Is diesel price hike & move on LPG cylinders by the Government justified?

Recently on September 13, 2012 the UPA Government among other decisions on FDI related issues, amid protests from Opposition and few allies, took a bold step of increasing the diesel prices by Rs.5 per litre and capping the purchase of subsidised LPG cylinders to 6 per year. Economists and market experts around the globe welcome this move by the Government amid rumours that the country’s rating would soon be downgraded by rating agencies across the globe unless the Government acts on the worsening situation of the country. The Opposition and allies like the Trinamool Congress (TMC) have cried foul on this move of the Government alleging that the Government is out there to “destroy” the country as these steps would hit the aam aadmi in a very harsh manner. Personally speaking, I support this move of the Government and would go on to saying that it was long overdue.

India’s fiscal deficit in the year 2011-12 was at an alarming rate of 5.9% of the GDP while the current account deficit was at 4.2% of the GDP. These are not comfortable figures. No doubt fiscal deficit is necessary for a developing country like India but not at the cost of an already extremely high inflation faced by the Indian economy and extreme depreciation of the rupee in the past one year. This four-fold problem of the country does not give much room for RBI to cut interest rates and bolster the economic growth of the country. Accordingly, the ball was and is still in the Government’s court to push for reforms and changes so as to control the situation. Accordingly, the Government moved and took steps on the following –

·        Certain FDI related issues (which would be discussed later in subsequent articles)

·        Hiking the price of diesel by Rs.5 per litre out of which Rs. 3.5 would go on to reduce the under-recoveries faced by the oil marketing companies (OMCs) and Rs.1.5 is hike in excise duty on diesel. The under-recoveries still faced by the OMCs on sale of one litre of diesel is Rs.13.5 post hike in diesel prices.

·        Capping the purchase of subsidised LPG cylinders costing Rs. 399 per cylinder to only 6 per year and subsequent cylinders would be purchased at market price which would be around Rs. 750 to Rs.800. This move has been partially diluted by the Government by removing the customs and excise duties on non subsidised household LPG cylinders to zero and furthermore, the Congress ruled states of the Government have increased the limit of LPG cylinders to 9 per year instead of 6.

·        No increase in petrol price was done although current under recovery of OMCs is about Rs. 6/litre. However, this loss was offset by reducing the excise duty on petrol by Rs. 5.30/ litre with no change in pricing done by the OMCs to ultimate consumer.

These bold steps taken above should be able to improve the situation of this country. No doubt the diesel price hike and the move on LPG would cause a risk of increasing the inflationary pressures in the economy and hit the aam aadmi but still this move is justified due to the reasons and arguments mentioned below.

For every litre of petrol/ diesel sold in the country, only 55-65% is non-tax portion and the rest is tax portion borne by the consumers. In short, due to the inelastic demand for these commodities, Government tends to treat these commodities as “tax collection agents”. These taxes are arguably high as the Government is running on huge fiscal deficits (when Government expenditure is greater than the Government revenue, excluding the borrowings made). If they reduce taxes on them, money needs to be raised from somewhere else. However, the price at which diesel, LPG and kerosene is sold in the country are at subsidised rates (petrol prices being deregulated from 2010 onwards, they are usually not sold at subsidised rates as much as possible). Now, one must be confused. On one hand, we are talking about high taxes on these fuels because of which these fuels cost high while on the other hand, we are talking about subsidy given by the Government on them. This can be explained below.

Companies involved in the exploration and extraction of crude oil (upstream companies) sell the petroleum products mentioned above to OMCs (downstream companies) at a particular price (say Rs. 60 per unit) which ultimately sell to consumers at cheap prices (say Rs. 53 per unit instead of market price of Rs. 63 per unit). Thus, OMCs end up declaring under-recoveries of Rs. 10 per unit (market price minus selling price). These under-recoveries are borne by both the Government and the upstream companies under a cost sharing arrangement notified by the Government from time to time. To bridge the under-recoveries which takes time to be disbursed, OMCs tend to take loans from the market or banks and end up paying huge interest costs as expense. Government, no doubt, collects the tax from the downstream and upstream companies upfront while disbursement of under-recoveries to OMCs (downstream companies) takes a lot of time which adds to the burden of the Government due to pending obligation (to pay to OMCs) from its side and interest burden on the OMCs.

