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Can India afford fully free oil prices?

Research suggests full decontrol can hit India's growth in the short term. With growth just about recovering, is oil price politics good for the economy?

, ET Bureau|
Last Updated: Mar 25, 2012, 07.46 AM IST
Can India afford fully free oil prices?
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Perhaps those recalcitrant allies of the Congress are right, but for the wrong reasons. The Trinamool Congress and the DMK, along with a few others, are fighting tooth and nail any move to deregulate diesel and LPG prices — all in the name of the aam aadmi.

Which means the UPA is under tremendous political pressure from within not to decontrol oil prices, but much to its delight, an “economic justification” has just cropped up.

A study — which departs from the common-sense argument in favour of market-driven oil prices — suggests that the more decontrolled oil prices are, the lower will be growth, at least in the short run.

Refreshing Logic

A National Institute of Public Finance and Policy (NIPFP) paper, authored by NR Bhanumurthy, says, “Contrary to existing beliefs, passing on oil price hikes [to consumers] has an adverse impact on growth.” Simply put, when we compare two scenarios— one of a 100% and other of a 50% decontrol of oil prices — when oil prices rise, GDP growth will be lower in the first case, at least in the short run.

The paper forecasts that even if overseas crude prices remain the same between 2012-13 and 2016-17 — a period when the Centre may gradually get rid of oil subsidies — average growth of the Indian economy may fall to 7.6% from 8.44% and average inflation accelerate by 0.7%.

The study is based on the intuition that when the government decontrols oil prices, state expenditure on subsidies will fall and if there is no increase in any other component of expenditure, lower government demand will result in lower growth. Besides, higher inflation will contribute to lower real GDP growth.

“Reducing oil subsidies per se should not be the only objective of diesel deregulation. Unless the decrease in subsidies is substituted by an increase in capital expenditure, the short-run impact on growth would be negative,” Bhanumurthy says.

Can India afford fully free oil prices?
Can India afford fully free oil prices?

The Flipside

In the long run, however, the move will lead to higher private investment and GDP growth. Kirit Parikh, chairman of the 2009 expert group on pricing of petroleum products, agrees there will be little gain from merely slashing subsidies and switching to other wasteful expenditure. He concedes that in the short run, there will be a decline in growth.

He adds: “But one has to factor in the efficiency gains that deregulation would bring via lowering distortions in fuel utilisation as well as by reducing under-recoveries by oil and marketing companies [OMCs],” he notes.

In fact, OMCs such as IOC and HPCL currently incur total daily under-recoveries (difference between the desired and actual price) of Rs 486 crore on the sale of diesel, PDS kerosene and domestic LPG.

A part of the under recoveries is financed by the government and oil PSUs and the rest borne by OMCs. As high as 60% of the under recoveries are due to diesel. Between April and January 2011-12, diesel alone contributed to more than 68% of the overall growth in petroleum products.

The ‘New’ Argument

“Once you take other factors into account, the short-run-growth impact of oil price decontrol needn’t necessarily be adverse,” says Shashanka Bhide of the National Council of Applied Economic Research (NCAER). A few others argue that postponing the decision to deregulate oil prices will only harden the crisis.

“The more we wait, the more difficult it will be to deregulate (oil) prices. One and a half years ago, the accumulated shortfall in prices was Rs 3-4, now it is around Rs 11,” says Saumitra Chaudhary, member of the Planning Commission and the Prime Minister’s Economic Advisory Council.

But then, for the government, reeling under coalition pressures, the “new” argument could well be a godsend. For the time being.

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