the oil shock and with current partial pass-through regime,a 10 percent rise in oil prices result in a 0.6 percent fall in growth while in the full pass-through

situation, it can reduce the growth by 0.9 percent. The pass-through policy has differentialimpact on growth and inflation over the 12th Plan period. Hence, the policy of oil pricederegulation must be carefully weighed and prioritized.

II. Rationale Behind The Analysis

International oil prices have seen frequent sharp increases since 2002, spiking to more than $140per barrel in mid-2008. UNCTAD (2008) calculations showed that in developed countries thefuel import bill increased from 1.6 percent of their GDP in 2002 to 3.6 percent in 2007. Indeveloping countries, the fuel import bill rose from 2.7 percent of GDP in 2002 to about 5

percent in 2007. These ratios were estimated to amount to about 6 percent of GDP and 8 percentrespectively at an average oil price of $ 125 per barrel in 2008 in the same study. In India,similarly, the net oil import to GDP ratio has gone up from less than 3 percent in 2003-04 tomore than 5 percent during 2008-09. Though oil prices fell in the interim, current trends againshow significant increases, with analysts predicting high oil prices in the foreseeable future (IMF2011). Combined with the world-wide slowdown in economic activity and political instability inthe MENA countries, the implications of a further rise in international oil prices could bealarming for oil importing economies.

While the oil importing countries, even large ones like India are price-takers in the internationaloil market, countries usually exercise discretion in passing on international price shocks to

domestic prices. In India the administered price system has traditionally offered a mechanism tocushion the international price changes and achieve domestic policy objectives on inflation,growth and equity. The administered price system for oil is supported by budgetary expenditures(subsidies), even as revenues from oil constitute a significant portion of the overall revenues forthe government. The pass-through policy, presently on the reform agenda, thus has importantimplications for the way international oil price changes impact the macroeconomy.


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As the entire country, particularly the poor people, are reeling under heavy pressure of inflation,the UPA government has hiked the prices of diesel, kerosene and LPG by Rs 3 per litre, Rs 2 perlitre and Rs 50 per cylinder respectively. The reasons given for this move can be broadlycategorized as follows:

1. The prices have merely moved in tandem with the international prices.

2. The government could not take the burden for it more than what it already takes in theform of heavy subsidies for various petroleum products.3. There is a case for deregulation of prices of these three products on the lines of petrol as

it is becoming unsustainable for the exchequer and the public sector oil companies whoare facing 'under-recoveries' for a long time. This step is a forward movement in thatdirection.

4. In a period of inflation, such increase in prices would bring the demand downand, hence, would put a downward pressure on inflation.

This note attempts to analyze these arguments by presenting both the factual picture and theeconomic logic behind these arguments. In this regard, there are four major findings. Firstly, it isfound that despite deregulation of petrol, the prices in India are significantly higher than the

world prices. Secondly, a large portion of the retail prices that the consumers end up payingconsists of taxes levied by both the central and state governments. Thirdly, the government isheavily subsidizing the petroleum products and hence deregulation is the only way forward.In fact, we find that government's receipts through taxes are markedly higherthan the subsidiesthat they provide on petro-products. Lastly, we address the last point mentioned above that thisstep would help easeinflation.

III. Introduction

International Crude Oil prices have risen steadily over the past two years. If one were to visualize the web

of interactions among the relevant variables one would have to consider the Dollar Value and Volumes ofCrude Oil imports, Forex rates, Household consumption, Private Investments, Government Investmentsand Consumption, Net Exports (Exports minus Imports), Inflation, Interest rates besides other factors likebusiness sentiments, fiscal deficit, etc.Aggregate Demand is composed of four components, namely Household Consumption (C), GovernmentConsumption & Investments (G), Private Investments (I) and Net Exports (X).

