After oil surge, Fed rate hike will shape challenge

On Wednesday, Brent crude reached above $100-per-barrel for the first time since May 26, peaking at $110 during the week and closing at $104.6. The US Federal Reserve may raise interest rates this week, with the rate decision scheduled for September 15-16. The recent surge in oil prices is attributed to the Houthi militia's seizure of most of Yemen's Red Sea coast, jeopardizing the passage through the Bab el-Mandeb Strait.

Interest rates in the US have already factored in the Fed's potential rate hikes, with 10-year Treasury yields nearing 5 per cent, the highest since October 2023. The conflict in West Asia is also influencing US producer price inflation, which increased to 5.4 per cent year-on-year in August, and diesel prices reaching a record $6.20 a gallon.

These developments pose a significant challenge for India, which imports both energy and capital. With rising oil prices and their prolonged duration, the impact on inflation and economic growth is likely to be considerable. Additionally, higher interest rates in countries like Japan (3 per cent), the US (5 per cent), and the UK (5.4 per cent) make it less attractive for foreign investors to put money into India, given the uncertain returns after accounting for currency depreciation risks.

Higher international energy prices contribute to India's current account deficits, which are difficult to finance as capital flows move towards the safety of industrialized nations. Despite the energy supply shock caused by the Iran war, India has managed to handle it relatively well so far. The $127.2 billion of FCNR(B) deposits brought in through the RBI's special dollar-rupee swap facility have helped prevent a rupee run.

In the short run, there is hope for a deal that will enable shipping through the blocked Hormuz and potentially threatened Bab el-Mandeb chokepoints. However, India's long-term challenge lies in boosting its export competitiveness and attracting foreign investors. To achieve this, India must eliminate duties on imported raw materials and components while investing in infrastructure such as roads, railways, inland and coastal waterways, and ports.

The other crucial aspect is to create an environment where investors are confident in India's long-term growth potential, policy predictability, and stability. Lastly, India must practice fiscal prudence and avoid overspending, which could lead to higher current account deficits.