Month: December 2014

What central banks can learn from the Indian cricket team

BCCI

A few days back, a list of thirty probables who could make it to the Indian cricket team for the 50 over cricket World Cup scheduled in Australia early next year, was declared. Interestingly, only four out of the 15 players who had played for India in the 2011 World Cup, made the cut.
This disbanding of the Class of 2011 led to a lot of nostalgia in the media. In one such piece published on www.cricinfo.com, the writer said: “The class of 2011 has been well and truly disbanded. Only four have made it through to the 2015 list…For the rest, all we have for now are memories.”
I sincerely feel that instead of being nostalgic about the entire thing we should be happy about the situation. The selection of players is just about the only thing that is currently right about Indian cricket, which remains surrounded by a whole host of controversies.
The players who did not perform over the last few years (the likes of Virender Sehwag, Gautam Gambhir, Zaheer Khan, Harbhajan Singh, Munaf Patel and Piyush Chawla who played in the 2011 World Cup) have fallen by the wayside and have had to make way for a new set of players.
And that is how any market should operate. The non-performers need to be weeded out and not rescued. Nevertheless, that is not how the world at large operates. A great example of this are the financial firms all over the world, which had to be rescued by central banks in the aftermath of the financial crisis that started in September 2008, around the time the investment bank Lehman Brothers went bust.
As Nigel Dodd writes in The Social Life of Money: “Since the collapse of Lehman Brothers in September 2008, the world’s major central banks have been plowing vast quantities of money into the banking system. The U.S. Federal Reserve has made commitments totalling some $29 trillion, lending $7 trillion to banks during the course of one single fraught week…The U.K. government has committed a total of £1.162 trillion to bank rescues. The European Central Bank has made low-interest loans directly to banks worth at least €1.1 trillion.”
Scores of financial institutions across the United States and Europe were bailed out, nationalized, or simply merged to ensure that they continued to survive. If these financial institutions had not been rescued, the trouble would have spilled over to other financial institutions and from there to the general economy. This would have had a negative impact on the economic growth of the countries which they belonged to. Hence, it was necessary to rescue them. This was the explanation offered by central banks and governments which came to their rescue.
Soon after the central banks came to the rescue of financial institutions a quotation “supposedly” from Karl Marx’s Das Capital went viral on the internet: “Owners of capital will stimulate the working class to buy more and more of expensive goods…until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism.”
As Dodd puts it: “The passage appeared on countless blogs…The quotation was a fake.” Nevertheless, whoever wrote it summarised very well how things had turned out in the aftermath of the financial crisis.
The move to rescue financial firms all over the world built in a huge amount of moral hazard into the financial system. As economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
Moral hazard, other than encouraging the insiders of the financial system to take on increased risk gives them the impression of the financial system being a safer place to do business in than it actu­ally is. This is because the financial firms assume that in case of a crisis, the government(s) will come to their rescue. And this is not good for the financial system as a whole.
Interestingly, in the aftermath of the financial crisis, the American government passed the Dodd–Frank Act. The Act, prohibits government bailouts and the form of support that the Fed used to bailout AIG and other financial institutions. In fact, when he signed the bill into law, Barack Obama, the President of the United States said: “The American people will never again be asked to foot the bill for Wall Street’s mistakes.” He went on to add that in the time to come, there would be “no more taxpayer-funded bailouts.”
But former Federal Reserve Chairman, Alan Greenspan, does not buy this at all. In his book The Map and the Territory, Greenspan writes that “most of the American financial system would be guaranteed by the US government,” in the event of the next crisis. He explains his reasoning through an example.
On May 10, 2012, J.P. Morgan, the largest bank in the United States, reported a loss of $2 billion from a failed hedging operation. The loss barely reduced the bank’s net worth. And more than that, the shareholders of the bank suffered the loss and not its depositors. Nevertheless, the loss was considered to be a threat to the American taxpayers and Jamie Dimon, J.P. Morgan’s CEO, was called to testify before the Senate Banking Committee. Why did this happen?
As Greenspan writes: “The world has so changed that this…loss was implicitly considered a threat to taxpayers. Why? Because of the poorly kept secret of the marketplace that JPMorgan will not be allowed to fail any more than Fannie and Freddie have been allowed to fail. In short, JPMorgan, much to its chagrin, I am sure, has become a defacto government sponsored enterprise no different from Fannie Mae prior to its conservatorship.”
Fannie Mae and Freddie Mac were government sponsored financial firms which the United States government had to take over in early September 2008. Greenspan further points out that: “When adverse events depleted JPMorgan’s shareholder equity, it was perceived by the market that its liabilities were effectively, in the end, taxpayer liabilities. Otherwise why the political umbrage and congressional hearings following the reported loss?”
To conclude, this also explains to some extent why global financial firms have been borrowing money at rock bottom interest rates, and investing them in “risky” financial markets all over the world. They know that if things go wrong, the central banks and the governments are likely to come to a rescue.
As Anat Admati and Martin Hellwig write in The Bankers’ New Clothes: “It is very difficult for governments to convincingly commit to removing these guarantees. In a crisis it will be even more difficult to maintain this commitment and provide no support to institutions that are deemed critical for economic survival. Once a crisis is present, it may even be undesirable to do so, because letting banks fail in a crisis can be very damaging.”
Or as the Americans like to put it “You ain’t seen nothin’ yet”.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on December 10, 2014

