Rising crude prices drive up bond yield, threaten to derail fiscal maths

High oil prices also feed into inflation, necessitating the central bank to be more hawkish in its monetary policy than it so far it has conducted itself

The 10-year bond yield rose sharply to close at 6.64 per cent on Monday, from its previous close of 6.58 per cent, as high oil prices threatened to derail the fiscal math, necessitating potentially higher or out-of-turn borrowings. This yield is the highest since January 22, 2020.

Brent crude oil opened at $86.15 a barrel on Monday and rose to a five-year high of $86.71 during the session, according to Bloomberg data.

This means more expensive crude oil for India, which meets around 85 per cent of its domestic requirement through imports. The Indian basket of crude oil traded at $84.54 a barrel on Friday, highest since the beginning of the current financial year.

High oil prices also feed into inflation, necessitating the central bank to be more hawkish in its monetary policy. If oil prices stay at higher levels, rate hikes can be expected quicker, and the bond market largely reflected that on Monday, say experts.

The rupee also came under pressure, closing at 74.25 a dollar, amid RBI intervention supporting the rupee sporadically, from its previous close of 74.15.

“We are seeing WPI trending higher than CPI, which, at a broad level, indicates higher input prices relative to output prices,” said Badrish Kulhalli, Head of Fixed Income at HDFC Life Insurance.

“The weak demand, due to the successive Covid waves, is likely to have subdued the manufacturers’ pricing power in the recent period. However, as manufacturers regain pricing power, the transmission of rise in input prices to output prices could be faster. Hence the rise in energy prices is likely to prove more inflationary in the coming months,” Kulhalli said, adding that if this pushes up inflation beyond the RBI’s tolerance limit of 6 per cent, the central bank will be forced to hasten steps in normalising monetary policy stance.

“Technically, oil is a self-correcting asset class. The more it goes up, supply increases and automatically the prices come down,” said Rahul Singh, fund manager, fixed income for LIC Mutual Fund.

According to Prashant Vasisht, vice-president and co-head of corporate ratings at ICRA, Brent crude crossing $85 a barrel — and even another $10 rise — will not impact auto fuel consumers much in India.

“It will largely result in a Rs 6-8 per litre increase in petrol and diesel prices. These are levels at which consumers have already bought fuel before the government cut excise duty.”

But the impact on the Indian economy will be much wider.

B. Prasanna, executive director and head of global markets at ICICI Bank, said: “A spike in international crude prices has always been a red flag for India’s macro, given its impact on CAD (current account deficit), inflation and fiscal deficit.”

“We expect India’s net crude import bill to be upwards of $110 billion next year on account of high usage volumes due to increased mobility and an already elevated crude price to begin with. Even a realistic rise of $10 in average crude prices next year would mean a $13 billion increase in CAD. Given that we are already pencilling in upwards of 2 per cent CAD/GDP next year, a spike in crude prices would therefore further muddle India’s BOP situation, putting pressure on the rupee," Prasanna said, adding that overall, given fiscal deficit at upwards of 6 per cent, CAD over 2 per cent and CPI near the top of the MPC’s target range, a spike in crude prices could put further pressure on both the rupee as well as bond yields going forward.

The impact on oil marketing companies will depend on the Centre’s resolve to allow pass-through of higher costs on kerosene and cooking gas consumers. “If Brent crude oil prices average closer to $85 a barrel, it will mean no adverse impact on oil companies since they are already marketing their products at this price level,” Vasisht added.

Devendra Kumar Pant, chief economist of India Ratings & Research, said: “It is going to deteriorate our CAD, which is expected to widen to between 2 and 2.5 per cent of GDP. If crude oil prices remain high for months, there will be an impact.”

China has already eased short-term liquidity, but if the US Fed and other major central banks start tightening rates, then there will be an impact on the capital flows to India. “If those flows are affected, (and) on top of it you have high crude oil prices, both current account and the value of the currency are expected to deteriorate,” he added.

On the impact of oil prices on subsidy allocation in the Union Budget, Pant said petroleum subsidy spent so far this fiscal year is close to 15 per cent of the Budget Estimate.

“As of now there are only two products on which oil subsidy is given, kerosene and Liquefied Petroleum Gas (LPG). The domestic LPG cylinder prices have also been raised. If crude oil prices go up and domestic LPG prices rise further, then the oil subsidy may come back again explicitly. But that amount is unlikely to be very significant as it is limited only to two products,” he said, adding, “if prices go up by Rs 5 or Rs 10 per cylinder then it is unlikely that there will be a major change, but if they go up drastically, then there is no other option but for the government to come and bear a part of it.”

He said the allocation for cooking gas subsidy is likely to remain the same as the last Budget “because the government has to budget for a surge in crude oil prices of, suppose, 20 per cent from here.”