Collateral damage: High crude oil prices will stifle economic growth

The conflict between Israel and Iran has opened another front of uncertainty for the global economy, with implications for the Indian economy. Since both sides have refused to back down, and given the objectives Israel has set for itself, the conflict may widen and prolong. The immediate impact of conflict in West Asia is being felt on oil prices. Fearing an escalation, benchmark Brent crude prices have risen about 9 per cent over the past week. Analysts are now predicting that oil prices can double from the present level to $150 per barrel. Notably, oil prices in the wake of Russia’s attack on Ukraine remained above $100 per barrel for over five months. There are at least two ways in which the Israel-Iran conflict can affect prices. The first is the production side. Israeli attacks have targeted Iranian oil facilities, which could disrupt supplies. While analysts say the Organisation of the Petroleum Exporting Countries has the spare capacity to bridge the shortfall, how quickly production can be expanded remains in question. Moreover, if the conflict draws in other regional powers, the consequences could be more severe.

 

The second source of uncertainty is possible disruption in the Strait of Hormuz. About a quarter of the global oil supply comes from this route. Along with crude oil, the supply of gas could also be severely affected. For a global economy already grappling with trade-related uncertainties, a sustained increase in oil and gas prices would further cloud the outlook. Those will also have a direct impact on the Indian economy through multiple channels. High oil prices could significantly widen the trade deficit. The current account deficit (CAD) in the current year is projected to remain at a modest 1 per cent of gross domestic product. However, if oil prices increase to substantially higher levels as projected by analysts for an extended period, it could widen substantially. Although India has comfortable foreign-exchange reserves to deal with external uncertainties, a significant widening of the CAD could pose financing challenges because global financial conditions would also be expected to tighten. Thus, oil prices could put significant pressure on the currency.

 

Higher crude-oil prices would also have a direct impact on growth and inflation outcomes. According to the Reserve Bank of India’s (RBI’s) projections, a 10 per cent increase in oil prices from the baseline assumption can push up the inflation rate by 30 basis points and reduce the growth rate by 15 basis points. A substantially higher increase in oil prices would inevitably have a bigger impact. The RBI’s Monetary Policy Report in April had a baseline assumption for crude oil (Indian basket) at $70 per barrel for 2025-26. Although India is comfortably placed on the inflation front, which allowed the Monetary Policy Committee to front-load the policy rate cut, a sustained higher level of oil prices could affect expectations and potentially change the inflation outlook. Higher oil prices can also affect the government’s fiscal position if it reduces excise duty or asks oil companies to shoulder part of the burden to cushion the impact of higher crude-oil prices on pump prices. The fiscal position could also be impacted if oil drags economic growth, affecting revenue collection. The sheer uncertainty caused by war and higher oil prices could postpone consumption and investment decisions by households and corporations, affecting growth prospects. Indian policy managers need to be alert to deal with the fallout.