Lessons from the collapse of SpiceJet


SpiceJet_Boeing_737-900ER_Vyas-1
Vivek Kaul

In June 2010, Kalanithi Maran took over SpiceJet. I wrote an article around the takeover, in the newspaper I used to work for at that point of time, starting with the line “It takes a brave man to buy an airline.”
Towards the end of the article I quoted Warren Buffett. This was something the Oracle of Omaha had written in his annual letter to Berkshire Hathaway shareholders, in February 2008. As Buffett wrote: “Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
What made Buffett say this? “The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt,” wrote Buffett.
After a shorter version of this piece of wisdom from Buffett, I closed the article on SpiceJet, with the line: “Surely, Maran knows what he is up against.” As it has turned out, I was hoping against hope. SpiceJet is now in major trouble and has had to scale back its operations.
Between October 2013 and September 2014, the company faced losses of Rs 928.9 crore. During the period July to September 2014, the company made losses of Rs 310 crore. This, despite the fact that global oil prices fell during the period.
In the last few months the airline has also used what aviation industry insiders term as the “Christmas tree” option. This essentially means that the airline is taking out spare parts from its aeroplanes and using them for other planes in its fleet. Long story short: it doesn’t even have the money to pay for spare parts.
The commercial aviation business is a huge cash guzzler and has led many a capitalist to his ruin—Vijay Mallya being the latest such example. And as things currently seem Maran’s SpiceJet seems headed that way.
This is not only an Indian phenomenon, it seems to be the case globally. Economist Severin Borenstein examined the scenario in the United States in a 2011 research paper. He found that the airlines had lost around $60 billion (2009 dollars) between 1978 when the aviation sector in the United States was deregulated and 2009. High taxes were a reason for the losses and so was the fall in demand after 9/11.
A February 2014, article in The Economist suggests that profits margins of airlines have been less than 1% on average over the last 60 years. This makes me wonder why do businessmen still want to enter this sector?
Interestingly, airlines made a profit of only $4 per passenger in 2012. Another interesting study carried out by McKinsey points out that in 2010, around $500 billion of capital was invested in the airline industry. The overall cost of capital for this stood at around 7-8%, whereas the return on invested capital was at 2.8%. No wonder investors constantly lose money on airline stocks.
What this tells us is that commercial aviation is a tough business to be in. And why is that the case?There are several reasons for the same:
a) It is a highly capital intensive industry.
b) There is a lot of competition.
c) It gets impacted by a lot of things that are not under its control (the overall economic sentiment, taxes, outbreak of illnesses, price of oil and so on)
d) While the industry has to face a lot of competition, the industries that airlines have to deal with are highly monopolistic. As an article in The Economist puts it “Two firms—Airbus and Boeing—provide the majority of the planes, and airports and air-traffic control are monopolies.” Given this, airlines are not always in the best position to control their costs.
e) For a very long period of time, airlines were run by governments, and hence, profit was not the only motive. Over the last few decades, the world has seen a spate of low cost carriers being launched. These airlines have given tough competition to full service carriers.
These are general reasons as to why airlines find it tough to make money. Some of these reasons apply to SpiceJet as well. But there are other major reasons as to why the airline is in trouble. Unlike Vijay Mallya’s Kingfisher which was confused about being a full service carrier or a low cost airline, SpiceJet was always a low cost airline. There was no confusion on that front.
But like Mallya, aviation is not Maran’s primary business. His primary business is spread across television channels, a cable TV distribution network and newspapers in the state of Tamil Nadu and the other Southern states. Further, these businesses have always had the political protection of the DMK party (Maran is the grand-nephew of DMK boss M Karunanidhi).
Maran’s lack of experience in the aviation sector started to come out as soon as he took over the airline. After taking over the airline he went around installing his own people to run the place. As a report in the Business World points out “With the change in ownership, everyone at the airline knew that the chief executive officer and chief financial officer would change…The replacements on the board were largely Maran’s own family members and trusted aides but not necessarily people with experience of running a business — leave alone an airline.”
The airline also saw a steady exit of employees who knew how the aviation business operated. Another major blunder committed by the airline was allowing IndiGo to capture the slots in the Delhi-Mumbai route, left vacant by Kingfisher, after it stopped flying.
As the Business World report referred to earlier points out “SpiceJet had roughly six to seven flights a day between the two metros and IndiGo had around seven to eight. Today, IndiGo has close to 15 flights between the two metros. Delhi-Mumbai drives the aviation business in India and accounts for almost 60 per cent of traffic in the country.”
This was more because of the lack of experience of running an airline than anything else. Moral of the story: It is one thing running a business with the protection of a political party and it is another thing running a business which has some semblance of competition.
To conclude, what the failure of airlines like Kingfisher, Air India and now SpiceJet, clearly tells us is that you cannot “also” be in the commercial aviation business. Mallya found this out the hard way. He also ran an airlines business, along with his primary liquor business, real estate business and some sports business. Maran seems to be headed Mallya’s way with his huge losses. The government owned Air India continues to accumulate losses, in a country where Railway infrastructure remains very poor. A report in the Mint newspaper points out that combined losses of airlines in India over a period of seven years ending March 2014, stood at close to $8.6 billion.
What a mess!

