Israel-Iran escalating tension: How rising crude prices can impact external account, rupee

Worries over India’s current account deficit (CAD) have re-emerged with crude oil prices expected to touch $100 per barrel soon if the Iran-Israel War escalates. Being the world’s third largest consumer of crude oil with around 80 percent of the crude being imported, India is particularly vulnerable to any price fluctuations in this commodity.

Historical data shows that there is a high correlation between oil prices and the current account deficit (CAD). As the average oil price increases, the current account deficit widens. According to a 3P Investment Managers analysis, when the average brent crude price was below $40 per barrel, the current account deficit as a percentage of GDP stood at -0.7 percent.

However, when the oil price was between $100 and $120 per barrel in the past, India saw its current account deficit burgeoning to -3.6 percent of GDP.

Sensitivity of oil prices to CAD and Rupee

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Research has shown that the CAD/GDP ratio increases by 0.5 percentage points for every $10 per barrel increase in crude oil prices,” economists at Emkay Global, Madhavi Arora and Harshal Patel said in a note earlier.

Notwithstanding the recent escalation in the Iran-Israel tensions, there have been talks about the possibility of higher oil prices given the low investment in conventional energy over the past decade. However, a massive rise in US shale output kept oil prices in check despite OPEC curtailing production.

"OPEC’s spare capacity is currently 4mb/d, which provides comfort on oil prices," said said Prashant Jain, CIO of 3P Investment Managers.

Notably, India's current account deficit (CAD) narrowed sequentially to $10.5 billion in the quarter ended December 2023 (1.2 percent of GDP), down from $11.4 billion in Q2 FY24 (1.3 percent of GDP). The deficit also narrowed annually, down from $16.8 billion or 2 percent of GDP in the year-ago period.

Warning bells for rupee?

Given that India settles its oil imports in dollars, a surge in oil import expenses can drive up demand for dollars, potentially depreciating the rupee vis-à-vis the dollar.

Currency experts have warned before that sustained crude price increases may widen the CAD and exert considerable pressure on the rupee, given that foreign flows have went back to dollar assets in view of prevailing high US interest rates and the strengthening of the dollar.

“Rising oil prices can be a problem and can bring back volatility in the domestic currency market, which the RBI has been able to control," said Anindya Banerjee, vice-president of currency derivatives and interest rate derivatives at Kotak Securities Ltd.

One blessing in disguise will be the $30 billion inflows into the Indian bond market because of the inclusion of Indian government bonds in the JP Morgan GBI-EM Global Diversified Index (and other related indices). However, crude will be the key monitorable in the days to come.

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