Accordingly, hike in the price of diesel and limit on LPG cylinders is necessary to control the Government expenditure by reducing the subsidy portion and increase the Government revenue of the country. In other words, the fiscal deficit of the country would be reined in. It is important to do so as financing the fiscal deficit entails either borrowing by the Government or printing more money. Borrowing can only be done to a certain extent as the repayment of the principal and interest portions of the money borrowed on the sovereign bonds or from international institutions or other countries needs to be made. Furthermore, excess borrowings increases interest costs of the sovereign debt of the country which is already quite high for India. However, printing more money leads to increasing the money supply in the economy and if this money supply does not lead to increased productivity in the country, inflation is the outcome. Taking one step even further, high inflation leads to general lowering of living standards of people as compared to rest of the world and the currency depreciates. This depreciation of the currency refrain foreign investors from buying into asset markets of India and further selling by foreign investors in the asset markets of India and pulling out their funds from the country depreciates the currency even more. This depreciation of currency further harms the current account deficit of a net-import country like India leading to depletion of foreign exchange reserves of the country. Thus, it is all inter-linked - from fiscal deficit to inflation to currency to current account deficit. Even though people may argue fuel price hikes lead to high inflation in the short run, however, in the long run, considering the situation of a country like India, these hikes would be beneficial and prevent the downgrade by the rating agencies across the world. Preventing downgrade is necessary to maintain stable foreign exchange inflows in the country in the form of FDI and portfolio investments. A downgrade would lead to massive pull out of funds from the country leading to exchange rate reaching Rs.60-65 levels very soon.

In short, what has been explained above is similar to choosing between fracture of a leg versus a massive heart attack. Indeed when choice has to be made, one should not mind fracture. To conclude, I would say that the Indian economy is no doubt, a strong economy with great economists running the country very well as compared to rest of the world. Many times it is only the populist and coalition politics because of which many reforms tend to get side-lined or delayed. More than eight out of ten times it is politics that tends to win the battle over economics, but sometimes economics has to come out bold and strong and slash the sword on the face of politics when extremely needed. This time it was one such situation when economics has done so and we would all hope the economic decisions taken by the Government are not rolled back.

Excessive highs and suicidal lows of Asset Classes

Asset classes have a tendency to show extreme movements many times. Sometimes, they may be so generous that they may move up and scale new heights regardless of the fundamentals and political and economic scenario of the country or the world, while there may be times when unfavourable situations may make them go down so drastically that overall asset classes become ridiculously cheap. These wild movements of the asset classes, many a times, play havoc for a general small time investor/ speculator. It is at these times that general public lose faith in the markets and are driven by emotions while buying or selling asset classes. They tend to buy at the highest levels and sell at the lowest levels succumbing to the elation and depression respectively. However, a patient investor and an intelligent speculator would reap huge gains in these situations.

These extreme movements of the markets like the ones seen in 2008 (because of sub-prime crisis) or 2001 (because of technology bubble burst) or 1979-80 (because of silver market mania) are not a new age 20^th or 21^st century phenomenon. Trading in asset classes dates back to centuries and these movements also find their way in history. Let me apprise you all to the famous “Tulip mania” that gripped the Dutch as far back as first half of the 17^th century. It is generally and arguably considered as the first recorded speculative bubble in the history of asset markets-

Tulip was different from every flower because of its saturated intense petal colour and was regarded as a coveted luxury item in many parts of the world. Tulip grew from a bulb that normally takes 7-12 years to grow from the seed. Accordingly, bulb was a sought after commodity. Bulbs not infected by mosaic virus produced petals with single colours, while certain virus infected tulips produced petals with vivid and spectacular colours making them rare and desirable commodity. By 1634 as a result of demand from French, speculators began to enter the market. A formal futures market in 1636 was established by the Dutch where contracts to buy bulbs were bought and sold. The contract prices of rare bulbs continued to rise throughout 1636 but by November of 1636, price of common, non infected bulbs also began to rise. Besides the reason stated above, price rise was also due to the fact that the trading public was speculating that soon a legislation was under way which would convert the futures contracts entered into by the trading public for tulip bulbs into options contracts, thus, greatly limiting the liability of the buyer of tulip bulbs in the market as he can always pay a penalty amount (call premium) and avoid the contract in case the prices of bulbs fell. Accordingly, the prices rose to astronomical levels by the end of 1636 and early 1637. Everyone thought that the party will last forever. Higher prices would only go higher. People purchased at such sky high prices intending to resell the bulbs at a profit. Finally around February 1637, the “party” stopped and prices fell dramatically. While some economists are of the view that the fall in prices was due to  the outbreak of bubonic plague in Haarlem (a city in the Netherlands), others are of the view that the fall was due to halting of trading in tulip contracts by the Dutch authorities. Whatever be the case, one can imagine, at the peak, some of the bulbs costed around 10 – 14 times the annual earnings of a skilled craftsman while when the prices of the bulbs fell; the fall was so severe and intense that some of them collapsed 99% of the peak traded price.

