India Energy Demand May Stoke Inflation, Dampen Growth in Asia's Third Largest Economy

The outlook for India appears increasingly troubling after the country's central bank kept its key lending rate unchanged despite widespread calls for a cut to help stimulate growth.

Coupled with this, India which relies on 80 percent of imports for its crude oil needs, is also opening itself up to more inflationary pressures as it seeks more oil and cooking gas from the Organisation of the Petroleum Exporting Countries (OPEC) after it axed imports from Iran due to US-led sanctions.

The combination of both factors does not bode well for the country which is trying to halt slowing growth and rising inflation, while also battling to not set a precedent and become the first BRIC country to be downgraded to junk status.

India's Step Change in Oil Imports

As the US and the European Union tighten sanctions against Tehran over its nuclear program, India has revealed that it plans to cut oil imports from Iran by 11 percent to 310,000 barrels a day (bpd). In tandem, India's Oil Minister Jaipal Reddy is asking Saudi Oil Minister Ali-Naimi for 100,000 bpd more crude.

Saudi Arabia, already the country's largest supplier of crude oil and cooking gas, will have to deliberate as to whether India will be able to receive the extra supply.

However, if India receives the extra amount from OPEC, market prices could be pushed higher and therefore affect the amount the country is spending and impinge on growth and inflation.

Last week, OPEC decided to retain its output limit at 30 million barrels a day but is currently over-supplying the market by around 1.6m bpd. Saudi Arabia has largely been to blame for the oversupply, as "(it) has not pared back on output, after the country increased production to make up for the shortfall in Libyan supply," said Amrita Sen, oil analyst at Barclays Capital.

Furthermore, despite, oil prices largely retreating since then, Al-Naimi has called for an increase in the industry group's output target, before last week's OPEC meeting.

"Recent oil price weakness has seen Brent crude and West Texas oil both fall a quarter from recent highs," says Andrew Latto, senior analyst at research house Fat Prophets. "This has created pressure from many members of OPEC for the cartel's biggest producer, Saudi Arabia, to cut output. However, Saudi Arabia isn't playing ball with the country's production at 30-year highs."

Oil prices have tumbled over the last month, as slower demand and OPEC oversupply continue to weigh on prices. Nymex Light Sweet Crude is currently trading at $84.26 per barrel while Brent crude is still under the $100 per barrel mark at $97.62 and is down 24 percent from its 2012 high.

Analysts warn that increased demand from India, as well as other emerging market growth demand will rebalance market prices this year and push prices above the key $100 per barrel mark and significantly affect heavy importer countries, such as India.

"In the longer-term oil demand is set to increase as emerging market demand growth offsets flat demand in developed markets," says Andrew Latto, senior analyst at research house Fat Prophets. "Therefore a lower diversity of supply does create the potential for price spikes and exposes importers to greater risks."

"In the second half of this year, we could see the increased demand from India for Saudi oil and increasing demand from Japan and South Korea, help balance the market and take the pressure of prices," adds Amrita Sen, oil analyst at Barclays Capital. "Currently, we are not seeing reductions in the data from the apparent squeeze on Iranian output but this will change in second half of this year."

The increased pressure on India's energy import needs could significantly hurt the country's falling growth and intensify inflation, as it still battles to control its troubled economic scenario.

India's Ongoing Economic Issues

As IBTimes UK has reported, the outlook for India has become increasingly troubling as the country battles against high inflation, consistent falling GDP growth and political turmoil.

The Reserve Bank of India (RBI) defied widespread expectations for an interest rate cut following high inflation and poor market performance and kept its key lending rate unchanged at 8 percent and its cash reserve ratio for banks at 4.75 percent, despite market consensus forecasting a 25 basis points rate cut.

RBI said that a "further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures."

The move has already widely confused market analysts, as "the policy statement failed to provide much of a rationale for the central bank's decision apart from re-emphasising that interest rates have had only a limited role in the current growth slowdown. Forward guidance was also scanty," says Sanjay Mathur, Chief Economist (Non-Japan Asia) at RBS.

"Although we have always agreed with the view that the current slowdown in India is attributable to a host of reasons and not interest rates alone, it is disconcerting to see that the emphasis on inflation is not stable. The operating parameter has periodically swung from headline to core to consumer," adds Mathur.

Indeed, India's first quarter GDP report card shows the slowest pace of growth in nearly a decade.

Following a decline in manufacturing output, which shrank 0.3 percent from the year earlier, the overall 5.3 percent GDP advance is spectacularly lower than the consensus forecast of 6.1 percent.

Furthermore, India's economy only grew 6.5 percent in the last fiscal year ending March 31 2012, which is lower than the government's projection of a 6.9 percent expansion and its fiscal deficit during the 2011/12 fiscal year was 5.2tn rupees, which is equivalent to 5.9 percent of India's GDP, according to a Reuter's calculation

On top of that, the third largest economy in Asia, India is still suffering from inflation and currency weakness.

The Indian rupee has plummeted by more than 27 percent against the US dollar since July 2011 and even more following the interest rate decision on June 18. Coupling inflation and a currency, spending power is waning and anger towards with Prime Minister Manmohan Singh's embattled coalition government has intensified.

"Our view has always been that in a period of weak growth, core inflation should be the operating parameter as 'pass-through' effects from higher fuel prices tends to be limited," says Mathur. "In fact, supply side disturbances are so persistent in India that they really need to be de-emphasised. The RBI has acknowledged the recent moderation in oil prices but at the same time highlighted that the broader failure to re-align domestic prices with international prices has been a stumbling block."

Only a few days before the recent key interest rate decision, ratings company Standard & Poor's said India's slowing growth and political gridlock could hamper efforts to liberalise the country's economy and potentially put its BBB- rating, which was set in April of this year, at risk of a downgrade into sub-investment grade, or junk, status.

"The combination of a weakening political context for further reform, along with economic deceleration, raises the risk that the government may take modest steps backward away from economic liberalization in the event of unexpected economic shocks. Such potential backward steps could reverse India's liberalization of the external sector and the financial sector," said S&P credit analyst Joydeep Mukherji, author of the report "Will India be the first BRIC Fallen Angel"?

Energy and Rates: Will India Pull Inflation Down?

As India now enters a key moment in 2012, in order to control its waning economy, analysts do say that there is hope that the RBI will realise that it will need to cut rates.

Furthermore, they hope that if oil prices do remain low, which again is tentative at this moment, then it could help curb inflation.

"The RBI has emphasised that inflation will be the main determinant of future rate action, again without delving which type of inflation," says Mathur. "Our own view is that while food prices remain a wild card particularly in light of the poor start to the monsoon season, the combination of a more stable INR, falling fuel prices and weak growth will drive inflation lower. We do believe that the RBI will cut rates even if this review has been disappointing."

"The recent inflation readings have provided fair degree of discomfort and in terms of fiscal adjustment, steps are yet to be taken by the government," adds Shubhada Rao, chief economist at YES Bank in Mumbai. "And, the RBI may want to keep its powder dry for future course of actions, in case there is resurgent stress in the euro zone. The front-loading of 50-basis-points cut in April was showing that growth momentum will be addressed. Future rate action would be contingent on concrete steps being taken by the government and the inflation trajectory. We are still looking at 25-50 basis points in the rest of the year."