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 9, 2014

RBI must ensure that interest rates remain greater than inflation

RBI-Logo_8Vivek Kaul

The Raghuram Rajan led Reserve Bank of India (RBI) has now more or less made it clear that it is likely to start cutting the repo rate from early next year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay on their fixed deposits and hence, charge on their loans.
The question to ask now is by how much will the RBI cut the repo rate by, as and when it does start to do so. The answer to the question is not very straightforward. As ex Federal Reserve chairman Ben Bernanke said in a speech December 2004, when he was a governor of the Fed, “If making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”
Keeping this analogy in mind, let’s look at the accompanying table. Take a look at the green line and the red line.
VivekChart
The green line is the inflation as measured by consumer price index. The red line is the average interest rate which the government has been paying on the money it borrows. In 2007-2008, the green line went above the red line and that’s how things stayed till 2013-2014.
What does this mean? This means that the government managed to borrow money at a rate of interest that was lower than the rate of inflation. Or as an economist would have put it, the government managed to borrow money at a negative real rate of interest.
As can be seen from the table, the difference between the rate of inflation and the average interest at which the government managed to raise debt was significant. Since the government was offering a lower rate of interest, it set the benchmark low. Even though banks had to borrow at a rate of interest higher than that of the government, it was still lower than the prevailing rate of inflation between 2007-2008 and 2013-2014.
This is how things have stood over the last few years. The situation has been reversed only over the last few months as inflation as measured through the consumer price index has fallen dramatically. And for the first time in many years, the rate of interest offered by banks on their fixed deposits is actually higher than the rate of inflation. The country has had to pay a huge cost for this scenario. The household financial savings have fallen dramatically over the last few years. The household financial savings rate was at 7.2% of the gross domestic product in 2013-2014, against 7.1% of GDP in 2012-2013 and 7% in 2011-2012. It had stood at 12% in 2009-2010. Financial savings did not exactly collapse because people ultimately need to save some money, but they came down nonetheless. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
When individuals figured out that the interest rates offered on fixed deposits were lower than the rate of inflation, they started to looked at other avenues of investments where they could earn a higher return. One such avenue was gold. As the 2012-2013 Economic Survey had pointed out “The last three years have seen a substantial rise in gold imports (the value of gold imports increased nine times between January 2008 and October 2012)…Gold imports are positively correlated with inflation.”
Money invested in gold is essentially locked up. It is not available in the financial system to be loaned out. Further, the rise of Ponzi schemes was also linked to the era of high inflation. People moved their money into Ponzi schemes which promised a slightly higher rate of return than fixed deposits did. Money moved into real estate as well.
Given these reasons, it makes sense for the RBI to make sure that interest rates continue to be higher than the rate of inflation. This is one way of ensuring that household financial savings which have fallen dramatically over the last few years, start building up again. Also, this is one way of ensuring that money does not get locked up in the blackholes of gold and real estate, or is invested into Ponzi schemes.
So, this brings us back to the question, what should the repo rate cut be like? It actually depends on where the rate of inflation is in early 2015. RBI’s prediction is of consumer price inflation being at 6% in March 2015.
As Chetan Ahya and Upasana Chachra of Morgan Stanley write in a research note titled RBI Policy – Fight Against Inflation Over, Rate Cuts to Come: “We expect the central bank to follow a framework of keeping positive real rates to the tune of ~150-200 basis points[one basis point is one hundredth of a percentage]. As such, the key determinant of the magnitude of nominal rate cuts will be where inflation settles on a sustainable basis. In our base case, we expect inflation to reach the 6% level on a sustained basis by Mar-15 (same as the RBI). We thus assume 50bps policy rate cuts in 2015 in our base case.”
If the inflation falls to below than 6% then the rate could be higher.
To conclude, wherever the inflation lands up, the RBI must make sure that interest rates are higher than that.

