Column : Getting the diesel pricing right this time

Written by Madan Sabnavis | Updated: Jan 18 2013, 05:38am hrs
While hike in diesel prices will help lower losses of OMCs and fiscal deficit, the timing is important for inflation and rate cuts

The move to partially deregulate diesel prices has had an important announcement effect with the market spooking upwards. There can be nothing fundamentally incorrect about this move to make the price market-oriented, and the two questions that need to be asked are whether companies will increase prices and to what extent With the fiscal deficit under strain and the next Union Budget to be critical in terms of providing future direction to the economy, this move is quite appropriate, as something seriously needs to be done to control the petroleum subsidy bill and hence the viability of the OMCs. The issues here are three-fold: pricing per se, fiscal deficit and inflation.

The current under-recovery on diesel is quite high at R9.6/litre. This needs to be brought down. The overall under-recovery on this bill has been around R53,000 crore for the first half of the year, which is around 60% of the total under-recovery on the fuel account. The justification of providing a subsidy is based on the use of this fuel by farmers. With the direct cash transfer concept catching on, it would be easier to charge market rates for diesel, and subsidise farmers directly through cash transfer. As the other users can afford to pay the market price, vehicle owners as well as power generators can be made to get market-oriented, though the issue of inflation would still have to be addressed.

The related question is how will prices move up Will it be a big increase of, say, R5/litre, as was done last time, or a gradual one Ideally, a gradual increase makes sense as it is easier to absorb and does not come as a shock. Therefore, incremental prices of, say, R0.5-1 would be easier to take in on a more frequent basis until such time that the gap is closed.

The fiscal deficit is the second element which is being addressed here. For this year, the petroleum subsidy has been targeted at around R45,000 crore. Last year, out of the total under-recovery of close to R1.38 lakh crore, around 60% was taken on by the government through the subsidy while the rest was borne by the upstream companies. Assuming that the current level of R85,000 crore of under-recovery for the first half of the year doubles to R1.7 lakh crore, the subsidy level would be close to R1 lakh crore, or more than double of what has been projected. This is a scary number and the FM would be pleased to cut this down considering that there have been pressures on the LPG and kerosene ends. By raising the diesel prices, one part of the subsidy bill could be addressed.

Quite clearly, this approach would be more critical from next year onwards, as there is little that can be done for the next two months or so when the financial year ends.

Third, inflationary impact of a diesel price hike is critical. With the under-recovery of R9.6/litre, the overall future correction would be around 20% over a period of time depending on the phasing of this increase. Diesel has a weight of 4.8% in the WPI and, using the thumb rule of indirect weight being another 50% of the original, the total weight is close to 7%. Intuitively raising the price by 20% means an inflationary impact of around 1.4-1.5% on a point-to-point basis. This is where the phasing of the price increases comes in. If done gradually, it would not get reflected immediately and can get absorbed in the system, given price fluctuations of commodities. The impact on retail inflation would be higher as it comes in both directly and indirectly as price of transportation increases. Railway fares have already been hiked and higher diesel prices will add to the retail prices of derived and user products (public transport). But, this is inevitable and we really have a tradeoff between getting the fiscal balances and viability of OMCs right against higher inflation. By spreading these increases in price, the pain can be alleviated to an extent.

This brings the discussion on the timing of these price increases. While the quantum may be in bits and pieces, the timing is important. Today WPI inflation is 7.2% and CPI inflation 10.6%. Increasing the prices currently could just add to inflationary expectations that RBI would be looking at closely, as there is debate on whether the central bank will lower interest rates later this month given that inflation is getting tempered. Such rate actions could get pushed forward.

The other thought on this move relates to who will take this decision The OMCs are government-owned and, therefore, even if they wish to increase the price by, say, R5/litre, the ministry of petroleum and the ministry of finance will actually have the final say. Thus, there is reason to believe that the deregulation moves by the OMCs would not be in a hurry and will be done on due consultation with the relevant authorities.

Given that the government is keen on controlling this subsidy bill and that it is willing to increase prices of petroleum products, a thought that comes to mind is that the government should ideally follow a strict budget when it comes to petroleum subsidy. As the subsidy for the three products is known in advance and budgeted, it should ideally be apportioned across 12 months so that the allocations are fixed. The subsidy can be provided until this amount is exhausted, after which prices should be revised so that a price-rationing system is created. This way, the subsidy level, which is required in a society where lots of people do require such assistance, is provided but not breached. While this may not be easy to implement, a beginning is worth trying, as one cannot really lose in this scheme.

The author is chief economist, CARE Ratings. Views are personal