The government’s announcement of hike in diesel prices of by `0.50 per month will put additional burden on the transport companies on one hand and on the other hand it will not reduce the subsidy burden on diesel and petrol through this fiscal ending in March. Though GOI claims that it has announced the step following the Rangarajan Committee report, the reality is far from it. The Rangarajan Committee had suggested a gradual phasing out of Administered Pricing Mechanism (APM) and leaving the prices to free market, thus reducing the subsidy burden on the government and also eliminating the burden of under-recoveries of the Oil Marketing Companies (OMCs). It’s recent step may give some relief to the OMCs, but the fiscal burden will not ease, it remains stubbornly high and impact of this increase is partially offset by the increase in the limit of the subsidised cooking gas cylinders to nine per year from six.
This will increase inflation significantly and it may reach double digits. The fiscal deficit will remain stubbornly high and even in the fiscal the impact of hike in prices will be to reduce the deficit by about 0.07 per cent of the deficit. Since the government is not exactly deregulating diesel prices, private players will remain wary of investing in the sector. This will stop the much-needed investment and innovation in the sector, which is in an urgent need of renovation. FDI and FII are unlikely to increase due to recent announcement.
This, at a time when the economy is struggling and growth-rate is flagging, demonstrates the lack of forethought from the government. This will cripple the investment environment and the GOI is risking a downgrade from credit-rating agencies. Among the BRIC countries, India has the lowest productivity in refining crude-petroleum, while among BRIC nations we are the most dependent on imports of crude-petroleum.
A completely deregulated diesel market may increase inflation, but it will reduce the fiscal deficit and give a boost to the private investment in the sector. The hasty decision to increase the prices, but not necessarily deregulating them completely, does not make any economic sense. Almost all the bulk users of diesel already have agreements in place with the PSUs, hence the chance for private players to enter into the bulk markets is minimal. On the other hand private players are well-equipped to serve retail customers, but the government’s decision to raise the prices for retail customers gradually is viewed by companies sceptically. This gradual increase may or may not happen depending upon how the politics in Delhi turn-out in the next 18 months, hence any investment in this sector, if it will come, will only come after 18-21 months. Hence the fiscal deficit and CAD will continue to deteriorate for the next two fiscals.
To remedy the above mentioned situation, recent announcement from the finance ministry suggests that the GOI is mulling over the proposal to compute the refinery gate prices at export parity price (unlike the trade parity price proposed by the Rangarajan Committee). This step will reduce the subsidy burden on the government by `182 billion per annum. This is not feasible in the long-term, because the GOI is gaining at the expense of the OMCs. The OMCs already operate in an economic scenario where crude prices fluctuate along with the fluctuating rupee-dollar exchange rate. Their margins are 3-4 per cent depending upon the pricing model adopted. It is estimated that OMCs will stand to lose about `1.2/litre of the crude petroleum. Hence they will operate in loss even if the exchange rates and crude petroleum prices were to remain relatively steady in future. Also if the GOI adopts export parity pricing model, it will not send the correct price signals to the customers. Any pricing model, if it should be sustainable in the long-term, should reflect the actual supply and demand of the commodity. Current APM is in need of change exactly because it is not sustainable; hence the GOI is just trying to evade the problem, rather than trying to face it.
The GOI should encourage the OMCs to form long-term forward contracts with the upstream companies on one-hand and try to keep the exchange-rates stable. The exchange-rates fluctuate in the first place because of the current account deficit (CAD). The CAD is high because of increasing petroleum imports. So in the long-term India needs to improve the efficiencies of their supply-chains, extraction and refining. The average refining costs per litre have come down by about 20 per cent in developed countries in the last decade. This figure in India remains at 10 per cent. This happens only in a free market, where there is perfect competition. Even in India refining efficiency of Reliance is far more than the likes of HPCL, BPCL etc. BP’s investment in the RIL is single largest FDI in India to date. So, improving the investment climate remains the only long-term option to reform the petroleum sector in the long-term. To ease the impact of inflation and reduce the fiscal burden in the short-term, it should de-regulate the prices to discourage the consumption of diesel for non-commercial purposes and use schemes like direct cash transfer to the commercial vehicles, based on the kilometres travelled. So the solution is simple, de-regulate the prices, and if the GOI fears that inflation goes out of hand, provide direct relief on the diesel consumed by commercial vehicles rather than current APM.
Other suggestions include the tweaking the VAT imposed by states. Make them impose a specific tax per litre rather than the ad-valorem taxes. Ad-Valorem taxes are the taxes that are imposed as a percentage of final prices. This will reduce the fluctuations in the price to some extent and states can use this as a fiscal tool by changing the fixed tax depending on the fiscal climate. States could review the fixed tax at least once in a quarter.
If states feel that the diesel prices are too high, they can review and change this tax, which will reduce the price of diesel only without affecting other commodities, whereas any change in VAT will affect other commodity prices also — specific tax is the way forward for state governments.
The revenues the GOI earns from the petroleum sector by the way of taxes and expenses it incurs by the subsidies should be clearly mentioned in the budget. The sector is in an urgent need of reform and transparency. Lack of transparency and red-tape are crippling the sector.
Gourav Vallabh is professor of finance at XLRI