Partial Decontrol of Fuel Prices – Advantages & Disadvantages

Better late than never!

That’s the phrase that came to my mind when the Manmohan Singh government, finally, decided to partially decontrol the fuel prices yesterday in order to bring down the burden of subsidies from the increasing domestic consumption of fuel products.

The Empowered Group of Ministers, or EGoM, headed by Finance Minister Pranab Mukherjee has hiked petrol prices by Rs.3.50 per litre, diesel prices by Rs.2 a litre, domestic LPG by Rs.35 per cylinder and poor man’s cooking fuel kerosene by Rs.3 per litre from today.

It is important to note over here that the government has not decontrolled the fuel prices at its entirety. Even as the EGoM has rendered the petrol prices to be completely market-determined, the impact of hike in diesel prices will be passed on in a phased manner as it is likely to directly add-on to the inflationary pressures in the economy. The subsidy regime for the LPG and PDS kerosene will continue to remain.

Positive Outcome for Oil Marketing Companies

It is estimated that at around current crude prices of $75 per barrel, the under-recoveries for the Oil Marketing Companies (OMCs) from the fuel price hike will come down by Rs.22000 crore this year. The overall burden of under-recovery on the OMCs from all the four fuels products – petrol, diesel, LPG and kerosene – was earlier estimated around Rs.78000 crore.

This overall under-recovery is currently being shared in the form of subsidies by the upstream PSU oil companies, government and through the internal accruals of the OMCs themselves. More recently, government had announced that the subsidies to OMCs will be paid in cash rather than bonds to enhance more clarity in terms of off-budgetary subsidy outgo and strain on the country’s fiscal deficit.

Negative Impact on Inflation

The hike in fuel prices, especially diesel, is likely to have a spiraling effect on the surging inflation over the medium-term horizon. Food inflation rose 16.90% for the week ended June 12 from a year-ago period, largely on the back of wholesale prices of the vegetables shooting up. The government’s step to hike diesel prices by Rs.2 a litre would further aggravate the inflationary pressures driven by surge in the transportations costs of the goods.

However, the Chief Economic Advisor to the Finance Ministry, Dr Kaushik Basu, has defended the Government’s decision to deregulate petroleum and diesel prices as being beneficial to the economy and exert downward pressure on general prices over the next 6-9 months horizon. He expects the monthly WPI to surge by 0.90% over the short-term duration, on the back of fuel price hikes.

Looming Rate Hike Fears

Although hike in fuel prices has little to do with RBI policy initiatives, but the expectations that the surge in fuel prices would further stoke inflationary pressures, could as well prompt RBI to upwardly tinker with the interest rates in its forthcoming monetary policy review slated on July 27.

Borrowers may have to brace for one more hike in interest rates of their loans induced by RBI move. So far, RBI has affected a 50 basis point of hike in the key policy rates over the last quarter as a calibrated approach of unwinding the stimulus measures provided during the global recession.

Equity markets have almost discounted a rate hike in the policy rates next month. In fact, pundits expect a possibility that RBI may as opt for a mid-term rate hike even before the formally scheduled July meet. Banking analysts are expecting repo rates to move up at 5.50%, from the currently prevailing 5.25%.

Guess what? One of the leading brokerage houses have given a short sell call on Oil Marketing company stocks, as they expect expect a political backlash over the weekend, subsequent roll-back of the hike measures announced. Lets see what happens to those client positions ;)

Moving a Notch Higher

Of course, I need to conclude over here saying this is a positive reformist movement to start by any political party. Since, Indian political system comes with the package of entangled democracy; there will always be political protests to such bold moves effecting poor public.

But, it is equally important to call quits from such economy-straining measures of high subsidy and fiscal deficit. Market linked fuel prices would also ensure that the consumers start valuing the natural resources and use it more optimally once they are made to pay market-driven price for the same product.

This is a good first step with partial decontrol of fuel prices and can be keenly followed for complete decontrol of fuel prices one by one, so as to ensure a gradual process of shifting burden on the public in general.

Would like to know your views on this topic…