West Asia war: Are the effects priced in amid rising economic risks?

As the Strait of Hormuz disruption deepens, India faces rising inflation, supply shocks, and fiscal strain, with markets yet to fully price in the risks

The United States-Israel war on Iran has entered the fourth week and the Indian benchmark indices are down 8 per cent. The first-order effects of the war are familiar to all of us, with the Strait of Hormuz effectively closed. Of India’s imports, roughly 54 per cent of crude oil, 60 per cent of liquefied natural gas, and as much as 90 per cent of liquefied petroleum gas transit through Hormuz. Along with oil and gas, India faces a shortage of refined products like naphtha, aviation turbine fuel, and gasoil. Deeper vulnerability lies in food. Food production depends on diesel and fertiliser. Diesel runs tractors, irrigation pumps, and the transport system, which carries crops. Fertilisers — urea, ammonia, and phosphates — determine yields. More than 30 per cent of the global urea trade and roughly 20 per cent of ammonia and phosphate pass through Hormuz. 

The Gulf region is also a critical supplier of more than a third of global helium, a niche input indispensable for semiconductor and imaging machines. It accounts for around 30 per cent of global methanol production, a base chemical for plastics, paints, and fuels. It dominates sulphur exports — about 45 per cent of the world’s total — which feed directly into fertiliser production. Sulphuric acid is used in the extraction of copper, cobalt, and nickel, which are used in transformers, batteries for electric vehicles, and advanced electronics. Even aluminium is affected: The Gulf produces roughly 9 per cent of global output and accounts for 22 per cent of supply outside China, leaving Europe and America exposed in sectors from automotives to construction. Investors now have to decide how much of these effects are priced in so far. 

Consider aviation fuel, which accounts for 35-40 per cent of the cost of running an airline. A 10 per cent increase in fuel prices can cut operating profits by around 15 per cent, according to analysts. Add to this the complication of closing West Asian airspace and longer flight paths, and their margins erode further. In consumer goods, pressure is more diffused. Crude oil-linked packaging materials — polyethylene terephthalate (PET) chips, liquid paraffin, high-density polyethylene, and flexible laminates — account for roughly 15 per cent of operating costs, calculate analysts. Larger firms, with pricing power, can pass some of this on to customers; smaller, unorganised players cannot, accelerating a shift in market share. Glass production depends on natural gas. Textile producers rely on intermediates; disruption has already pushed polyester yarn prices up by 15-20 per cent. Cement avoids direct supply disruption but still suffers from price effects: Increase in fuel costs can reduce earnings, with an additional hit from higher polypropylene prices used in packaging. Tile producers in Morbi, Gujarat, have shut down due to lack of gas. 

Each of these is a small cog. Together, they form a system that is bound to be affected by time and price. Over the past few weeks of shortages, very little has appeared amiss. But once inventories run down, in one to three months, replenishment will come at sharply higher costs, triggering a bigger hidden shock. The question is: How much of this has been priced in by the market? Markets react quickly to first-order shock — equities wobble, currencies weaken. By nature optimistic, investors tend to assume that normality will return soon. The second- and third-order effects are less visible. The broader fiscal arithmetic, and the effect on consumption, is treated as secondary concerns. 

Every rise of $10 in crude oil adds $12 billion-15 billion to India’s import bill. A sustained oil price above $80 risks pushing up the inflation rate beyond 4.5 per cent. This widens the current-account deficit towards 1.5-2 per cent of gross domestic product (GDP) and weakening the rupee, potentially past 95 to the dollar. Capital inflows will slow at a time the rupee is weakening and foreign portfolio investors are already exiting. Of the $130 billion-135 billion in annual remittances India gets, some $45 billion-50 billion comes from the Gulf. Even a 10 per cent decline would shave off inflows of $4 billion-5 billion. 

The biggest impact will be a worsening trade balance, higher inflation rates, a widening fiscal deficit, and lower tax revenues. Higher costs of fertilisers raise subsidy bills and shortages risk lower application by farmers, which in turn threatens yields. Governments can absorb some increase in fuel prices, but absorbing both fuel and fertiliser shocks is harder. At oil prices above $100, the fiscal cost of subsidies and tax cuts can exceed 1 per cent of GDP, says one estimate. Add fertiliser support to that, and the burden rises further and the deficit goes haywire. In response, the government will cut capital expenditure, which is India’s main growth engine in recent years. 

If the war continues, we will see a vicious cycle emerge. Energy drives up fertiliser costs, which lift food prices, causing higher inflation rates, which then feed into energy through currency depreciation. Rising costs from dearer fuel and fertilisers will leave households with less discretionary spending and tax revenues will soften. The system can absorb shocks in the first few weeks. Beyond that, the problem will appear through many small changes: A few percentage points off margins, a few weeks of delayed production, and a few basis points added to inflation. Each time, the markets will react. And because these changes will unfold slowly, they are easy to underestimate. Brace yourself for a bumpy ride. 

The writer is cofounder of www.moneylife.in and a trustee of the Moneylife Foundation; @Moneylifers