Away from the street protests over the fuel subsidy cut announced last week, the assessment of its impact has been guarded. The Reserve Bank of India (RBI), which reviewed the credit policy on Monday, wants to allow the inflationary impact of the diesel price hike to work its way through the system before it takes a call on interest rates. In the central bank’s view, the government has not passed the fuel’s full price increase on to consumers, and there is a very real possibility that crude oil prices will spurt as the US and the European Union pump more money into the global financial system to revive their economies. So inflation remains a clear and present danger.
On the other hand, the diesel price hike has a limited capacity to curb overall government spending. Credit rating agency Moody’s estimates the move will lower the fiscal deficit by a mere 0.1% of the gross domestic product (GDP). This will be a small gain on a deficit projected at 5.1% of GDP in the 2012-13 budget, which on current indications is likely to settle close to 6%. The rating agency feels that reform of the fuel subsidy system, instead of episodic price increases, will improve India’s credit profile.
In effect, a section of India’s policy-makers and the global investor are concerned that the government will stay behind the curve on energy prices so long as they remain administered. This concern is shared by Prime Minister Manmohan Singh, who favours an overhaul of India’s energy policy to improve supply and efficiency. It would have to begin with pricing.
In 2009, the then finance minister Pranab Mukherjee set about finding a way to do this. The petroleum ministry constituted a committee of experts headed by economist Kirit Parikh to suggest reforms of the taxes and subsidies on fuel. By February 2010, the committee had submitted its report, which made a pretty compelling case for freeing all fuel prices. The government acted on it partially later that year, freeing petrol while keeping diesel and cooking fuels under price controls.
This is now coming back to haunt the Manmohan Singh government. The Parikh committee’s rationale for freeing diesel prices ran along these lines. Trucks burn around 40% of the diesel used in the country, and they are free to charge higher freight if fuel prices rise. Power generators and industry use another 18% and they anyway charge market rates for their output. No subsidy is needed for these three categories of consumers. Likewise, car owners, who account for 15% of diesel use, can afford to pay more for the fuel and, in fact, can even cough up more for an additional excise duty on the cars they buy. The only vulnerable segment is agriculture, which consumes 12% of the country’s diesel, and it, too, can be shielded from volatility by higher minimum support prices for farm output.
The inflation that will result from all this, the committee argued, could be neutralised by the central bank squeezing credit. In the event, the RBI did embark on a rate hiking cycle since 2010, but the fact that diesel prices were kept artificially low has taken away some of its thunder. And diesel prices would not have been very volatile either: Parikh demonstrated that as crude oil prices rose from $70 a barrel to $120 — the range in which it has oscillated since — diesel at the pump would cost around Rs. 20 more for a litre.
The Manmohan Singh government did not muster the courage in 2010 to do all that was recommended by its consultants on fuel pricing. When it did two years later, it was still tentative. A steep hike in diesel prices has jolted Indian consumers out of a false sense of security that the government can shield them from the rise in oil prices. Incremental increases since the government last put a lid on diesel prices have bunched up to a 14% surge. Twelve months from now, the government could be doing this again.
Singh may have gambled a lot for little. If the political backlash to the latest hike was anticipated, the Congress could have rebuilt its reform credentials by moving out of the diesel price control regime completely. The shock of the government relaxing its intervention questions the official belief that capping fuel prices pays political dividends. India changes its fuel prices with an eye more on the election calendar than on the Brent graph, losing much of the damping desired and stretching, in the process, both the buyer and seller of oil.
The world has learnt to live with wildly fluctuating energy prices. The standard practice is to let the economy adjust continuously to crude oil prices while the central bank has the explicit job of keeping inflation in check. Governments do not wobble when oil prices rise. Since the shock of the 1970s, India has tried valiantly to tame energy prices. The results have almost always been disastrous. Our politicians should be as king themselves whether four in five litres of diesel sold in the country deserve a subsidy rather than by how much the fuel’s prices ought to be raised. Singh could still use the opportunity in the current political turmoil to steer India’s energy pricing into rational territory.