(a) Impact on Net Exports (X)The first direct impact of Crude Oil price rise has been to increase the cost of imports. As Crude Oilforms a large part of the Indian import basket (approx. 30-32%), any price rise in crude has a sizeableimpact on the cost of imports. In the past 2 years, the quantity of Crude Oil imports has more or lessremained constant (refer Graph 4) but it is important to note that imports account for around 80% of

Indias Crude Oil requirement, the remaining being sourced from domestic crude oil sources. Crude Oildemand has remained inelastic in the past two years as tendency has been to maintain the growthmomentum causing the cost of Crude Oil imports to increase. As Crude Oil procurement in internationalmarkets is Dollar driven, this has led to a higher Dollar demand leading to depreciation of the IndianRupee. It is important to note that although Crude Oil has been a major contributor to depreciation, otherfactors like Gold imports and reduced FII inflows (as a result of persistently high fiscal deficit leading toreduced Dollar supply) have also played a part in the downslide of the rupee. The downward pressure onthe rupee would ideally make exports more competitive at the expense of imports but in light of the ofrecession-like conditions prevailing in EU and US, the export demand itself has taken a hit leading to


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overall decrease in value of exports. Thus, the net impact of exchange rate has been to increase the cost ofimports although the quantity imported has not increased. In fact, recent imports trend shows that fromJuly `11 onwards the overall Indian imports have (on average) remained stagnant at around $38- $40billion, barring some volatility, while the Rupee has depreciated by approximately 27% (~Rs 44/$ to Rs56/$) (refer Graphs 1 & 2). Therefore, in Rupee terms, imports have increased reducing the Net Exports(X) component of aggregate demand.


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(b) Impact on Household Consumption (C)The second impact of the Crude Oil price rise has been to increase the cost of production. Consideringthat Crude Oil fractions have wide-ranging applications, like in diesel for trucks and railway locomotives,fertilizers and pesticides for agriculture, plastic-manufacturing, it would not be difficult to understand thereason for increased cost of production of a wide ranging set of goods and services dependent on various


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crude oil fractions. This increase has been a major contributor to Cost-Push Inflation as, in such cases;producers tend to protect their margins by offsetting the increase in cost of production by increasing theprices. High inflation coupled with the negative sentiments attached to uncertainty of future prices haveled to reduction in Household Consumption (C). It is important to note here that the complete price rise isnot transferred to the consumer.

(c) Impact on Government Consumption (G)The Government cushions the impact through various fuel subsidies, also called the Administe redPricing Mechanism, which increases the Governments Revenue Expenditure. However, contrary topopular notion, there is practically no subsidy burden of Crude Oil on the Government as the RevenueReceipts from Crude Oil, in the form of Sales Tax, VAT, Excise and Customs duty, more than offset thesubsidy. Although partial pass-through of price rise cushions the fall in household disposable income,which has a positive impact on Aggregate Demand, this approach may not be sustainable in the long runconsidering the supply side bottlenecks and the fiscal deficit. It would, therefore, be advisable for theGovernment to reallocate the money used for subsidy to more productive channels, like incentivizing thesearch for Crude Oil sources domestically or long-term capital formation through infrastructuredevelopment. Moreover, the government should decrease its dependency on Crude Oil, especially Petrol,as a revenue-generating mechanism considering the fact that a sizable portion of the cost to consumer is

due to the plethora of taxes. A case in point is the cut in VAT on Petrol by the Goa state government(effective 2nd April`12) from 20% to 0.1% bringing the prices down from approximately Rs 65 to Rs 55.Obviously, such actions would reduce revenues for the state but an effort needs to be made to find viablealternatives for income generation. For example, the Government could look at increasing its stake inprofit-generating PSUs instead of disinvesting, along with working towards increasing realizations fromother existing taxes.

(d) Impact on Private Investment (I)Finally, private investment has reduced due to negative business expectations from the future due todecreasing Aggregate Demand and persistently high interest rates.

