It hasn't happened since the Ukraine conflict erupted in February 2022. It hasn't happened since the Gaza conflict erupted in October 2023? Will events in the Middle East now derail the global economy? One obvious way they could is by causing oil prices to shoot past the $100 barrel a mark.
Let us see if we can list a few facts:
i. Israel is not interested in a cease-fire in Gaza, much less in a two state solution
ii. Israel thinks it has a good chance of eliminating Hezbollah, the Lebanon-based militia or at least reducing it to a point where it cannot interfere with events in Gaza
iii. Israel also thinks that in order to degrade Hezbollah, it has to deliver damaging blows to Iran
iv. Israel thinks it has the US behind it, wintess the latest US decision to deliver the THAD anti-missile system to Israel and have it manned by American technicians.
The four above mean an escalation in the conflict and a prolonged conflict. Will the oil market remain unscathed in such a scenario? It's not just a matter of enough oil supply being available outside Iran. If Iran's supplies are disrupted, Iran is not going to allow other oil supplies to go through. When Israel attacks Iran, it has to deliver a blow powerful enough to deter Iran from any sort of retaliation. I leave it to military experts to judge if that is possible.
The prospect of an escalation in the Middle East and higher oil prices has obvious implication for the Indian economy. That is the subject of my article in BS, India's economic growth faces two risks and two key challenges.
FINGER ON THE PULSE
T T RAM MOHAN
The finance ministry’s latest Review of the economy, which came out on
September 26, exuded confidence about the Indian economy being able to meet the
Economic Survey’s growth forecast of 6.5-7 per cent in FY 25. Some two weeks
later, the prospect of the forecast being upended by global events is very
real.
Oil prices are hovering around $80 a barrel for Brent crude, an increase
of 16 per cent from the September low. The Indian economy can take the
increase in its stride. However, if events in the world at large were to push
the price of oil beyond $100, we will have to start worrying.
“Nothing new there,” optimists would argue. “The world has shrugged off
worries about oil prices for over 30 months since February 2022, when Russia
commenced its military operations in Ukraine.” In June 2022, the price of oil
went up to around $120 a barrel. From July 2022 onwards, oil prices have stayed
below $100, with prices staying below $80 for the most part.
Two factors contributed to this remarkable outcome. One, the North Atlantic
Treaty Organization (Nato) and the European Union (EU) imposed a price cap of
$60 on oil purchased from Russia while also reducing dependence on oil supplies from
Russia. The cap turned out to be quite effective.
Two, the doctrine of “managed escalation” has played out well. According
to this doctrine, Nato would progressively equip Ukraine to effectively fight
Russia. Each step on the escalatory ladder would be managed so that Nato itself
was not drawn into a direct conflict with Russia. Escalation has been managed, the war
in Ukraine has not derailed the world economy.
The same doctrine has been applied to the conflict between Israel and
the Axis of Resistance (comprising Iran and its proxies, such as Hezbollah,
Hamas and the Houthis). For over a year now, Israel has been trading fire with
Hezbollah on its northern border with Lebanon. These exchanges have been confined
to a narrow strip on either side of the border, with casualties on both sides
staying within limits. Iran and Israel have engaged in tit-for-tat missile
exchanges, inflicting damage that both sides find acceptable.
“Managed escalation” always carries the risk of miscalculation or error-
at some point, one party or both parties can cross tolerable limits. The issue
now – and this is where optimists would be mistaken- is not so much
miscalculation as cold calculation on Israel’s part. With the successes Israel
has had against Hezbollah in recent weeks, Prime Minister Benjamin Netanyahu
believes the time has come to “change the Middle East.” There is the (prospect?- ok) not only of escalation but of
a prolonged campaign.
A probable Trump victory in November heightens the implied risk.
Following Iran’s missile attack on Israel, Mr Trump wants Israel to go after
Iran’s nuclear facilities. While Mr
Trump may well be posturing in the run-up to the polls in early November, his
known hawkishness on Iran poses clear risks for West Asia and the world
economy.
There is another risk that a Trump victory poses, one about which there
seems to be less ambiguity. Mr Trump promises sweeping cuts in taxes for corporations
as well as individuals, higher tariffs and substantial deregulation. He sees the
tax cuts as paying for themselves by boosting growth, but many economists are
sceptical. They think the tax cuts will result in wider deficits, an increase
in public debt, and slower US growth down the road.
Mr Trump has promised a tariff of 20 per cent on all imports and a
tariff of 60 per cent on Chinese goods. Mr Trump sees higher tariffs not just
as protecting US manufacturing but as paying for the tax cuts he has in mind.
Economists have raised a howl but many American business leaders think Mr Trump
has got it right. Whatever the long-term impact, there is little doubt that Mr
Trump’s policies will be disruptive for the world economy in the short term.
The two risks apply to the world economy as a whole. Apart from these,
there are two challenges that are specific to India.
One relates to foreign direct investment (FDI). Net FDI (item 1 in the
accompanying table), which is the FDI inflows minus FDI outflows, fell by over
$28 billion in 2023-24 compared to 2021-22. The Review says that this is
because repatriation of profits (item 4) surged considerably in 2023-24. It
says this is not a bad thing because it assures foreign investors of an exit
route for profits made in the country.
However, repatriation of profits is not the only factor dragging down
net FDI flows. Gross inflows of FDI (item 3) have fallen steeply from $85
billion in 2021-22 to $71 billion in 2023-24. The Review argues that FDI
flows to emerging markets as a whole have fallen by 15 per cent in 2023 and
India is likewise affected. But if India is positioning itself as an
alternative to China for FDI, this should not be happening.
Some analysts contend that the fall in gross FDI has to do with India’s
scrapping of bilateral investment treaties that allowed for third-party
arbitration of disputes. The change, they say, has made foreign investors
nervous. Maybe. Or it may well be that FDI has fallen for the same reasons that
private domestic investment has not picked up in recent years. If gross FDI does
not rebound strongly in FY25, we would need to be concerned.
The second challenge, which is relatively short-term in nature, is with
respect to foreign institutional investment (FII) flows. FIIs invested $44 billion
in India in 2023-24. FII inflows in the April- July quarter of FY25 have fallen
to $6.3 billion, from $20.5 billion in the same period of FY24. Analysts
say this is to be expected as Indian stocks are overvalued. There has also been
a huge switch of funds to Chinese stocks, given the low valuations in that
market. This shift is said to have increased in recent weeks following the
stimulus to the Chinese economy.
A fall in capital flows, combined with oil prices exceeding over $100,
is not the best place for the Indian economy to be in. Happily, India’s
external position today is strong enough to cope with such a scenario. However,
higher oil prices and disruptions in the world economy could undermine
growth projections.
India has had considerable success over the years in dealing with the
sources of instability within the economy. The threats to growth and stability now
emanate from outside- geopolitical risks, rising protectionism, and banking
instability in the West.
