Download Impact of Oil Prices on the Indian Economy

RESEARCH NOTE
Impact of Oil Prices on the Indian Economy
A. Aparna
Abstract
Crude oil prices play a very significant role on the
Vector Auto Regression (VAR) has been used to analyse
economy of any country. India's growth story hovers
the objective since a direct causal relationship could
around the import of oil as India imports 70% of its
not be established.
crude requirements. In this paper, an attempt has
been made to study the impact of crude oil price on the
Keywords: Gross Domestic Product (GDP), Index of
Indian economy by considering Gross Domestic
Industrial Production (IIP) and Wholesale Price Index
Product (GDP), Index of Industrial Production (IIP) and
(WPI), Vector Auto Regression (VAR).
Wholesale Price Index (WPI) as the relevant variables.
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
University Day Special Issue January 2014
Impact of Oil Prices on the Indian Economy
141
Introduction
could be adversely affected by the increase in crude oil
The recent rise in the prices of crude oil has drawn
price are usually characterized by high net imports of
everyone’s attention towards the crucial role that oil
oil per GDP. Traditionally, the non-oil producing
plays in the economy of any nation. Crude oil is one of
developing countries fall under this category. Against
the most necessitated commodities in the world and
this background, developed countries are more
India imports around 100 million tons of crude oil and
economical in their usage of oil and therefore, see an
other petroleum products. This in turn, results in
easing of this adverse effect of rise in crude oil prices.
spending huge amounts of foreign exchange. The
This phenomena has led to many European developed
increasing quantum of imports of petroleum products
countries enjoying a significant inflow of oil money.
has a significant impact on the Indian economy,
especially when crude oil prices are shooting up
Today, we may find a negative impact of rise in crude oil
globally. Crude oil not only serves as a source of energy
prices. A steep fall in the current accounts leads to
but also as a major raw material to various industries.
further worsening of the treasury budgets, which, in
With no major discoveries in the recent years, the
turn, will further worsen the balance between savings
increasing costs of production have pushed up crude
and investments. Also, reducing tax revenues and
oil prices globally. Also, the high volatility in the prices
other extraneous factors will further deteriorate the
of oil breaching the $100/barrel mark and rising to a
treasury budgets. Due to the economic crisis in
high of $147/barrel could be attributed to the fact that
Europe, where the treasury budgets have shaken,
in the recent years, many index funds have taken
there is a monumental imbalance between savings
positions in commodities considering oil to be an asset
and investments. These imbalances continue
stock in their portfolios. It has been usually observed
worsening because of rising crude oil prices, which
that in India, the pricing scheme is designed in such a
threaten to push the economy into much deeper crisis.
way that it offers a system to moderate the soaring
When a country has a fixed nominal exchange rate and
international oil prices and thereby study the impact
there is also an output gap, increases in oil prices leads
on growth, inflation, etc.
to an increase in the general price levels. According to a
RBI report (2005), for every unit dollar increase in
In spite of the global economy being affected due to
crude oil price, WPI inflation rises by 30 basis points.
the European debt crisis, crude oil prices are soaring
Kaushik Bhattacharya et al. (2005) analysed the impact
against a backdrop of increasing tensions around the
of increase in oil price on inflation. They studied the
situation in Iran. The price of Brent crude has gone
mechanism of increase in the prices of petroleum
beyond $120 per barrel. This spike in crude oil price
products on the prices of other commodities and the
significantly increases the energy costs of every
output in India. In February 1999, from an all time low
country and becomes a major concern in the fragile
of 11 U.S Dollars per barrel, it increased to a peak of 35
global economy.
dollars in the first week of September 2000. Due to
this, all oil importing countries faced the threat of oil
The impact of rising oil prices on the economy differs
shock; India, being a major oil importer, was
from country to country depending upon individual
particularly affected.
energy supply and demand structures. Countries that
142
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
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Impact of Oil Prices on the Indian Economy
Historically, there have been four oil shocks in the past
Strategically, oil plays a very significant role in the
thirty years. In spite of this, low inflationary pressure
economy of any country. Keeping this in view, an
has been assisting the developed countries in
attempt has been made in this paper to explore the
mitigating the risk associated with oil shocks. Contrary
relationship between volatility in oil prices and its
to this, developing countries are affected more
impact on the Indian economy. This topic is pertinent
because of the absence of advanced technology to
to the current situation when India imports almost
conserve oil.