Overall Impact and RBIs Monetary Policy stanceThe overall impact of the Crude oil price rise, therefore, has been to reduce the GDP growth rate whichwould lead to higher involuntary unemployment levels. The accompanying Cost-Push Inflation has hit thepeople at the bottom-of-the-pyramid the hardest. This peculiar situation, where the GDP growth isdecreasing but inflation is high, is called stagflation.RBIs traditional stance has been to give priority to curbing inflation in the trade-off between inflationand growth, causing it to pursue a tight monetary policy. To curb the high inflation rates in FY`10-11,RBI increased policy rate by 525 basis points (bps) from 3.25% in March `10 to 8.5% in March`11. Morethan 13 hikes in the Repo Rate along with increase in CRR in the past two years has led to reducedlending and therefore, reduced investments. RBIs thought-process seems to be that by sucking liquidityfrom the system, Aggregate Demand will decrease sufficiently to curb inflation. However, in the currentscenario where inflation faced is Cost-Push and not Demand-Pull, the rationale behind continued rate

hikes is not apparent. In Indias case, the major contributors to inflation are Crude Oil and Food inflation,so unless the supply side constraints are addressed, monetary policys impact on inflation will beminimal. RBI has justified its actions by citing both supply and demand-side pressures (following post-recession recovery), their rationale being that many manufactures have taken the alibi of increasedproduction costs by passing on the complete increase to the consumer instead of decreasing the mark-up.By assuming a tight monetary policy, RBI aims to send a consistent signal into the market that it will notbuckle under pressure and that inflation being the priority, RBI will not shy away from increasing rates tocurb demand. This would force manufacturers to reduce their mark-up to drive sales, thereby decreasingprices to a certain degree.


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IV. Review of Literature

(A) Oil shock and its transmission through the supply side

A key insight from prior studies on oil and the macroeconomy is that the magnitude of the effect

of oil price shock on gross output must be small. Assuming an aggregate production functionwith three inputs (labour, capital, and oil) at full employment equilibrium, marginal productivityof oil equals the ratio of oil to output prices, i.e., the marginal cost of oil measured in terms ofdomestic product. An increase in price of oil raises its cost above marginal product leading to acutback in amount of oil used in the production. In the process, marginal productivity of labourand capital declines and there is a fall in output. Lower the elasticity of substitution between oiland other inputs, larger will be the fall in GDP.

These models predict only small changes in output when applied to real data, and are unable toexplain why oil price shock should trigger downturns as sharp as those of the 1970s. A onepercent reduction in oil usage reduces gross output by a percentage corresponding to the cost

share of oil. 2 This share of oil in output is thought to be no larger than 4 percent and may bemuch smaller. Thus, a 10 percent increase in oil prices, for example, should result in a less than0.5 percent reduction in gross output (Rotemberg and Woodford, 1996). However, following theSuez crisis in 1956, the drop in US real GDP was 2.5 percent, and the 1973 oil shock produced a3.2 percent drop in US real GDP (Hamilton, 2003).

To explain the much higher real drop in GDP, researchers have turned to additional transmissionmechanisms by which oil price shocks might contribute to lower growth, e.g., capital equipmentutilisation; uncertainty and investment pauses; labour markets; sectoral shocks. Besidesextending the number of channels through which the oil shocks play out, many of the modelshave invoked the theory of imperfect competition to explain the facts. The intuitive idea behind

most of these models, as discussed below, is that an increase in the price of energy works like anegative technology shock to generate contraction in economic activity.

Finn (2000) develops a model with perfectly competitive markets, but incorporates energy as anessential input for the utilisation of capital. This creates an indirect channel, working through thecapital stock, in addition to the usual direct production function channel, for transmitting theimpact of fluctuations in energy usage to the macroeconomy. Oil price increases depress thefuture marginal product of capital, thereby reducing investment and the future capital stock, andthus can have long-term effects on output. Using this model, Finn was able to arrive at muchlarger quantitative effects than the traditional studies in this area.

A different class of explanations emphasises the frictions in reallocating labour or capital acrossdifferent sectors that may be differentially affected by an oil shock. For example, one commonconsequence of an oil price shock is a sudden drop in demand for certain kinds of cars, whichleads to lower capacity utilisation at affected plants (Bresnahan and Ramey, 1993). Becauselabour and capital can move to alternative productive activities only at a cost, the result is idleresources that can significantly multiply the effects described above.


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Some of the channels described above have not been subjected to rigorous empirical testing, socaution is required in generalising from these results. Also, the very different response of realoutput and prices in recent episodes of oil price increases (IMF, 2007; Blanchard and Gali, 2009)requires fresh research on the theoretical and empirical relationship between oil price shocks andgross output.

