Tag Archive: inflation

Reserve Bank of India (RBI) reduced the repo rate by 50 basis points to 8.0 per cent in its annual monetary policy review on April 17, 2012. While the markets were expecting a moderate 25 basis point cut to be in place, a sharp 50 basis point cut surprised many. Reserve Bank does seem to have its own logic for this rate cut but it seems like a step which is too fast and too furious. Is it a gamble for growth that RBI is willing to play or are they succumbing to demand and pressure from industry for some easing in policy rates?

Rate cut from RBI comes on the back of declining growth rate to sub 7% which apparently is below the desired/expected growth rate which RBI has targeted. While the growth rate has been impacted due to continuous rate hikes by RBI in the past 2 years, there has been moderate impact on inflation. Headline inflation still hovers at around 7%, however there has been moderation from last year’s rate which has prompted RBI to take this cautious step of rate cut.

Although inflation levels are yet far off from RBI’s comfortable target of 4-4.5%, but declining growth rate has prompted RBI to shift its focus on growth over inflation for the time being. This is a risky approach.

Firstly, risks to inflation spiraling high again are looming at large. The reasons remain the same which have till now not let the monetary measures by RBI control inflation. Large fiscal deficit which has been further fuelled by focus of government on spending and giving benefits and subsidies has led to increase in demand which further triggers inflation. Further, inflation is driven by supply side factors primarily in the food category. Sturdy supply chain measures are yet to be taken by the government to counter these challenges. Further the decline in investment activities has more to do with weak fiscal policies than high interest rates. Policy-related bottlenecks, higher cost of inputs, weak rupee and slowing external demand has all led to decline in investment activities. Foreign investments also have seen to take a dwindling in wake of weak confidence in Indian Economy in the backdrop of slow growth, non-industry friendly policies, political uncertainties and row of scams. Amidst all these, there is also pressure of fuel prices to rise in the global markets. Even if the prices remain steady, government has but little choice to increase retail fuel prices given the already burdened subsidy budget.

While the RBI has said it has taken a cautionary approach and intends to closely monitor inflation and growth rates and if needed might even go for rate hike, but it is moving into dangerous grounds. Growth does certainly seems to be a significant factor on RBI’s mind when playing the repo rate cut card but for it to be significantly effective, Banks need to pass on the rate cut to corporate so that investments can be boosted. Apparently the banks are reluctant to do so. Given the slow deposit growth, banks are hesitant to drop the deposit rates as it may further slow down deposits and so if the lending rates are cut it will hit the profitability of Banks. The banks will ultimately pass on the rate cut but it will be crucial to see who wins in the race – inflation or growth. We all hope that the measure turns out beneficial and gets Indian Economy back on track of solid growth.

Government recently raised the prices of diesel, kerosene and LPG cylinder on 24th June 2011. With the increase in prices of diesel by Rs 3 per litre, cooking gas (LPG) by Rs 50 per cylinder and kerosene by Rs 2 per litre, there has been a huge outcry about its impact on the economy and the masses. It also eliminated the 5% custom duty on crude oil and reduced the excise duty on diesel from 4.6/l to 2.0/l which will further increase the fiscal deficit. With the increasing inflation constantly biting the government which is already bruised by multiple controversies in terms of XIX Common Wealth Games Fiasco, 2G scam and social movement by Anna Hazare & Baba Ramdev, the questions arises if the hike in prices is wrong move or a bold move?

The Cause

With as estimated losses of INR 1,77,000 crores in FY12, government has tried to reduce the losses to an extent of INR 21,000 crores through price hike and INR 49,000 crores through reduction in taxes. These losses occur because the oil that is used in the form of diesel, kerosene and LPG is available to us at a huge subsidy from international market rates. The OMC – Indian Oil, Bharat Petroleum and Hindustan Petroleum were losing INR 18.11 per litre of diesel, INR 28.33 per litre of kerosene and INR 315.86 per 14.2 kg of LPG cylinder – before the recent hike. This loss burden is shared to the extent of 33% by upstream companies (ONGC, Oil India & GAIL), and the remaining by Government of India through Oil Bonds and the OMCs.

Another worrying factor is that subsidized oil prices have led to diversion and wasteful consumption of certain petroleum products. Due to artificially depressed prices for diesel, the demand for industrial products such as FO, LSHS, Naphtha, and LDO has been partially substituted with increased consumption of diesel by certain industrial consumers in sectors such as cement, coal, steel, and mining etc. for captive power generation. 

The Impact

The cumulative weight of diesel, kerosene, and LPG in the Wholesale Price Index is about 6.3%. With the upward revision in prices last week, headline WPI inflation will increase by about 65-70 bps (direct impact) over Jun-Jul 2011. Apart from this the transporters will feel the pinch from the hike in diesel prices and will pass on the cost to the users causing inflation to rise by approximately another 20-30 bps indirectly.

The price hike can be considered a bold move given the fact that the government would be taking a hit on the fiscal deficit for FY12 after its move to reduce taxes which will give benefit to the oil PSUs to the tune of INR 49,000 crores. With expected oil subsidy of INR 40,000 crores in FY12 the fiscal deficit to GDP ratio is likely to touch 5.5% vis-à-vis the government target of 4.6%.

The Advantage

The advantage of the price hike would be first and foremost in terms of reducing the losses of the oil companies. Moreover the step by government to increase the prices amidst so much opposition can be taken as a feeler that the government is willing to break the decision inertia, which is most certainly expected to improve the market sentiments and confidence in the government. Also the move towards price hike and deregulation is expected to create level playing field for private players. Not only on the downstream front, but also on the upstream side, price deregulation would attract huge investments in the refineries.

Way Forward

Swaminathan S. Anklesaria Aiyar in one of his articles, proposes to revive the Oil Pool Account (OPA), which in the 1980s and 1990s smoothed fluctuations in product prices.  When price control imposed losses on oil marketing companies, they got compensating cash from the Oil Pool Account (OPA). If, however, world prices dropped below the controlled Indian price, the surplus went into the coffers of the OPA. A similar situation occurs today when the prices of crude oil are on a decline and creation of an OPA account would help in creation of surplus if the government doesn’t gives in to pressure to reduce oil prices.

Further there is a need for phased abolition of subsidies as advocated by Kelkar committee in 1990s. The recommendations of the committee have not been implemented till date because of political reasons and for appeasing the masses. Learning can certainly be taken from countries that implemented oil price hike/deregulation and took steps to mitigate the effect and protect the poor.

There is a strong need for oil price hikes to be taken more rationally and at the same time stronger and sincere efforts from government to implement measures to soften the impact of price hikes. A necessary evil it is, to be managed and never to be let out of sight.

A more detailed discussion paper can be downloaded from the Downloads section of the blog.