Oil prices and Indian fiscal federalism
International oil prices stayed well below $ 50 a barrel in the 1980s and 1990s. The figure shows this for Brent. But they have become excessively volatile since the mid-2000s – Brent has ranged from $ 132 in mid-2008 to $ 30 in January 2016, with large swings between the two. A spike below $ 81 in October 2018, as well as an $ 18 crash with Covid-19 did not last long.
This volatility was one of the reasons for the slowdown in global growth in the 2010s. Spillovers from losers to winners reduce net gains.
For example, while commodity-exporting countries were in dire straits after the 2014 oil crash, India’s gains fell short of expectations as slower global export growth moderated gains.
As a commodity produced, the price of oil depends on the supply-demand balance, inventories, oil production capacity and costs. If stocks are low, supply or demand shocks can cause large price fluctuations in the short term. Over time, rising prices reduce demand and increase supply.
As administrative price mechanisms have been abandoned in the physical market, deep and liquid futures markets, which bring together diverse viewpoints, have been developed to facilitate price discovery. These were to make the oil market more prospective. As a financial asset, the price of oil depends on the structure of the markets, expectations of oil fundamentals and the news impacting them. In the 1990s, investors began to take positions in commodity futures as part of a diversified portfolio.
As the figure shows, average price levels, as well as their volatility, increased sharply after 2000, indicating sustained deviations from fundamentals. This follows the US Commodity Futures Modernization Act, passed in 2000, which eased position limits, among other deregulations. Swap dealers, who facilitate over-the-counter investments in exchange-traded funds that track commodity indices, have been granted position limit exemptions. Subsequently, open interest in petroleum derivatives more than tripled and the number of traders doubled during the period 2004-08. Large-scale index investments took place as pension funds diversified their portfolios after the dotcom crash.
Deregulation has compounded the pro-cyclical waves of optimism or pessimism. Even oil producers consider oil futures to be too volatile. They prefer a price range around $ 60, which keeps production stable. The G20 should adopt uniform prudential regulation of the futures markets. Position limits could be reimposed.
The size of cycles decreased after 2015, as the entry of shale oil made supply response easier and faster. As OPEC’s market share declined, its pricing power also declined. But the cycles are still larger than they were before 2000.
The sharp drop due to the unprecedented shock of Covid-19, however, bankrupted many over-indebted shale oil producers. This made it easier for OPEC to regroup and regain market power with an agreement on production cuts.
However, as oil prices rise above $ 70, shale oil is once again very profitable. The restructuring had reduced the costs and lessons learned from a more disciplined expansion. It is dangerous for OPEC to allow oil prices to rise. Countries are tempted to break the cartel. Green substitutes are also getting a boost. Their recent meeting again shows the difficulty of reaching an agreement. Consuming countries, like China, will use up large stocks of oil built up when prices collapsed, reducing demand. If an agreement is reached on sanctions, large stocks of Iranian oil could be released into the market. When prices peaked in October 2018 at $ 81, the following month, they had fallen to $ 64. History could repeat itself this year.
It is unclear whether, in general, the recovery will fuel excessive demand and inflation, or whether supply chains will recover and secular stagnation will reappear. The markets seem to be approaching the idea that inflation will be temporary. US bond yields eased.
The domestic entanglement
Indian fuel taxes were sharply increased when oil prices fell in 2020, to recoup the blow to tax revenues from the foreclosure. But they have not been reversed although tax revenues and international oil prices have recovered.
Unfortunately, the Center and the States are competing for space, each fearing that one setback will allow the other to prevail. State taxes are imposed on value added and automatically increase with prices. The inclusion of energy in the GST offers a solution to this impasse.
Central State shares could be settled according to GST principles, to those set by the 15th Finance Commission (CF) on the basis of relative expenditure responsibilities. Even taxation at a luxury cap of 28 percent of the GST would result in a double-digit reduction in the price of fuel per liter. It would also reduce cascading cost-driven inflation and improve the competitiveness of exports and household consumption demand.
The graph shows that international fuel prices rise and fall. Indian prices continued to rise when administered. Even after being determined by the market, taxes tend to increase more when international prices fall, but less when prices rise. As a result, Indian fuel prices are increasing more than internationally.
The resulting persistence of domestic oil prices undermines flexible inflation targeting. Monetary policy can look through volatile commodity price shocks, as well-anchored inflation expectations limit transmission.
But if the policy makes the price increase permanent, inflation expectations cannot be anchored after a shock. The bullish click is supporting inflation. A second hike in wages and long-term bond rates will follow. If policy rates are forced to rise, so too will borrowing costs for central and state governments.
Back in the days when oil prices were administered, loud political battles made it difficult for domestic prices to rise when international prices rose. Now the oil marketing companies are smoothly changing prices with the international. The political protest, however, has shifted to imposed taxes.
This discretion allows arbitrary distortion of prices and resources to continue and imposes enormous indirect economic costs. Deleting it will allow you to focus on more interesting questions. But will governments be willing? The relentless scramble from the public for more hides the fact that states did not lose with the GST; The 14 percent compensation was generous and was decided on the then prevailing nominal income growth rates, but continued even when growth plunged. Now, in part as the loopholes are closed and the economy recovers, there is an increase in revenue to be shared.
Incentive reforms with the 15th Finance Committee are opening up new sources of revenue for the States. An increase in user fees and property taxes may be linked to better services.
Relations between the Center and the states were strained in part because the Constitution gave the Center more powers to keep the nation together. Co-operative federalism works if functions are distributed according to what is best performed at different levels.
It is clear that there is an advantage in centralizing certain functions – purchasing vaccines, borrowing, certain types of taxation, ensuring the homogeneity of public services, when the services must be provided locally.
States want the GST compensation to continue beyond the agreed date – it could be more modest and tied to the energy input into the GST. Revenue neutrality will come from the increased efficiency and resulting growth, complemented by an additional carbon tax, which would also encourage green alternatives and lower India’s oil bill. Domestic additions would then not worsen international oil shocks.
The author is Professor Emeritus, IGIDR. Views are personal