The above event clearly highlights the fact that time and again, prices of asset classes have risen and fallen and would continue to do so in future also. Sometimes the rise may be quick while the fall may be painfully slow, while at times, it may be the other way around. However, many times it so happens that both the rise and the fall is so sudden that it does not give time to even experienced investors/ speculators to digest the fact. Accordingly, the investing/ speculating public tends to lose faith in the markets. As an Indian, I can personally recount many people losing faith in the stock markets after the sensational crash of 2008 when the Sensex fell from 21000 levels to as low as 7700 levels in the same year. It was very simple to understand that the level of 21000 was fundamentally not the right level to enter the market in January 2008, considering a major investment bank Bear Stearns’ two hedge funds had just collapsed in July 2007 and the whole investment bank was on the brink of a collapse. Furthermore, the US housing market was showing signs of extreme weakness due to default on sub-prime loans with many economists warning of a systemic collapse of the housing market. The concept doing the rounds that time was that India and some other emerging markets are decoupled (separated and insulated) from the happenings in the US. However, the “foolish” experts forgot to realise that in this era of globalisation, every country (except extremely backward/ tribal areas of the world) is linked to the other. Furthermore, if we analyse more, even the level of 7700 or so attained in October 2008, was so absurd that great quality stocks with relatively stable business outlook were available at throwaway prices. Both, the intelligent investors and the smart speculators could have and certainly may have made huge gains.

Thus, it is clear; the markets and asset classes will show absurdly high and low levels at times and it is upto the investing/ speculating public to make the best use of these movements. We are all aware that the prices of stocks, shares and commodities change on a daily basis even though the fundamentals surrounding them do not change so often. However, when we are speaking of excessive highs and suicidal lows of the market, we are speaking about change in fundamentals and other reasons governing their pricing and value. But, the highs become excessive and the lows become suicidal because of the psychology of people. If the value of an asset class is “1/2x” and the value determined by fundamentals is “x”, the prices would tend to rise inevitably. However, the speculative and “insane party” at times, tends to stretch the prices to absurd levels of “2x” or even “4x”. Such high prices are not sustainable for long term as sanity tends to enter the market sooner or later and the prices correct themselves to “x”. Conversely, an overvalued asset trading at “2y” may be fairly valued at “y” but while the prices tend to fall, they may fall dramatically downwards to values like “1/2y” or “1/3y” only to rise back again to “y”. No doubt, these excessive highs and suicidal lows cause immense pain to most of the speculators/ investors of asset classes, however it is also at the same time giving them an opportunity; an opportunity to reap huge profits from these situations. When the prices fall to absurdly low levels, the assets should be bought while when they rise to high levels, they should be immediately sold if kept in portfolio or short sold (and later bought at lower levels to square off the position). These movements should not be treated as an enemy that takes away wealth of investors/ speculators, but should be treated as a friend that gives them the golden opportunity every time to earn huge.

However, patience and discipline is the key. One has to master the art of valuation of asset classes and have conviction in one’s ability. For this, one should start with smaller amounts and over the years, try to hone and fine-tune the art of valuation in a strictly disciplined manner. If this is done properly, one would automatically start treating the excessive highs and suicidal lows as the best thing that could happen in the market and accordingly, make big bucks out of it. In the Indian scenario right now, we are seeing huge rise in the prices of real estate in many select urban pockets. Even the world recession of 2008-09 did not have any major impact in the prices of residential properties in areas like Delhi, Mumbai, Bangalore, Chennai, Ahmedabad, etc. This is primarily due to increasing urbanisation, better infrastructure in the above mentioned cities and the general trend of people living in smaller towns or rural areas to flock to those cities in search of jobs. However, even if we consider all these reasons and a few others also, such high prices may not be justified and we may soon see a downward spiral in prices in these areas. But, why the prices are still on the rise is due to the following reasons –

1.     Large amount of black money in the unregulated property market in India

2.     Greater personal interest of property brokers, who in collusion with real estate developers practically buy the properties on their own account many times and control their supply. Consequently, they later sell them at a substantial profit.

However, this “insane party” may either continue and real estate prices may further rise to even higher levels or the prices may move laterally for a long time now or they may fall. All depends on the uncertain future but if stringent regulations to control the real estate sector by having a real estate regulator (a proposal that has already been considered by the Central Government) is enacted or regulations like tax collected at source (TCS) on the sale of property (a proposal introduced in Finance Bill, 2012 but did not pass to become a law) is enacted, the prices of real estate in many urban pockets may take an immediate hit. Whether this hit may turn out to be a suicidal low for the sector is yet to be seen but all depends on investor/ speculator sentiment.

For every seller of an asset class, there is a buyer of that asset class and vice-versa. However, sometimes, buyers tend to dominate the pricing while at times sellers tend to dominate, leading to high and low prices respectively for the asset classes. But what an investor/ speculator should be aware of is “insanity” in the market and as much as possible try to benefit out of it rather than become another sheep in the herd. At this moment, I would like to conclude by quoting a phrase from Warren Buffett’s 2001 letter to shareholders of Berkshire Hathaway – “Try to be fearful when others are greedy and greedy when others are fearful”. This is the mantra to master the extremism and absurdity in the pricing of asset classes in the market.