The ground action by Russia after a long-standing build-up has begun in Ukraine; however, the chances of much more significant escalation look less at this point. Irrespective of the military objectives, the impact of the conflict will be felt across commodities and asset classes. Oil prices have already crossed US$100 per barrel. In such a case, the prices of petrol and diesel in India should have been higher by Rs9 to Rs14 by now, says a research note.
In the report, Dr Soumya Kanti Ghosh, group chief economic adviser of State Bank of India (SBI), says, "Based on the existing structure of value-added tax (VAT) and taking Brent crude price of US$100 to US$110 per barrel, diesel and petrol prices should have been higher by Rs9-Rs14 each as of now."
Interestingly, petrol and diesel prices have not changed since November 2021. The average price of the Indian basket of crude oil has risen to $84.67 per bbl in January 2022 from US$63.4 per bbl in April 2021, an increase of 33.5%. If the crude oil price rises to an average of US$100 per bbl from the current average, inflation is likely to increase by 52-65 basis points (bps), the report says.
However, SBI says, if the Indian government reduces excise duty on petroleum products and prevents the prices of petrol and diesel from rising, then it will incur excise duty loss of Rs8,000 crore for a month. "And if we assume that the reduced excise duty continues in the next fiscal and assuming petrol and diesel consumption grow around 8-10% in FY23, then the revenue loss of the government would be around Rs95,000 crore to Rs1 lakh crore for FY23. In this context, the FY23 budget numbers that are pegged conservatively would act as a clear countercyclical buffer for such revenue loss."
Dr Ghosh , however, puts forth an interesting point about trends in crude oil prices. He says, "Historical trends since 2018 indicate that it takes around 18 months for crude prices to crash by as much as 67% from the highest level and a 30% drop from highest level could even come in less than three months. Thus the decline in crude prices from the current high levels could come even faster going by the recent trends and it augurs positive for the overall macro prognosis. Financial markets also recover faster after a geo-political induced decline as the experience of three decades reveals."
Talking about the war between Russia and Ukraine, Dr Ghosh points out that the current escalation can be seen as the second phase of conflict after 2014 when Russia annexed the Crimean peninsula.
"The current escalation most likely will progress on a similar template seen in Georgia and Crimea, a swift action to secure certain strategic objectives which in Russian viewpoint are non-negotiable. The chances of much larger escalation look less at this point," he says.
Irrespective of the military objectives, the impact of the conflict will be felt across commodities and asset classes, SBI says, adding oil prices have already crossed $100 per barrel while other commodities which will see inflation include precious metals like gold, palladium and platinum.
It says, "Ukraine is an important exporter of agricultural products; there will be an impact on prices of wheat and corn if navigation lines in the Black Sea are disturbed. For India, which has no strategic interest in this conflict, the fallout will be mostly economic. The rise of commodity prices will impact the current account deficit (CAD) and domestic inflation. The export outlook of services towards Europe will be impacted negatively. Sanctions on Russia may impact regular trade like tea between India and Russia."
Meanwhile, SBI says, there remains upside risks to inflation, even though it is high time the methodology of computing consumer price index (CPI) inflation by using the Consumption Expenditure Survey (CES), last updated in FY11-12, may be updated.
This, according to the report, is a significant issue as using the CES survey to compute inflation might be introducing an upward bias in CPI estimates as food has a weightage of 45.86% in headline CPI, which is misleading.
For example, it says, in the Indian context, private final consumption expenditure (PFCE) data as released by National Account Statistics (NAS) for the year ended March 2021 reveal that the share of food consumption was at 32.5% in FY20-21. The NAS and CES estimates differ in coverage, estimation methods, and databases; therefore, the inflation derived from weights under both the methodologies would be different.
"However, some of the policy decisions taken by the Indian government during the pandemic should have resulted in much lower CPI, but that was not to be, given the methodology of computing CPI through CES survey," SBI says.
As the most glaring example, according to SBI, how both the NAS and CES value estimates for the items in the rice and wheat groups represent the expenditure actually incurred on the items.
The quantity available from the public distribution system (PDS) is evaluated at the administered price in the NAS, while the cost actually paid by the households for the quantity obtained from the PDS are recorded in the CES.
"The government had given free food under PDS throughout the pandemic, but that is not reflected in CPI cereal data, which shows an increasing trend and this problem could get compounded further because of the current military conflict," the report points out.
Interestingly, SBI says, "during the pandemic, it is not clear why the service inflation has climbed up significantly, even as most services were closed. If we estimate CPI by using the NAS weights, the headline CPI declines to 5.26% for the latest reading for February 2021 from 6%."
"Setting aside such concerns, there appears to be an upside risk of 90-100 bps to Reserve Bank of India (RBI)'s inflation of 4.5% for FY23 if oil price averages to $90 per bbl. And 100-130 bps upside if oil price averages to $100 a bbl. We are, however, hopeful of a significant course correction in oil prices going by trends," it added
Since October 2021, services and food CPI are converging. Most importantly, rural goods and urban goods are converging to rural and urban services.
"This indicates that services CPI that has been sticky downwards for a considerable period of time may have resulted in mild inflationary expectations pushing up goods prices in the process. Goods prices will also increase in future as pass through becomes more pronounced. Thus overall concerns to inflation remain," SBI concludes.