First, firm crude prices are likely to impact stock markets in more than one ways. On the macro-economy side, though India is still a marginal player in the international market when it comes to consumption of crude in absolute terms, we are very energy intensive economy. Consider the graph below.

What does this mean? For every 100 units of output of the economy (popularly referred to as Gross Domestic Product or GDP), India requires 288 units of oil as input as compared to 232 units for China.

This figure is benchmarked against the consumption pattern of OECD countries, which largely comprise of developing economies. If the Indian economy is expected to grow by 6 per cent to 8 per cent in FY05 (the typical forecast range), then the requirement of crude oil is also likely to increase. The impact is felt both by the economy and consumers.

On the economy -- When crude prices escalate (as they have), the cost of purchases increases for manufacturers and consequently, there is a general increase in price levels (called as inflation). Secondly, since the energy sector has the element of subsidies (i.e. kerosene and LPG prices are priced lower and is partly compensated by pricing petrol higher), when crude prices increase, subsidies also go up.

Since the government shares a part of this burden, expenditure of the economy rises faster resulting in a deficit. The government therefore, has to borrow more to fund the deficit and to that extent, demand for money increases.

On the consumer -- Rising crude prices and consequently rising inflation levels bring with them a host of concerns. First, rising crude and petroleum product prices, when transferred to the consumer leads to a burden on the wallet. This, in turn impact demand for FMCG products and automotives (if manufacturers transfer the burden of rising raw material costs).

This rise in prices, or inflation, leads to a decline in real income for the consumer, as while costs rise, income levels remain almost constant.

Now, to counter the threat of rising inflation, the central bank generally raises interest rates in the economy. This acts as a double whammy for the consumer as, apart from the rise in inflation, his cost of borrowings also rise.

Conclusion…

The effects of a sustainable rise in crude prices and, consequently, inflation might result into slowing down of the economy's growth. This might then have a resultant effect on the stock markets, as in times of reduced demand and rising cost of inputs, corporate profits slow down. At these times, there is a tendency for investors to wait. The approach could be that of "let things settle down and then take a investment decision in equities".

In an inflationary situation, the attractiveness of fixed deposits and debts (unless they are floaters or inflation indexed) declines, as the returns may not compensate for higher inflation. Therefore, the case for equities is strong. We are not trying to conclude that equities will not be affected.

But over a period of two to three years, the returns from equities could be higher than other investment avenues. At this point, investors can lower their risks by investing in a systematic manner, i.e., investing at regular intervals, which lowers down costs in the long-term, if one believes that the stock market is likely to be shaky in the short-term.

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