(B) Oil shock in a demand constrained economy

The following survey explores the impact of an oil-price rise for an economy with less than full-employment output, and with high levels of involuntary unemployment.

Trade channel

Given the preponderance of oil imports in the import basket of the developing countries and theirgrowing energy needs, an increase in oil price would lead to a worsening of trade balance, givena fixed exchange rate.

The decline in trade balance works through movements in terms of trade. Rakshit (2005) pointsout that for examining the effect of an oil shock in terms of an open economy macro model weneed to distinguish between two price ratios or terms of trade: (a) ratio of oil price to thedomestic price level; and (b) the ratio of the price level of non-oil importables to that of domesticgoods. The countrys trade balance is negatively related to (a), but im proves with an increase in(b). Since the proportional rise in the domestic price level is less than that in crude oil prices, anoil shock raises (a), but lowers (b). Thus, the result relating to worsening of the trade balance andthe consequent fall in aggregate demand and GDP through the foreign trade multiplier is clearcut.The assumption here is that the nominal exchange rate is fixed, so that a rise in domestic prices,ceteris paribus, results in real exchange rate appreciation. However, if the nominal exchange rateis flexible, oil importing countrys currencies will depreciate, while oil exporters currencies willappreciate in response to their real income gains. Over time, the initial oil trade deficit willdecrease, and the non-oil trade balance will increase. Thus the fall in real output, or at least a partof it, might be temporary in the oil-importing economy.

The theoretical case for flexible exchange rates rests on the ability of flexible exchange rates toabsorb adverse oil shocks that obviates the need for a prolonged adjustment through excessdemand in the goods and labour markets to push prices and wages to the new equilibrium. Thishypothesis was tested and affirmed by Al-Abri (2007) for nine major OECD countries between1973 and 2004.

Consumption and investment channel

In a recent survey on the effects of energy price shocks, Hamilton (2008) stresses that a keymechanism through which energy price shocks affect the economy is the disruption inconsumers and firms spending on goods and services other than energy. This view is consistentwith evidence from industry as most U.S. firms perceive energy price shocks as shocks to thedemand for their products rather than shocks to the cost of producing these products.


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There are four complementary mechanisms by which energy price changes may directly affectconsumer expenditures (see, Edelstein and Kilian, 2009).

1. First, higher energy prices reduce discretionary income, as consumers have less money tospend after paying their energy bills. Other things being equal, this discretionary incomeeffect will be larger the less elastic the demand for energy. But even with perfectly

inelastic energy demand, the magnitude of the effect of a unit change in energy prices isbounded by the energy share in consumption.2. Second, changing energy prices may create uncertainty about the future path of the price

of energy, causing consumers to postpone purchases of consumer durables (see,Bernanke, 1983). Unlike the first effect, which applies to all forms of consumption, thisuncertainty effect is limited to consumer durables.

3. Third, consumption may fall in response to energy price shocks, as consumers increasetheir precautionary savings.

4. Finally, consumption of durables that are complementary in that their operation requiresenergy will tend to decline even more, as households delay or forego purchases ofenergy-using durables.

Contractionary tendencies could be strengthened by a hardening of interest rates due to the risein prices and by investors turning extra cautious because of concerns about heighteneduncertainty.

Financial channel

It is useful to distinguish the traditional channels of external adjustment, the trade channel, andthe financial (or valuation) channel of adjustment. The trade channel works through changes inthe quantities and prices of goods exported and imported; whereas the financial channel worksthrough changes in external portfolio positions and asset prices.

The financial channel could either cushion or exacerbate the effect of oil price increases on oil-importing countries external balances. A decrease in asset prices and dividends in oil-importingcountries in response to an oil price increase will affect all asset owners, including residents ofoil exporting countries. Conversely, asset prices in oil exporting countries will increase, againaffecting all asset owners, including residents of oil importing countries. As a result, capitalgains and income flows may blunt the impact of oil-price changes on the current account and onnet foreign assets (NFA) changes. Bond and equity prices and exchange rates typically respondmuch faster than the prices and quantities of goods (and faster than portfolio positions). Inpractice, the response will depend on the precise configuration of countries portfolios, and theextent to which these portfolios can be rebalanced effectively.

