Just What are the Petrol Prices Smoking?

The lovely @Shradzie tweeted other day: “I want to smoke what the petrol prices are smoking.” The promising thought resonated with a lot of people, me included.

The state-owned Oil Marketing Companies (OMCs) had just announced the single largest hike in history – Rs. 7.50 per litre of petrol – some major high that. Understandably, people were on the edge. The anti-UPA outrage had started boiling over, many were suddenly more resolute about using public and alternative modes of transport, while the rest simply flocked to the gas stations to get their tanks filled for a short-time joy before the agony really kicked in.

Everyone seemed to be clear that this hike was nothing but a result of the anti-people policies of the UPA government as well as its terrible fiscal discipline. I am no fan of the UPA government, and there certainly is much more wrong with UPA-2 than just the northward-bound petrol prices.

What then is the real trouble with petrol?

Petrol prices were officially decontrolled in 2010 by the Government of India after an expert panel headed by Dr. Kirit Parekh recommended a slew of measures to reform the subsidy regime. Since then, the Government bears no subsidy on petrol leaving the OMCs to absorb all losses on account of under-recoveries. Diesel prices were set to be decontrolled soon thereafter. However, in late-2011, the Government announced that diesel prices would continue to be regulated in order to rein in the massive food inflation. Diesel, being largely a transport fuel for freight including food products, is assumed to be a direct impactor on food inflation.

Theoretically, the oil marketing companies were set free to price petrol as dictated by the market. Informally, and in practice, the Oil Ministry continued to regulate the prices and the OMCs had to seek the Ministry’s blessings before any hike.

This was because petrol prices are a major emotional issue that could be easily politicised and used to spark dissent. Oil Ministry, in all its wisdom, would approve a hike only when there was no immediate political fallout foreseeable. The most recent hike was one such – the last Assembly elections were a few months away, the next round of Assembly elections are not any time soon, and the Parliament session had just ended.

Coming back to the issue of the raging prices, let us understand what really goes into the pricing of petrol in our country. We shall then go on to examine if the petrol price rise would really solve any of our fiscal problems.

Crude prices internationally have been well over the $100 per barrel mark for months now. India is largely dependent on imported crude oil, with our basket price on May 22, 2012 being at $107 a barrel. With the Rupee continuing to scale new lows and testing levels below Rs 56 per Dollar, it takes no economist to tell you that we are spending a lot more in Rupee terms for the same amount of oil. Since January 2012 alone, the Rupee has lost more than 11% versus the Dollar.

Petroleum products, however, continue to be a major revenue earner for the governments – both at the Centre and the States. Rarely is a ruling party willing to forego some of the revenues and cushion the consumer. Most, being the politicians that they are, merely froth and rage.

Petroleum products have a convoluted tax structure at both levels of governance in our country. At the Central level, petroleum products bear customs duty, excise duty, royalty, cess, dividends, and other taxes such as corporate taxes, and service taxes. For the state governments, they bring in sales tax, entry tax, octroi, royalty, dividends and some other taxes. Many of these taxes on petrol are ad valorem – they rise in Rupee terms when the prices go up.

Petroleum products together brought in more than Rs. 225,000 crores for the Central and State governments last year.

Considering current crude prices and the weakened Rupee, some quick back of the envelope calculations show petrol prices at the dealer, sans taxes, to be less than Rs. 50. Clearly, a very major portion of the final prices to consumers go to the government kitties.

With that understanding, let us examine the other side of the problem – the government’s fiscal irresponsibility and its inability to stem the fall of the Rupee, and how the situation would not improve despite the petrol price hike.

India loves two things dearly – oil and gold. Unfortunately, we are woefully short on both when it comes to our internal reserves. We feed the gigantic domestic appetite through importing them in massive quantities. We pay for them in Dollars. On the other hand, we export a variety of products and services that bring in the Dollars that allow us to pay for our imports. In an ideal scenario, we bring in enough Dollar to meet our import bill, and hopefully, be left with a surplus. Given the current dismal scenario where we import far more than we export, the net result is a shortage in Dollars and an oversupply in Rupee, leading to a precarious slide in its value.

To add to the woes, the FIIs have been systematically withdrawing from our stock markets in recent times following global cues. The government’s recent policy has been quite unfriendly to FDI. The usual development blockers in India were up in arms against opening up of the retail sector to FDI. There has also been systematic witch-hunting in the way the Government has gone after Vodafone chasing taxes despite the Supreme Court declaring the they were not liable to pay taxes in India. The Government went ahead and amended the laws retrospectively to arm themselves against Vodafone. Such factors have collectively dried up Dollar inflows.

The RBI has been doing its bit to keep the Rupee propped up. It periodically keeps selling Dollars in the market to increase its supply. Then again, the RBI does not have a limitless supply of foreign exchange and its capacity to intervene this way is fairly limited. This keeps the Current Account deficit wide and getting wider.

The other way the Government has shown tremendous fiscal irresponsibility has been in terms of revenue deficit. With an eye on polls in key states as well as the General Elections in 2014, there have been a slew of populist schemes announced that guarantee virtually everything from food, to income, to rural employment. Precious little thought goes into the exact modalities of funding these schemes. The Government thus ends up with a far more expenditure than income.

The government has also shied away from hiking the prices of diesel, kerosene, and LPG keeping in mind their political compulsions. These are the three fuels on which the Government bears a massive subsidy expenditure – the maximum going towards diesel.

With a freeze on the prices of these products, the subsidy bill is also spiralling out of control leading to a scary revenue deficit.

Since the Government bears no subsidy cost on sales of petrol, the hike in petrol price does not contribute to reducing the subsidy bill and thus the deficit. For that, it is important in the short term to raise prices of diesel, and in the medium term to rationalize the tax structure itself.

Raising the prices of diesel is a scary prospect for our political leaders. There is assumed to be a direct linkage between diesel and food prices though the exact relationship is not clearly known, nor accurately quantified.

Having said that, raising the prices of all fuels would still not do the economy any good. It would certainly bring the Navaratna oil companies PSUs out of the precarious brink that they are in now. However, for a lasting good to the economy and to get back to the high-adrenaline growth path, the Government must reform subsidies by introducing direct credits, cut down on the innumerable mindless welfare schemes – each bearing a variant of the same late leader’s name, and kick start the policy-making.

To do all of this, there needs to be a strong political will; and a Government that can stand on its own feet unlike the UPA-2 which lives in perennial fear of being toppled over by regional satraps.

Coming to think of it, Congress perhaps assumes that if it has to come roaring back to power on its own in 2014, it needs as many populist schemes that it can manage to name after Rajiv Gandhi, to woo its vote bank. Back to square one, are we not?