MUMBAI/NEW DELHI (Reuters) - India is ready to deal with any external shock arising from the Iraq crisis, its central bank chief said on Tuesday, even as a spike in oil prices heightens the inflation, growth and budget risks facing new Prime Minister Narendra Modi.
Modi capitalised on popular anger over low growth and high inflation to claim India's biggest election victory in three decades last month, but it is those same troubles that now pose his first big economic test.
Reserve Bank of India Governor Raghuram Rajan reassured markets that India was better prepared to deal with external shocks than last year, when warnings by the U.S. Federal Reserve that it would scale back its monetary stimulus hit the rupee.
"As far as the external front goes, we are in a much better position than we were last year," Rajan said on the sidelines of an industry event in the financial capital Mumbai.
"We have sufficient reserves, the current account deficit is low. So I think one shouldn't worry too much about the external side at this point," Rajan said.
The Indian rupee sank to 60.55 to a dollar on Tuesday, its lowest since April 29, on rising crude prices and increasing geopolitical tensions centred on Iraq.
Brent crude futures have risen by around $3 over the past week, during which Islamic militants have taken control of tracts of northern Iraq. The United States is considering whether to launch air strikes and hold talks with former arch-enemy Iran to bolster the Baghdad government. [O/R]
The RBI's dollar reserves rose to $314 billion as of May 9, the highest since November 2011 as the central bank bolstered its ability to defend the rupee, before falling to $313 billion as of June 6.
Asia's third largest economy imports nearly 4 million barrels per day (bpd) of crude oil - of which more than half a million bpd come from Iraq.
Any sustained increase in the import bill would undermine progress in shrinking the current account gap. It would also pile pressure on Finance Minister Arun Jaitley as he prepares to present next month a final budget for the fiscal year ending March 2015.
Through the budget and discounts, the government spends $24 billion a year on diesel and cooking fuel subsidies. A one-dollar rise in the oil price would add $1.3 billion to its annual subsidy bill, one senior finance ministry official estimates.
"India has so far managed its current account well - the RBI has added to its reserves too," said Sandeep Nanda, chief investment office at Bharti AXA Life Insurance. "An oil price spike is a major risk to this management."
Shares of oil companies, which usually sell off on price spikes due to India's high import dependence, rallied on expectations that the government would bear the brunt and that their bottom line would benefit from its commitment to ease price controls.
Over the weekend, Modi warned he would have to administer "bitter medicine" to restore India's economy to health. The economy is in its most prolonged slowdown since the late 1980s, pressuring public finances.
Jaitley has also pledged to uphold fiscal discipline, without saying whether he would revise the budget deficit target inherited from his predecessor of 4.1 percent of gross domestic product for the 2014/15 fiscal year.
After wholesale price inflation rose to a five-month of high in May of more than 6 percent, Jaitley vowed to crack down on "speculative hoarding" responsible for steep rises in prices of fresh produce.
The late onset of this year's monsoon, forecasts of below-average rainfall, and even a strike that threatens the distribution of onions, have stoked concerns that India could slip back into an inflationary spiral.
Rajan said the RBI would be "vigilant" on inflation, which would need to be watched closely for the next few quarters. The RBI now targets consumer price inflation, which at 8.28 percent in May was above its medium-term target.
"The government is watching the movement of rupee closely," Jaitley said. "The slight instability of rupee is essentially because of Iraq oil shocks and global fear of (an) oil price rise."
($1 = 59.7000 Indian Rupees)
Additional reporting by Frank Jack Daniel, Abhishek Vishnoi, Devidutta Tripathy and Neha Dasgupta; Writing by Douglas Busvine; Editing by Richard Borsuk