Oil prices: Crippling economic consequences | Photo Credit: Max Zolotukhin

It is well-known that market over-reaction tends to raise risk spreads for emerging market economies (EMEs), when there is a global shock. Even so, the standard advice for EMEs continues to be to tighten further, take costs upfront and give special concessions for foreign investors. A report wants India to discourage mutual fund SIPs and raise interest rates so that stock markets crash enough to entice foreign investors back in!

But this does not factor in how India has changed and the nuances of the policy combination that delivered high growth and low inflation in the post pandemic period. In a nutshell, India has much more diversity, buffers and substitution ability to counter adverse shocks today.

The policy combination that worked was to look through transient shocks, give temporary and targeted help, pass through if shocks were persistent but moderate as much as possible, while fast tracking reforms that reduce vulnerability. For example, deeper markets with more domestic participation are what prevent the tail wagging the dog,

Reacting to persistence

Markets misinterpreted the PM’s appeal as indicating serious problems. But it was only a recognition that the Middle-East logjam is turning out to be longer lasting. That does not, however, mean it is going to be permanent.

When the Ukraine conflict first broke out, oil prices remained high for one year, peaking at 122, which deflated was a real value of 77. The fall in GDP growth and rise in inflation was about 2 per cent each, but the next year we were back to 9 per cent growth with inflation again in the tolerance band.

The Hormuz blockage has reduced other vital supplies but it could end sooner. The world finds alternatives and there are those who believe Hormuz will become irrelevant if blockages last a year. India itself is investing in gasification of coal, a gas pipeline from Oman and acquiring oil and gas reserves in the UAE beyond Hormuz.

Oil producing countries do not like high prices since they know then alternatives to oil become attractive. Oil futures are also fluctuating but remain below $100. They even touched $70 recently. A growth-inflation cost of about 1 per cent is realistic if shortages last for six months. Demands for a full pass through are growing but uncertainty is still there. Moreover, extreme polices are better avoided. Oil OMCs have said to have lost one year’s profits but domestic oil prices were unchanged for four years— they made excess profits when prices were $70 and below for more than a year, but they did not decrease prices. Their pass through, as well as government excise cuts are used in a counter-cyclical fashion to smooth oil prices for domestic consumers. And the taxes paid by Indian oil users remain one of the highest in the world — which is sufficient inducement to economize use.

Economists are also worried about a rise in fiscal deficits, but the FRBM reset allows a 0.5 countercyclical rise in fiscal deficits. The government has earned countercyclical space by bringing deficits down after the pandemic. Very few countries have done that.

The ideas of burden sharing, countercyclical deficits, stabilisation funds are all meant to enable moderation of external shocks on the economy. Post-pandemic experience shows it can be done and is productive to do so.

Pushing reform

Further green substitution possibilities can be accelerated using the crisis to overcome political resistance. Already a number of hitherto intractable steps have been taken. Our energy intensity continues to fall.

The PM’s seven appeals add to the list of policies available, helping avoid over-reliance on market prices. Prices have been raised, but more of a switch to less import intensive consumption and processes will save forex, increase domestic demand and lower impact on consumer wallets. Commentary focuses on extrinsic motivation but intrinsic motivation through a larger and common purpose can be extremely powerful. During the pandemic industry cut costs and worked with the government to mitigate effects. People say fight the fire today, but the more intelligent will use today’s fire to prevent fires tomorrow, raising growth potential.

Other types of policies, however, are also required to make the appeals effective and are part of essential reform to reach growth objectives. Monetary incentives need to supplement the appeals. Prices of oil products are being raised. This is the opportunity to drastically cut fertilizer and food subsidies by raising prices and shifting to direct benefit transfers. Basic food kitchens in cities can substitute free food. Never waste a crisis!

Rooftop solar can be further incentivised and integrated into power distribution. Improving last mile connectivity will increase the use of public transport. Coordination across ministries and States should be enabled and successful examples highlighted.

Let the rupee sink?

Pro-market analysts also want the rupee to be let go. But depreciation begets depreciation. Large depreciation since the last year has not improved matters. Having fallen to a real value it last touched during the taper tantrum the rupee is seriously misaligned. Then also RBI hands off approach and communication that forex markets are too large to intervene led the rupee to sink. Then they had to come in with heavy market restrictions that set back market development. In volatile times it would be more effective for the RBI to buy-sell daily without damping market volatility as much as it did in 2023. Then expectations of one-way movements and panic hedging can be avoided.

The over-depreciation will correct as it always has after past crises. This incident is no different. It is only prolonged because oil shocks followed the Trump tariffs. With almost $600 billion currency reserves accumulated with a BoP surplus in 29 of the 35 years after liberalisation, buffers are strong, and will be rebuilt again in future.

There is no need to pay more to acquire another few billion. It is better to fast-track intended reforms — regulations on inflows can be simplified; tax-exemptions in investments through GIFT City made more transparent; rules eased for pension funds; swap lines with other central banks can be strengthened.

Or raise interest rates?

The alternative call to raise interest rates undermines India’s resilience and ability to counter shocks. It is the traditional fear driven EME tightening. The trilemma holds only at the fictional point of a fixed exchange rate and perfect capital mobility. There is always monetary policy autonomy to set repo rates under a flexible exchange rate and prudential capital flow management tools. The interest rate defence is not in the inflation targeting (IT) mandate.

Raising short-interest rates to defend the rupee failed in 2013 — it was other measures that worked. Repo rates were raised to implement IT in 2014 but only raised risk premia and hurt growth.

Developing the debt market requires transparency, credit enhancements, good corporate governance, two-way quotes and market-making, broader trading and repo to reduce risk spreads. China and US debt markets boomed with low, not high interest rates.

Rates should be raised only if inflation is expected to persistently rise above comfort levels. In current circumstances, a real policy rate between 0.5 and 1.5 is appropriate.

Oil price shocks are as unfair as the earlier discriminatory tariffs against India and should unleash the same energy to protect ourselves and our development objectives.

The writer is Professor Emeritus, IGIDR

Published on June 2, 2026