This article seeks to clear the misconceptions that exist around diesel prices and their cascading effect on inflation.
Note: This article is a report based on Mr. Swaminathan Anklesaria Aiyar’s article in the Economic Times dated 2nd January, 2013.
There are several direct and indirect factors affecting inflation. The widely held belief that a rise in diesel prices will lead to a cascading effect on inflation is flawed essentially because it fails to recognise the indirect factors caused by the high fiscal deficit that the diesel subsidy generates.
Among the subsidies existing in India today, there is perhaps none that is as inefficient as the diesel subsidy. Originally targeted at the farm sector, the lion’s share of the subsidy has been cornered by the transport sector. While the farm sector accounts for a meager 12.2% of the total benefits, the transport sector takes in 67.6%. Manufacturing sector takes in 8.2% while the power sector accounts for 8.1%. The implicit oil subsidy is Rs 2,00,000 crore per annum. That essentially means that the government is spending Rs 2 lac crore to deliver benefits worth Rs 24,400 crores to the agricultural sector. This brings into focus the potential of direct cash transfer schemes to eliminate waste and multiply the precision with which subsidies are delivered. A similar conclusion may also be drawn with regard to power subsidies intended for the farm sector.
Mr. Swaminathan seeks to draw our attention toward countries without oil subsidies and their annualised inflation rates: USA – 1.76%, Germany – 1.9% and Japan – (-0.2%). Even in lower income countries: China – 2% and Philippines - 2.8%. It is also essential to bring the scale of the fuel subsidy in perspective: The flagship welfare scheme of the government, MNREGA costs Rs 33,000 crores per year as compared to the Rs 2 lac crore fuel subsidy (2% of the GDP).
The link between the diesel subsidy and inflation is drawn out by connecting the government’s fiscal deficit and the broad money supply (M3). A 1% rise in fiscal deficit raises the broad money supply by around 0.9% in Indian conditions. The money supply rises by around 1.8% due to the subsidy (Since it forces the government to borrow and then implicitly pump the money back into the economy paving the way for a rise in the money supply) and this leads to a higher sum of money chasing non-fuel products. A higher inflation leads to a depreciation of the rupee which makes fuel imports even more expensive thus worsening inflation.
A study quoted by Mr. Aiyar staes that a one shot 30% increase in the price of diesel will raise inflation by 2.3%, however, within 5 quarters raising diesel prices becomes less inflationary than keeping them static. Moreover, over 4 years, a 30% rise in diesel prices will lead to average annual inflation of 5.68%, much lower than the 7.13% if diesel prices are kept static. Four years after a 30% price hike, the WPI will actually be 5.66% lower than with a static diesel price. Moreover, a 10% rise in diesel prices will cost only Rs 2 per month more per person in the bottom rural decile and Rs 4-6 extra for the 5th decile (population divided into 10 parts on the basis of per capita income). Farmers with diesel pumps will have to spend Rs 2,500 crore. Direct cash transfers are an elegant solution to this problem.
The study estimates that GDP will be 3.86% higher, 4 years after fuel prices are raised by 30% leading to additional production worth Rs 4,00,000 crores. It will also lead to a healthier fiscal deficit which should lead to lower government borrowing. This will allow interest rates to come down naturally as well since the crowding out effect of government borrowings is eliminated. To conclude on a positive note, the government has announced its intention to raise diesel prices by Re 1 per month. If that is successfully carried out, most of the positive implications that we have noted in this article should definitely materialise.
Manan Vyas
Note: The primary purpose of this article was to spread awareness regarding the fuel subsidy and its misconceptions regarding inflation. A large portion of the analysis was adapted from Mr. Aiyar’s article in the Economic Times and I claim no credit for the research or analysis undertaken.