External supply shock’ is economic jargon for a certain kind of situation that is very familiar to the aam aadmi. Every modern economy specialises at producing certain goods and services, while importing other things, which it is less competitive at producing. If the price of one of the imports suddenly rises, or the external supply is choked off for some reason, inflation occurs until alternative sources of supply can be organised, or until prices come down.
This is not ‘normal’ inflation. Normal inflation occurs if demand exceeds supply of some good or service produced within the economic system. It is usually easier to manage an internal supply-demand mismatch. Often, ‘normal’ inflation can be a signal of healthy growth. Demand may be outrunning supply because people have more money in their pockets and given higher prices, supply will automatically increase to match the rising demand.
A classic external supply shock often involves a good that cannot, for whatever reasons, be produced within the system. This is usually a commodity.
The most obvious case of a commodity that causes external supply shocks is crude, and to a slightly lesser extent, natural gas. Most of the world’s imports of crude come from the region broadly known as West Asia-North Africa (WANA). From Iran in the east to Libya in the west, this region has a succession of unstable, undemocratic regimes, all with uncertain political futures and stressed relationships with the rest of the world.
Since the winter of 2010, there have been a succession of civil wars and much public unrest across WANA. This unrest has directly affected crude supplies to some extent, forcing prices up. For example, ONGC Videsh, which manages external crude supplies for ONGC, has seen lower production due to wars in Syria and Libya. The unrest has also indirectly affected fuel prices because the fear of a future supply crisis leads to hoarding and speculation in energy commodity futures.
India is among the most vulnerable economies in the world when it comes to crude supplies. It imports 80 per cent of its fuel and it doesn’t have a coherent policy to deal with either supply disruption or price rise.
The persistent inflation since crude prices rose in late 2010 indicates that the economy hasn’t been able to adjust to the price spike in this key input. All the structural problems that have surfaced in the past year can be attributed to this one factor.
On the external front, the trade gap has ballooned because imports have gone up in value with the price of crude. On the domestic front, the fiscal deficit has grown because of the insistence in subsidising fuel, power, fertilisers, etc; at a point of time when input costs have gone up.
Oldtimers will recall the decade of lost growth India suffered in the 1970s when the price of oil went through the roof. Indian GDP grew at a CAGR (per capita) of 1.3 per cent over the decade. At that time, four successive governments did nothing much about it, apart from praying that the price of crude would come down.
The sad thing is, not much has changed in terms of an energy management policy. Yet, a coherent energy management policy has become even more important. All GDP growth and development is founded upon the availability of abundant, affordable energy supplies and the optimal use of whatever energy supplies are available.
One problem with subsidies is that eventually we pay for it anyway since it comes out of funds that could have been spent in other areas. Another problem with subsidies is that users of the commodity have no incentive to utilise it efficiently if they’re getting it cheap anyway. We’ve seen both problems surfacing since the price of crude went up. A related issue is that gas and coal prices are, to a large extent, tied to crude. So when crude prices escalate, other fuels follow the lead. This means additional problems for power sector.
A third problem, which affects investors, is that subsidies cause a lose-lose situation. If the price of a commodity goes up, users suffer. But suppliers and producers of that commodity gain. Hence, a smart investor can hedge his personal suffering and mitigate it somewhat by investing in the production of that commodity. That’s if it is an open market. If the price is forcibly subsidised, nobody gains, and the pain is just spread around.
I’m not an expert in geopolitics or in geology. But you don’t need to be an expert to assert that the price of crude will not come down again ever, for any meaningful period. First, the exporters (this includes Russia and the CIS nations) are all unstable politically and they’ve been that way for decades. Any regime change that occurs will be massively disruptive and it will not necessarily mean a more stable government at the end of the change process.
Second, the supply of the commodity itself is limited. New fields may be found but these will be offshore, deep underwater, or in terrain such as Alaska or Siberia. The extraction itself will be very high-cost. Even if supply does rise, it will tend to come at a higher cost.
Arising from that, and taking into account the fact that India will always be a net importer of crude, what can be done? Eventually, subsidies to users will have to be cut. The fiscal deficit has hit alarming proportions already, and the external situation in terms of external obligations versus forex reserves is already stretched. If the government allows the price of diesel, kerosene and gas to directly reflect actual costs that will place an obligation on users to be more efficient.
Second, the government will have to develop a policy that encourages development of alternative fuel sources. This means reviewing its current exploration and exploitation policy vis-a-vis oil, gas, coal, lignite and coal-bed methane, etc.
Third, the government will have to develop a policy to encourage alternative green fuels which means a more serious thrust on solar, wind, biomass, tidal power, etc. Fourth, the power sector policies will need a review to improve its efficiencies. Power subsidies to certain sectors also need a review and transmission and distribution losses must come down across the board – India’s losses average over 30 per cent where the global average is closer to 7 per cent. If these losses halved, that would be equivalent to adding 25-30 GW in new supply.
No government will take these steps willingly, or with good grace. There are sound political reasons why problems that have been obvious for decades have not been tackled by a succession of governments with otherwise different political agendas.
But the financial situation is getting worse and if it’s allowed to fester a little longer, it will eventually hit crisis point. When it does, some reform will happen. The low-hanging fruit here, in political terms, is the encouragement of renewables. That could be a major growth area with companies coming to market and looking for listing fairly soon.
The other three broad areas that require reform are all very politically sensitive. My guess is that a review of exploration and production policy will occur first because that’s probably the least sensitive. But sooner or later, all these areas will need policy review.
None of this will be short-term. It will occur in fits and starts. Investors will have to keep their eyes open and make judgement calls, as and when crisis points are hit. An escalation of the simmering WANA situation that triggers another spike in crude prices would hasten the process. Reform in 1991 was forced upon the government because Iraq invaded Kuwait. We may need something similar to trigger another round.