Only big-bang diesel hike can save India from a downgrade

light-diesel-oil-250x250Vivek Kaul
Around a month back the under-recovery on every litre of diesel being sold by the oil marketing companies(OMCs) was Rs 9.29.
For the fortnight starting September 1, 2013, 
this has shot up by 30.5% to Rs 12.12 per litre. The under-recovery on cooking gas has gone up by 14.2% to Rs 470.38 per cylinder. The under-recovery on kerosene has gone up by 9.8% to Rs 36.33 per litre.
The OMCs are facing a total daily under-recovery of Rs 470.38 crore on the sale of diesel, kerosene and cooking gas. This is up by nearly 24.5% from a month earlier. The monthly under-recovery for the OMCs at the current level works out to a little over Rs 14,100 crore (Rs 470.38 crore x 30 days in a month).
So what are under-recoveries? The Rangarajan Committee report of 2006 stated that the OMCs are “are currently sourcing their products from the refineries on import parity basis which then becomes their cost price. The difference between the cost price and the realised price represents the under-recoveries of the OMCs.”
Realised price is essentially the price charged to the dealers by the OMCs. It is also referred to as the depot price. If the realised price fixed by the government is lower than the import price, then there is an under-recovery. Having said that under-recoveries are different from losses and at best can be defined as notional losses. (For those interested in a detailed treatment of this point,
 can click here).
The government has to compensate the OMCs for these under-recoveries. This is done in two ways. As 
A Citizen’s Guide to Energy Subsidies points out “a large part of these under-recoveries is compensated for by additional cash assistance from the government, while another portion is covered by financial assistance from upstream national oil companies.”
So oil producing companies like ONGC and Oil India Ltd compensate the OMCs like Indian Oil, Bharat Petroleum and Hindustan Petroleum, for a part of their under-recoveries. The government directly compensates the OMCs for a large part of their under-recoveries. This means a higher expenditure for the government.
The under-recoveries on diesel have gone by more than 30% in a period of one month. At the same time the under-recoveries on kerosene and cooking gas have also gone up significantly. This implies that the under-recoveries for the OMCs on the sale of diesel, cooking gas and kerosene, must have risen at a very fast pace.
Hence, the government will have to incur a higher expenditure to compensate the OMCs for the higher under-recoveries, in the months to come. A higher expenditure will lead to a higher fiscal deficit. Fiscal deficit is essentially the difference between what the government earns and what it spends.
If the government wants to avoid this it will have to increase at least the price of diesel, given that it makes for a significant portion of the under-recoveries. 
A few days back the government had increased the price of diesel by 50 paisa per litre.
This increase is too small to help the government control its fiscal deficit in any way. If the government wants to make a reasonable attempt at controlling the fiscal deficit, then the price of diesel needs to be raised by at least Rs 5 per litre.
It is important that the government does this to show the world at large that it is serious about controlling its fiscal deficit. The finance minister P Chidambaram and the prime minister Manmohan Singh have both recently said that whatever needs to be done to maintain the targeted fiscal deficit of 4.8% of the GDP (gross domestic product) will be done.
Just making such statements is not enough. These statements need to be backed by concrete action and raising the price of diesel by at least Rs 5 per litre would be one such action. If it is not carried out, the chances of a sovereign downgrade of India by the rating agencies will become extremely high in the months to come. This is because the fiscal deficit of the government will bloat up.
A sovereign downgrade will see India’s rating being reduced to ‘junk’ status. This would lead to many foreign investors like pension funds having to sell out of the Indian stock market as well as the bond market, given that they are not allowed to invest in countries which have a “junk” status. When they sell out, they will will be paid in rupees. In order to repatriate this money, they will have to sell rupees and buy dollars. This will increase the demand for dollars and put further pressure on the rupee. As Swaminathan Aiyar put it 
in a recent column in The Times of India “People ask me, will the exchange rate go to Rs 70 to the dollar? I reply, why not Rs 80?”
A weaker rupee will mean that our oil import bill will shoot up further. We will also have to pay more for the import of coal, palm oil, fertilizer etc. Hence, it is important that the government ensures that we do not end up in this situation. If it does allow the fiscal deficit to bloat and the rupee to depreciate, essential imports will get costlier, and that will lead to a higher inflation along with a slowdown in economic growth. It will also cause problems for corporate India, which has raised a lot of foreign currency loans over the last few years. If the rupee depreciates, companies will have to pay more rupees to buy dollars to repay their foreign currency loans.
On the flip side an increase in price of diesel will also create its share of problems. “
Prices of diesel are controlled primarily to keep a check on the cascading inflationary impact of higher freight and transportation charges on the prices of essential commodities,” A Citizen’s Guide to Energy Subsidies points out. An increase in price of diesel will immediately translate into higher food prices, which is something that the government can ill-afford given that there are many state elections due over the next few months. Also food prices are not exactly low presently (This writer bought onions at Rs 50 a kg and tomatoes at Rs 40 a kg, yesterday). The government hence has to make a choice between the devil and the deep sea.
It is also important to explain here that the diesel prices in India are not low and the government is not offering any subsidies on it to the end consumer, as is often pointed out. 
As Surya P Sethi, a formerly Principal Adviser (Energy), Planning Commission, wrote in a 2010 article in the Economic and Political Weekly “This is yet another myth that permeates…most government discourse. Petrol and diesel prices are made up of the base price for the fuel and the taxes/levies imposed by the central and the state governments.”
Data from the Petroleum Planning and Analysis Cell shows that in 2012-2013, the petroleum sector contributed Rs 2,43,939 crore to the central government and the state governments. Of this a contribution of Rs 1,17,422 crore was at the central level and the remaining Rs 1,26,516 crore at the state level.
At the central level the money came in from the cess on crude oil, excise duty, corporate income tax, dividend income to central government etc. At the state level money primarily came in from sales tax/value added tax on petroleum products.
In comparison to the total income of Rs 2,43,939 crore made by the central and the state governments through the petroleum sector, the total under-recovery in 2012-2013, came in at Rs 1,61,029 crore. Given this, there was no real subsidy on offer to the end consumers, as is often made out to be. The consumers paid more than the cost price once the various taxes and duties are taken into account.
There are several problems here. One is that the OMCs were not able to recover enough money from the selling price of petroleum products ( except petrol), which makes them viable as a going concern. Hence, they need to be compensated for their under-recoveries.
Second, the entire Rs 2,43,939 crore, did not land up with the central government. And third, the Rs 1,17,422 crore that the central government earned from the petroleum sector in 2012-2013 wasn’t specifically earmarked to be adjusted against “under-recoveries” made by the OMCs. It was a part of the general revenues that the government earned during the course of the year and could be spent against any expenditure that the government had planned to incur during the course of the year.
Given this, any under-recovery leads to a higher expenditure for the central government and thus a higher fiscal deficit. A higher fiscal deficit needs to be controlled by increasing the price of diesel.
But that does not mean that the diesel that we have been buying is subsidised.

The article originally appeared on on September 3, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)