90% of its oil requirements. The objective of this paper
is to determine the relationship between increase in
Literature reveals that most researchers agree with the
oil price and the change in GDP, IIP and WPI.
fact that inflation has a recessionary effect on oil
prices. According to Bruno (1982), oil price shocks lead
Methodology: Oil impacts the economy through
to an increase in wages and prices, and decrease in real
various channels. This study restricts itself to analyzing
output. The same conclusion was substantiated by
the direct impact of oil prices on the WPI and IIP, and
Hamilton (1983) using the Vector Auto regression
thereby on the GDP of the country. Quarterly data
(VAR) technique. Burbidge and Harrison (1984) found
from 1995 till 2008 has been considered for the study
that the impact was different across different
which has been obtained from the CMIE database. The
countries in spite of the fact that all were developed
variables that have been considered for the study are
countries. Hooker (1996) on the other hand, found
as follows:
that the causal relationship between oil prices and
macro-economic variables weakened post 1973 and
GDPX: Log normal change in Indian GDP (in Rs.)
were not able to capture the dynamics of business.
Christini (1998) observed a very strong correlation
IIPX: Log normal change in Index of Industrial
between macroeconomic factors and oil prices.
Production (in Rs.)
In India, increase in petroleum prices often results in
CPX: Log normal change in Crude oil price per barrel (in
debates among the public. This indirectly results in
Rs.)
delay in any kind of adjustment in prices and in the long
run, creates a bigger shock. It also impacts the prices of
WPIX: Log normal change in Inflation measured in
all those commodities which use these products as
terms of Wholesale Price Index (WPI)
inputs and can lead to a subsequent spike in the wage
prices which is evident from the 1970 oil shock. Most
Since the series is non-stationary and increasing, log
of the earlier studies in the Indian context are based on
normal values have been considered. Direct causal
estimating the cost push effect of a hike using input-
relationship (Granger’s Causality) using a series of t-
output analysis. Rangarajan et al‘ (1981) and Sastry
tests and F tests could not be established between the
(1982) used input-output analysis to estimate the cost-
variables. In this paper, VAR models are used to analyse
push effect of a hike. This method is not useful in
multi-variate time series data, because they are
estimating the shock over a long period of time given
extremely helpful in analysing the dynamic behaviour
its static nature.
of economic and financial time series. Also, the
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
University Day Special Issue January 2014
Impact of Oil Prices on the Indian Economy
143
superiority of VAR Models as compared to any other
The right hand side of each equation includes lagged
causal analysis is one of the reasons for it to be used in
values of all dependent variables in the system.
this paper. Lastly, since the paper brings in the aspect
of policy analysis, VAR as a technique has been found
to be appropriate. VAR is a multi-equation system
where all the variables are treated as endogenous. The
k- variable VAR model is given as:
is the error term which is a nx1 matrix.
An explicit causal relationship cannot be established
between the variables considered and hence VAR is
preferred.
Hypothesis: The hypothesis proposed here is as
where
below:
is an (nx1) vector of time series variables.
are nxn coefficient matrices.
There is a significant relationship between change in
manufacturing IIP, GDP growth, WPI change and crude
oil price change.
