Column : Side effects of fuel price hike

Written by Saugata Bhattacharya | Updated: Jun 30 2010, 02:48am hrs
The Union government has taken a courageous step towards implementing many recommendations of the Kirit Parikh Committee Report on a viable petroleum pricing system. Multiple benefits have already been emphasised by analysts and the media. The first being the increased incentive for fuel use conservation. Hydrocarbons will increasingly become a critical resource for India, given the extent to which we are dependent on imported crude for our refineries. Increased hydrocarbon prices are an incentive to move to non-conventional energy sources and to change consumer behaviour on energy use.

The reduction in the governments oil subsidy burden has also been noted. Not as widely highlighted, though, are the adverse effects of high fiscal deficits on household disposable incomes. The insidious impact of high government expenditure is not as immediately apparent as the more visible and immediate increase in petrol, cooking fuel and transport expenditure. Higher fuel subsidies result in a higher deficit in the governments borrowing programme, which pushes up interest rates, and consequently, the cost of loans for homes, auto, personal, etc, resulting in higher EMIs on such large-ticket loans. Over time, households will begin to see the benefits of lower rates offsetting part of the higher fuel-related expenditures.

The measures will certainly have the immediate effect of increasing the WPI inflation rate by about a percentage point, and the CPI inflation rate probably even more. As expected, calls for (and expectations of market participants) more stringent monetary policy tightening measures promptly followed the announcement. The desirability of a rate hike ahead of the scheduled policy review in late July, a steeper than anticipated hike in the July policyeverything has been voiced. However, this thinking is largely misplaced. This article seeks to make the point that there are three broad arguments why this specific deregulation should not be an input into recalibrating policy tightening.

First, the fuel price hike is a supply shock. The last such hike was in mid-2008, when global crude prices had climbed to above $145 a barrel and the Indian crude basket was around $123 a barrel. At that time, the perception was that the global economy was invincible. China was powering ahead, the developed markets sub-prime housing worries were relatively localised, the emerging markets had decoupled and their incremental energy demand remained robust. Indian real estate prices continued their giddy climb. RBI was completely justified, in those economic and financial circumstances, in rapidly tightening policy parameters to choke off demand.

This time around, things could not be less similar. Crude is at $78 a barrel, with current street estimates of end-2010 levels of at most $90. Indian prices have been far below fair value, with the implicit assumption that a selected category of fuels are a basic need of Indian families everyday existence. Without a doubt this is; just not in the way that the system currently operates. Monetary policy works on the presumption of controlling demand. There is no rampant demand driving up fuel prices this time. The current hike is a move to catch up on, even in this relatively benign global crude price environment.

As a technical corollary, the one percentage point jump in inflation will persist as a hump in the inflation trajectory only for a year before it comes down as sharply again in June 26, 2011, as an artifact of the year-on-year method in which WPI inflation is calculated.

Second, the price hike is an automatic demand compression mechanism. Particularly in urban India, transport accounts for a significant share of the middle classs monthly expenditures. The increased allocations to transport costs required will necessarily lead to a rebalancing of other household discretionary expenditures. Domestic food budgets will be tightened, entertainment limits tightened and holidays cut. The hike, in other words, is an automatic stabiliser for demand.

The third argument is less sharp. There is a distinct possibility that the increasingly credible commitment shown by the Centre of improving its fiscal environmentnot just by the windfall 3G auction proceeds will merit not just an outlook but a ratings upgrade by the credit rating agencies. A policy rate increase will only make yield arbitrage opportunities more attractive, attracting even more foreign funds.

This is not to argue that RBI should not reinforce its monetary tightening; it is noted elsewhere that movement in key industrial commodity prices do call for a rethink. Its just that this specific deregulation move is not a reason for increased tightening.

We could not have afforded behaviour-as-usual; India will have to go through a painful process of adjustment as various administratively controlled prices have gradually moved towards market ones. Lower income households will be particularly vulnerable. The fiscal space that the government has created for itself should be used as buffer for these vulnerable segments. The rest of us will perforce have to change our consumption behaviour.

The author is vice-president, business & economic research, Axis Bank. Views are personal