How did oil prices bring India to the brink of economic collapse, and can it happen again?

Introduction

1991 was a frightening year for the Indian economy. India was three weeks away from running out of money for essential imports. The government was close to defaulting on its debt, and had to literally airlift gold to the Bank of England for an emergency loan. Policymakers conceded that India’s formerly protectionist and isolated economy would have to open itself to the world to be saved, and this resulted in the liberalization of 1991.

In 2013, India was seemingly on the brink again. The government scrambled to increase import duties: 15% on gold, 36% on televisions. Emerging market fears began to make global investors jittery about what would happen to the Indian economy. This time, we were saved from complete collapse by a drop in global commodity prices.

The cause for both of these potentially catastrophic economic situations is deceptively simple: global crude oil prices.

India’s relationship with oil prices is fraught. An increase in oil prices often sets off higher inflation, lower economic growth, and a spell of pessimistic economic sentiment. And, as we saw in 1991, it can put our economy at grave risk. A rise in oil prices sets off a chain of complex macroeconomic factors, all of which start with the Current Account.

Current Account Deficit

All imports into a country have a direct effect on its Current Account. As our largest import, oil affects our current account more than anything else.

The Current Account is a simple concept:

Current Account Balance = Exports — Imports + Repatriations + Earnings on foreign investments-

If the current account balance is less than zero, it’s said to be in deficit; otherwise, it’s in surplus. Effectively, a current account deficit means that money is flowing out of the country. To make up the balance, a country needs to bring in money from abroad, increasing the amount of debt held.

The most important factor in this equation for India is Exports — Imports, or our trade balance. The more we import, the more negative this number gets, effectively increasing the amount that we need to borrow from abroad.

Deficit-fueled Currency Devaluation
A current account deficit puts pressure on the currency to devalue. This is explained by simple supply and demand. Global trade is priced in dollars. As we import more, we need to “buy” more dollars. Thus while the supply for dollars is fixed, our demand for dollars increases, causing the price of a dollar to increase. This makes each rupee worth less.

We can see an example of this between 2011 and 2014. In 2011, we could buy one US Dollar for Rs. 46. By 2014, we needed Rs. 61 to buy one USD.

In normal situations, this deficit should fix itself.

As the rupee devalues, our products become cheaper from a foreigner’s point of view. Imagine an Indian company that needs to make Rs. 45 per item sold. In 2011, it priced the item at $1. But, by 2014, it could price the item at just $0.73 to make Rs. 45. Since our products become cheaper, foreigners should start to buy more, causing our exports to increase.

Furthermore, from our point of view, imports become more expensive. In 2011, importing $1 of oil costs Rs. 46. But in 2014, it would cost Rs. 61. Since importing becomes more expensive, people switch to buying domestic products, reducing the import bill.

Theoretical Ways to Move Away from the Deficit
So in theory, a currency devaluation, which increases exports and reduces imports should push the current account in the positive direction. In practice, it doesn’t always work exactly like this.

Switching to domestic production isn’t as simple as it seems. Imagine that you own an Indian auto manufacturing company that heavily relies on parts from Germany. And there’s this one German company that makes the best ball bearings in the world — they’re so good that you can’t possibly use any others! Even if domestic producers step in, they can’t match that German quality. And so despite the devaluation of the rupee, and an increase in prices for those German ball bearings, you keep importing them. This is called a sticky import.

The stickiest import of them all is crude oil. Because no matter what we do, we can’t produce crude oil domestically — we don’t have the oil reserves.

So this sets off a vicious cycle. As we import oil, the rupee devalues. But as it devalues, the next barrel of oil becomes even more expensive. It feeds on itself, putting the rupee in a constant devaluation trap.

2014 is a great example of this phenomenon. Oil prices were relatively high between 2011 and 2014, hovering over $100 per barrel. RBI data from 2014 shows that we ran a deficit of almost $30 billion, our largest ever in history. Due to this, our currency devalued by almost 50% between 2011 and 2014.

When we have such a large import bill, we are at the mercy of foreign investors. Someone has to finance our deficit — if we’re spending more money than we have, we have to borrow! But if no one lends us money … we’re in deep trouble. We won’t be able to buy any oil, and our economy will come to a standstill.

This is exactly what happened in 1991. The gulf war, which started in 1990, caused a sharp increase in global oil prices. Government debt made investors fear for the country’s economic safety, and so foreign investors stopped giving us money. We had to pay for all our oil with our reserves of foreign exchange; and we almost ran out.

How can India prevent this in the future?
From a macro and policy perspective, India only has a few options to fix this situation.

The first, and best one, is to get India to export more manufactured goods. India is a net exporter of services (thanks IT companies!). But we lag behind severely in manufacturing; this increases our import bill as we are dependent on products from other countries. More manufacturing would increase exports, and reduce imports, having a great effect on our balance of payments.

The second option is to bring more foreign investment into India. This can balance out the import bill. Foreign investment can come in two forms, namely Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). Ideally, we want the former over the latter. FDI is investments in real assets, such as opening a factory. These investments are stable; it is difficult to liquidate your factory investment overnight. FPI is investments in the financial markets -foreigners buying stocks, or lending us money. This is rightly called hot money — it can flow out as easily as it flows in, so it is unreliable & volatile.

India used this option in 1991. Before 1991, very little foreign money could enter India. The famed liberalization of our economy was needed, to bring in FDI & FPI, and stave off the severe crisis.

The third option of course is to create a magical new energy source that reduces our oil dependence, while also discovering the fountain of youth and shambala.

How does this affect investors?
Unfortunately, this is a difficult one to plan for. This is a structural, long-term problem, where we are at the mercy of foreign investors and global oil prices. If our economy’s long term health is poor, there isn’t much that any of us can do to profit in the long run from the stock markets.

One possible hedge against this issue is increasing investments in companies that export, such as IT companies. Since they make money in dollars, if the rupee devalues, their earnings go up in rupee terms. So effectively as oil prices increase, IT stocks should go up.

Another option is investing in international equities funds, such as Franklin Templeton’s US Opportunities fund. These funds invest in foreign equities, and are the easiest way for domestic investors to get exposure to foreign stocks.

This issue is an example of how complex the economic machine is. It’s why, as we invest in India, we always need to have one eye on the oil price. India’s economic fundamentals look strong at the moment; we have $417 billion foreign reserves, and a current account deficit of just around $7 billion. But a few years of high oil prices could see us return to the dark days we faced in 1991 and 2013.

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