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.