With certain portfolio configurations, the financial consequences of the shock could evencompletely offset the need for short-term external adjustment. A case in point is the US, whichmostly has fixed income liabilities denominated in its own currency, while equity and foreigndirect investment holdings are denominated in foreign currency. Using the Lane-Milesi-Ferrettinet foreign asset data set, Kilian et. al (2007) show the presence of large and systematicvaluation effects in response to oil shocks, not only for the United States, but also for other oil-importing economies and for oil exporters. Their estimates suggest that increased international


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financial integration will tend to cushion the effect of oil shocks on NFA positions for major oilexporters and for the United States, but may amplify it for other oil importers.

What should be the monetary policy response?

Faced with an oil shock and higher prices, the monetary authorities have often tightenedmonetary policy. Bernanke, Gertler, and Watson (1997) have shown that the Federal Reserve,when faced with potential or actual inflationary pressures triggered by a positive oil price shock,responds by raising the interest rate, amplifying the decline in real output associated with oilprice shocks. In assessing the effect of this policy response from vector autoregressive (VAR)models, Bernanke, Gertler, and Watson postulated a counterfactual in which the Federal Reserveholds the interest rate constant.

In other words, the Fed is not responding to any of the effects of the oil price shock on theeconomy. They conclude that the Fed's systematic and anticipated response to oil price shocks isthe main cause of the recessions that tend to follow oil price shocks and that these recessions

could have been avoided (at the cost of higher inflation) by holding the interest rate constant.Bernanke, Gertler, and Watsons results have not remained unchallenged. Hamilton and Herrera(2004) showed that their estimates are sensitive to the choice of the VAR lag order. They alsodemonstrated that implementing a constant interest rate policy would have required policychanges so large to be unprecedented historically and hence not credible in light of the Lucascritique, a point acknowledged by Bernanke, Gertler, and Watson (2004).

It is obvious that in a demand constrained economy the tendency of the central banks to tightenmonetary policy when faced with an oil shock will result in further losses in output andemployment though it can neutralise the cost-push effect of the shock on the price level. Infigure1, the shift in aggregate supply from AS1 to AS2 begins a chain of adjustment that creates anupward pressure on price level and a decline in real output. If the monetary policy is tightened,the aggregate demand curve will shift inwards from AD1 to AD2 and real output contract from yto y, which is more than what would have resulted had there been no monetary policyintervention. In fact, the shock results in a shift from one equilibrium to another so that policy-makers are not confronted with a output-inflation trade-off or any danger of an unabated rise inprices. Unless a good case for the existence of a wage-price spiral can be made, oil price shockswould not be expected to cause sustained inflation.


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Hence monetary (or fiscal) contraction for curbing prices cannot be an optimal response to an oilprice shock in a demand deficient economy. Nakov and Pescatori (2010) demonstrate that awelfare-maximising central banker should not respond to increases in the price of oil. As long as

the monetary policy regime is credible, the central bank may allow for drift in the price levelwithout jeopardizing the objective of stable medium-term inflation. Since the 20032008 oilprice shock reflected a shift in the real scarcity of resources, there is nothing a central bank couldor should have done in response, beyond making sure that inflation expectations remainedanchored by way of following say, an interest rate rule, in the face of inflationary pressuresarising from both oil and industrial commodity prices is Kilians (2009) view.


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V. Macroeconomic Transmission Mechanism of International Oil

Price Rise: The Indian Situation

Here we study the impact of an increase in international oil prices on Indian economy

outlining the various transmission mechanisms. These mechanisms take into account some of theimportant macroeconomic relationships as relevant to the Indian economic context and theadministered nature of domestic oil price in India.

The three broad channels through which the international oil prices have a deep impact on theeconomy a) Import Channel b) Price Channel c) Fiscal Channel

A)Import Channel

India is a Net Oil Importing country , thus this leaves it susceptible to higher importBill in the case of rise in international oil prices. Under the reasonable assumption of low priceelasticity of demand for oil, ceteris paribus, the trade balance will worsen due to an increase in

international oil price. Rise in inflation due to increase in oil prices means that the growth in realGDP is even lower. The compression in aggregate domestic demand dampens growth.


