The Libyan crisis and its effect on the Indian economy

Last week the United Nations Security Council passed a resolution on enforcing a no-fly zone over Libyan airspace and its intention to prevent attacks on the civilian population by the Libyan regime. Resolution 1973 “demands the immediate establishment of a ceasefire and a complete end to violence and all attacks against, and abuses of, civilians”. It

establishes “a ban on all flights” in the airspace of Libya “in order to help protect civilians”. It authorizes member states to take “all necessary measures to enforce compliance with the ban”.

It is believed that this development could lead to a protracted low intensity conflict as the two warring groups consolidate their held territories.

Libya’s crude output had fallen to fewer than 400,000 barrels a day — a quarter of pre-crisis levels of around 1.59 million barrels a day in January 2011— and could stop entirely. Exports may be halted for “many months “because of sanctions and damage to facilities across Libya according to the International Energy Agency. Prospects of reviving the Libyan infrastructure to pre-crisis levels within a reasonable time-frame seem remote as illustrated by the Iraqi experience in turning around war-damaged infrastructure.

These delays act as fuel to inflate oil prices and make them stay at elevated levels for long periods. Higher oil prices place upward pressure on inflation and downward pressure on economic activity. Since most nations are net oil consumers, higher oil prices act as a tax on consumption and leave their people genuinely worse off, reducing their disposable incomes.

As the higher oil prices threaten inflation, central banks around the world are forced to act. The European Central Bank, for example, is now planning to raise interest rates in response to higher oil prices in a bid to keep inflation under control. By doing so, European consumers and companies will be hit both by the higher cost of fuel and by the higher cost of borrowing.

If countries have relatively healthy fiscal positions, they might be able to counteract the effects of higher oil prices through a well-targeted tax cuts or an increase in fuel subsidies. But for much of the Western world, whose economies have considerably weakened by the sub-prime crisis, looser fiscal policy isn’t really an option.

Such long conflicts which push up oil prices are bad news to emerging markets such as India, which are excessively dependent on oil imports to meet its ever increasing energy needs. Indian economy imports almost 70% of its crude requirement and could face the brunt of this crisis.

The increased oil price acts as gravity to the Indian growth trajectory with a USD 10 per barrel increase impacting growth by 0.3-0.5%. If the USD 10 per barrel increase is passed through fully to the consumer, it could increase inflation by 1.7-2.0%. In India, as the increase doesn’t get passed through fully in various fuel categories, the USD 10 oil price rise, in turn, increases the fiscal deficit by 0.2% of the GDP (if government absorbs 1/3 rd of the under-recovery) and increases the current account deficit by by 0.3-0.4% of the GDP At crude oil levels of USD110-115, under recoveries can go up to as high as Rs1,25,000- 1,50,000 crores from the earlier levels of around Rs.77,000 crores (on assumptions of crude prices of USD 85).

With the FY 2012 budgeted number for government’s share of oil subsidy at just Rs.23,600 crores, and these mounting under-recoveries could inflate the oil subsidy bill by around Rs.40,000 crores at these oil prices (assuming the government’s burden of 50%). The higher oil subsidy bill could inflate the FY 2012 net borrowing number and increase the government’s cost of borrowings by hardening the yields. The higher oil subsidy bill would
also increase the fiscal deficit in FY 2012 and stretch the government’s finances.

From CIO Desk, Tata AIG Life Insurance Company Ltd

Saravana Kumar
Disclaimer: Whilst every care has been taken in the preparation of this document, it is subject to correction and markets may not perform in a similar
fashion based on factors influencing the capital and debt markets; hence this review note does not individually confer any legal rights or duties.