Results:
The Vector Auto Regressive estimates, R-Squared and the Akaike Information Criterion and Schwarz criterion are
shown in the following table:
Vector Auto Regressive Estimates:
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ISSN: 0971-1023 | NMIMS Management Review
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Impact of Oil Prices on the Indian Economy
(Standard Errors in () and t-Statistic in [ ] )
R- squared and The Akaike Information Criterion and Schwarz criterion Table :
The Akaike Information Criterion and Schwarz criterion are the least for a lag of two therefore indicating that a lag
of two periods is the optimal. The high value of R-squared for GDP and IIP indicates a good fit between these
variables against WPI and IIP. The F values also indicate a significant relationship at 10% level of significance.
Hence, we may not reject the hypothesis. Therefore, we may say that there exists a significant relationship
between the GDP growth, manufacturing IIP, WPI and crude oil price. The relationship between the variables is as
under:
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
University Day Special Issue January 2014
Impact of Oil Prices on the Indian Economy
145
146
Any positive change in the crude oil price has an
It can be seen that the analysis conforms with the
immediate negative impact on the increment in the
discussion that the system does have a long term
GDP and IIP whereas it affects the WPI positively.
memory and has an effect for more than 10 quarters in
While GDP and IIP show signs of oscillating decay over
case of GDP and IIP while for WPI, the system returns
a period of time, WPI, after a positive increment,
to its original value immediately as compared to
returns to its original value within four months. A
others, thereby having a short term memory. Any
shock or impulse when given to WPI affects GDP in the
sudden change in the price of oil has the ability to
same fashion considering the fact that WPI also
impact the industrial growth adversely. It also causes a
includes other terms apart from fuel which constitute
very high spurt in the WPI. Altogether, change in oil
nearly 14.23% weight directly but also indirectly
price, WPI increase and declining IIP affect the
influences other commodity baskets. It also affects the
economy negatively and even if the impulse or shock is
IIP negatively and the effects last for a considerable
short term, it has a long lasting impact on the
period of time showing signs of oscillating decay.
economy.
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
University Day Special Issue January 2014
Impact of Oil Prices on the Indian Economy
References
1. Burbridge, J and A Harrison (1984) ‘Testing for the effects of oil price rises using vector autoregressions’,
International Economic Review, 25, pp 459-84
2. Bruno, M (1982) ‘Adjustment and structural change under supply shocks’, Scandinavian Journal of Economics,
84, pp 199-221
3. Bruno, M and J. Sachs (1982) ‘Input price shocks and the slowdown in economic growth : The case of U.K.
Manufacturing’. Review of Economic Studies,49 (Special Issue),pp 679-705
4. Cristini (1998) ‘Unemployment and Primary Commodity prices : Theory and Evidence in a Global Perspective’,
St. Martin’s Press, New York.
5. Hamilton, J D (1983) ‘Oil and Macroeconomy since World War II’, Journal of Political Economy, 91, pp 228-48
6. Hooker, M A (1996) ‘What Happened to the Oil Price-Macroeconomy Relationship’, Journal of Monetary
Economics, 38, pp 195-213.
7. Bhattacharya, Kaushik and Bhattacharya , Indranil (2001) ‘Impact of Increase in Oil Prices on Inflation and
Output in India’, Economic and Political Weekly, Vol.36, No.51, pp 4735-4741.
8. Rangarajan,C. ,R. Sah and K.S. Reddy (1981) ‘Impact of Hike in Prices of Coal and Petroleum Products on the
Other Sectors of the Economy: An Application of Input-Output Technique’, Artha Vignana, 23, pp 176-81
9. Sastry, D V S (1982) ‘Impact of the Rise in the Prices of the Petroleum Products on the General Price Level1970-1971 to 1980-81’, Reserve Bank of India Occasional Paper, 3 , pp 68-93
Dr. A. Aparna has done her Ph.D. in Statistics. She has more than 10 years of teaching experience. She is
currently working with NMIMS, Bangalore. Her research areas include supply chain management and
econometrics. She can be reached at [email protected]
ISSN: 0971-1023 | NMIMS Management Review
Double Issue: Volume XXIII October-November 2013
University Day Special Issue January 2014
Impact of Oil Prices on the Indian Economy
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