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INDIAS FOREIGN TRADE - US DOLLARS

(US $million)

YearExports Imports Trade Balance

Oil Non-Oil Total Oil Non-Oil Total Oil Non-Oil Total

1990-91 522.7 17622.5 18145.2 6028.1 18044.4 24072.5 -5505.4 -421.9 -5927.3

1991-92 414.7 17450.7 17865.4 5324.8 14085.7 19410.5 -4910.1 3365.0 -1545.1

1992-93 476.2 18061.0 18537.2 6100.0 15781.6 21881.6 -5623.8 2279.4 -3344.4

1993-94 397.8 21840.5 22238.3 5753.5 17552.7 23306.2 -5355.7 4287.8 -1067.9

1994-95 416.9 25913.6 26330.5 5927.8 22726.5 28654.4 -5510.9 3187.1 -2323.8

1995-96 453.7 31341.2 31794.9 7525.8 29149.5 36675.3 -7072.0 2191.7 -4880.4

1996-97 481.8 32987.9 33469.7 10036.2 29096.2 39132.4 -9554.4 3891.7 -5662.7

1997-98 352.8 34653.7 35006.4 8164.0 33320.5 41484.5 -7811.2 1333.1 -6478.1

1998-99 89.4 33129.3 33218.7 6398.6 35990.1 42388.7 -6309.2 -2860.8 -9170.0

1999-00 38.9 36783.5 36822.4 12611.4 37059.3 49670.7-

12572.5 -275.8 -12848.3

2000-01 1869.7 42690.6 44560.3 15650.1 34886.4 50536.5-

13780.4 7804.2 -5976.2

2001-02 2119.1 41707.6 43826.7 14000.3 37413.0 51413.3-

11881.2 4294.6 -7586.6

2002-03 2576.5 50142.9 52719.4 17639.5 43772.6 61412.1-

15063.0 6370.3 -8692.7

2003-04 3568.4 60274.1 63842.6 20569.5 57579.6 78149.1-

17001.1 2694.5 -14306.5

2004-05 6989.3 76546.6 83535.9 29844.1 81673.3 111517.4-

22854.8 -5126.7 -27981.5

2005-06 11639.6 91450.9 103090.5 43963.1 105202.6 149165.7-

32323.5-

13751.7 -46075.2

2006-07 18634.6 107779.5 126414.1 56945.3 128790.0 185735.2-

38310.7-

21010.5 -59321.2

2007-08 28363.1 134541.1 162904.2 79644.5 171794.7 251439.2-

51281.4-

37253.6 -88535.0

2008-09 27547.0 157748.0 185295.0 93671.7 210024.6 303696.3-

66124.7-

52276.6 -118401.3

2009-10 28192.0 150559.4 178751.4 87135.9 201237.0 288372.9-

58943.9-

50677.6 -109621.5

2010-11 41480.0 209656.2 251136.2105964.4

263804.7 369769.1-

64484.4-

54148.5 -118632.9

2011-12 55603.5 249020.0 304623.5154905.9

334511.5 489417.4-

99302.4-

85491.5 -184793.9

Note : Data for 2010-11 are revised and for 2011-12 are provisional.Source : Directorate General of Commercial Intelligence and Statistics.

In the figure explaining the linkages, the import channel is indicated by the link frominternational oil prices to current account balance to nominal GDP. Although managed float, thenominal exchange rate in India is observed to be determined solely by the capital account andnot by the current account in the present Indian context. The second order adjustment to higherimport bill and worsened trade balance occurs only through contraction in aggregate demandand decline in imports and it does not occur through movements in exchange rate(depreciation).


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Finally, the slowdown in economic growth would subsequently reduce the demand for importswhich, in turn, would partially mitigate the adverse impact of high international oil prices ontrade balance.

