The spike in global oil prices caused by the troubled situation in Iraq and the prospect of scanty rainfall pose a threat to India’s efforts to resuscitate a slowdown-hit economy and could halt a bull run in the stock market.

As about 80 per cent of the subcontinent’s crude oil requirement is met through imports, higher prices of oil can blow a huge hole in the country’s budget and dent plans to rein in the fiscal deficit. A 10 per cent rise in crude prices can push up headline inflation by one percentage point directly, and up to two percentage points indirectly, according to the Reserve Bank of India (RBI).

“India potentially faces a double whammy,” Frederic Neumann, co-head of Asian Economics at HSBC, wrote in a report. “For weeks already, weather experts have pointed to the risk of a dry summer which could raise the cost of food. And now, to top it off, the trouble in Iraq has pushed up the price of oil.”

The wholesale price index surprisingly climbed in May to six per cent from a year earlier, compared to a 5.2 per cent rise in the previous month, partly fuelled by higher energy costs. Sluggish rainfall in the first three weeks of the annual June-to-September monsoon has also sharply pushed up the prices of staple food items such as onions and potato.

Double whammy

The four-month rainy season is the primary source of irrigation for India’s vast farmlands. Patchy showers and uneven distribution of the rains across the country could seriously jeopardise agriculture output, and squeeze incomes in the hinterland where a majority of India’s more than 1.2 billion people live — and therefore hurt overall economic growth.

RBI Governor Raghuram Rajan said this week the central bank’s focus in the coming quarters would be in containing inflation pressures. In plain words this means you can forget any chance of lowering borrowing costs in the near term — a vital need to help an economic recovery — and instead raises the odds for an increase in interest rates.

“Our economics team does not rule out the possibility of a rate hike in the event of unexpected surge in inflation,” US investment bank JP Morgan said in a note on India.

Little surprise the top-30 Sensex, the Indian equivalent of the Dow Jones index, has backtracked 2.4 per cent to 25,105.51 since hitting a record high of 25,725.12 on June 11. The benchmark is still up 18.6 per cent so far this year and is one of the top performing emerging markets.

“There is no doubt that India is vulnerable to any sustained rise in oil prices and drought-like conditions if the rains fail,” said equity strategist V. Venugopal. “This limits the leeway for the government to push its reform agenda like curtailing subsidies and finding the money for productive investment.”

Energy stocks

The energy sector in India is dominated by state-run companies, popularly called public sector undertakings (PSU), and these are vulnerable to greater under-recoveries because of the price control on selling price of fuel such as diesel, kerosene and cooking gas.

“Based on our analysis, we believe that if the Iraq situation escalates and oil markets become more volatile and spike up near term, upstream PSU companies offer the most risk, on account of the uncertainty that comes with increasing under-recoveries,” BNP Paribas said. “Downstream companies should be relatively safe, with Bharat Petroleum our top pick.”

The French investment house also has a buy rating on HPCL, and recommends a hold on ONGC and Oil India. There could be near-term profit taking after a sustained rise this year, but this should be an opportunity to accumulate for the longer term as valuations would look attractive.

“The Iraq situation will have to be monitored closely, as in the near term this could have a material impact on share prices and hence provide longer-term opportunities because the reasons for such a rise in crude prices are not structural or fundamental in nature,” it said.

State-run firms

The next bigger trigger for the stock market would be Prime Minister Narendra Modi’s first budget, expected to be presented to parliament in the second week of July. It comes against the background of empty state coffers, a ballooning subsidy bill and an urgent need to revive investment.

“We’d expect a gradual bottoming out as the policy stimuli available with the policymakers are limited, both monetary and fiscal,” Bharat Iyer at JP Morgan said. “Economic indicators remain challenging.”

The new government, which was swept to power in May with a resounding majority on the promise of development, creating jobs and reversing an economic slide, would be looking to raise cash through divestment of state holdings in several companies that straddle the stock market.

Investor appetite for such stock sale is expected to be robust, especially from large foreign funds that are queuing up to grab a slice of the pie. The subcontinent is widely tipped to offer the best growth prospects in the years to come thanks to its huge domestic market, a big population that is relatively young and rising incomes.

Aiding the sale would also be a proposal by the Securities and Exchange Board of India for minimum 25 per cent holding in state-run companies. Currently, government holdings in leading companies such as Coal India Ltd — the world’s biggest coal miner — and MMTC is around 90 per cent.

“Our preferred sectors for the growth revival are quality financials, commercial vehicles, materials and energy,” JP Morgan’s Iyer said. “Fundamentally, we remain constructive on IT services and health care.”

The bank is underweight on telecom, industrials, utilities, consumer discretionary and state-run banks.

The writer is a journalist based in India.