B) Price ChannelThe price channel links the international prices to domestic inflation. For a typical developingcountry like India facing an oil price hike in the international market, an unhindered pass-through of oil price increase leads to a jump in the general price level on account of direct use ofoil at higher prices plus increase in costs of production of final goods using oil as an input.Modelling the pass through of oil prices through an input-output system, Jha and Mundle (1987)estimated that in India if the administered prices of crude oil, gas and petroleum productsincrease by 7 per cent, the overall WPI increases by 1 per cent (i.e. the total elasticity to be0.14). Recently the Reserve Bank of India (2011) has estimated that every 10 per cent increasein global crude prices, if fully passed through to domestic prices, could have a direct impact of 1

percentage point increase in overall WPI inflation and the total impact could be about 2percentage points over time as input cost increases translate to higher output prices acrosssectors. Greater the share of fuel in total consumption basket, larger would be the influence ofinternational commodity prices on inflation.

In India, a large proportion of the international oil price increase has traditionally beenabsorbed by the government (and shared with public sector oil producing and retailingcompanies). The objectives for regulation of price of oil have been three-fold:(a)To protect the domestic economy from volatility in international oil prices(b)To provide merit goods to all households, e.g., clean cooking fuels like LPG, natural gas and

Kerosene to replace use of biomass-based fuels such as firewood and dung(c) To protect poor consumers so that they may obtain kerosene (through PDS) and LPG at

affordable prices. In the recent years, there has been a change in the oil pricing policy with amove towards market determined oil prices. The extent of price regulation varies acrossproducts in the oil basket, with minimum control existing for petrol and very little pass-through for LPG and kerosene

The domestic price of oil is administered, which is essentially a policy decision, and therebydetermines the degree of pass-through of the change in international prices to domestic oilprices. In figure explaining the linkages between the channels, the price channel is indicated bythe link from international oil prices to increase in administered prices to WPI inflation

C) Fiscal Channel

The third channel of transmission of oil price shock considered here is the fiscal channel. Inthe absence of a complete pass-through, an international oil price increase will raise the subsidyon oil and therefore the revenue expenditure of the government.

Furthermore, in India, the oil prices are subsidised, but they also generate substantial taxrevenues both for the centre and the states. A rise in the international price of oil would entailhigher revenue receipts because of an increase in ad valorem tax collections on oil and petroleum


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products that would have to be netted out to arrive at the net addition to oil subsidy given by thegovernment.

Contribution of Petroleum Sector in Government ExchequerOn the revenue side, the contribution of the petroleum sector to the exchequer of both

Central and the State governments combined was 2.8 percent of GDP in 2009-10, with more than60 percent share of the Central exchequer. The Central governments earning from this sectorhas been higher than the total revenue expenditure of the Central government in this sector.Although, the direct subsidy figures vary widely from source to source, the bulk of the revenueexpenditure of the Central government on petroleum consists of petroleum subsidy. In 2009-10,the total revenue expenditure in petroleum was less than 0.4 percent of GDP. Even if we includethe issue of special securities in lieu of subsidies to the oil marketing companies, it does notexceed 0.55 percent of GDP during 2009-10. Clearly, the contribution of this sector in exchequerhas always been much higher than the sum of total revenue expenditure on petroleum and thepetroleum bonds. Thus, in effect there is no net subsidy accruing to this sector. Also, it isimportant to note here that the total revenue expenditure has always been lower than the net

profit (after tax) of the public sector oil companies including the upstream, downstreamcompanies and the stand alone refineries barring the exceptional year of 2008-09, when theinternational price of oil touched historic peak

In terms of the transmission mechanism, the impact of an oil price change on sales tax collectionwould be much more direct in case of full pass-through and would be realised both throughquantity and prices of imported oil (or the value of net imports). On the other hand, internationaloil price change will not directly affect the revenue generated from excise and customs dutiesbecause of the specific nature of these taxes, but only indirectly through its effect on the quantityof oil imported, which is a function of the level of economic activity.

The fiscal channel as indicated in figure of linkages brings together both the revenue andexpenditure effects of oil price change on the macro economy. There are two policy levers actinghere: the administered price of oil (and hence subsidy) and the indirect tax rates on oil andpetroleum products.The former determines the pass-through ratio that denotes how much of the change ininternational oil price change is to be passed on to domestic consumers as change in domestic oilprice, and therefore the subsidy. The revenue from oil is a function of tax rates and the oil importquantity or value depending on the type of indirect tax.

eco-before the model

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