The article originally appeared on www.FirstBiz.com on Dec 5, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

What India Inc needs to understand about interest rates

CII_Logo

Vivek Kaul


Big business has been after the Reserve Bank of India (RBI) to cut the repo rate or the rate at which the central bank lends money to the banks.
There seems to be a certain formula to the whole thing. Before any monetary policy the business lobbies make a series of statements asking the RBI to cut interest rates. And when the RBI does not cut the repo rate, they make another series of statements explaining why the RBI should have cut the repo rate.
The belief is that a cut in the repo rate will lead to banks cutting the interest rates at which they lend. The statements made by the business lobbies normally try to explain how a cut in interest rates will lead to people borrowing and consuming more and companies borrowing and investing more. The RBI hasn’t entertained them till now.
In the monetary policy statement released on December 2, 2014, the RBI said that it might start cutting the repo rate sometime early next year.
The business lobbies immediately issued statements expressing their disappointment on the RBI not cutting the repo rate. Confederation of Indian Industries (CII), one of the three big business lobbies, said in a statement: “At this juncture, even a symbolic cut in policy rates would have sent a strong signal down the line that both the government and the RBI are acting in concert to harness demand and take the economy to the higher orbit of growth.”
The phrase to mark here is harness demand (which I have italicized). As explained earlier the logic is that when the RBI cuts the repo rate, banks will cut their lending rates as well and people will borrow and spend more. This will mean businesses will earn more and will lead to economic growth.
Only if it was as simple as that: .
As John Kenneth Galbraith writes in The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount.
Let’s understand this through an example. An individual decides to take a car loan of Rs 4.5 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,672. Now let’s say the RBI decides to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage).
The bank works in perfect coordination with RBI (which is not always the case) and decides to cut the interest loan on the car loan by 50 basis points to 10%. The new EMI now stands at Rs 9,561 or around Rs 111 lower.
If the interest rate is cut by 100 basis points to 9.5%, the EMI falls by around Rs 221.5. Hence, a nearly one tenth cut in interest rate (from 10.5% to 9.5%) leads to the EMI falling by around 2.3% (Rs 221.5 expressed as a percentage of Rs 9,672, the original EMI).
Now will people go and buy cars just because the EMI is Rs 111 or Rs 221.5 lower? Obviously not. People spend money when they feel confident about their economic future. And that is not just about lowering interest rates.
For loans of smaller ticket sizes (consumer durables, two wheeler loans etc.) the difference between EMIs when interest rates are cut, is even more smaller. Hence, the logic that a cut in interest rates increases borrowing, isn’t really correct. As Galbraith puts it: “During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
What about the corporates? The business lobby CII felt that if the RBI had cut interest rates it would have “improved the poor credit offtake by industry”. In simple English this means that corporates would have borrowed and invested more, only if, the RBI had cut the repo rate.
But is that really the case? As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.”
But that doesn’t really happen. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low [the emphasis is mine],” Galbraith points out.
The last sentence in the above paragraph summarizes the whole situation. And it is difficult to believe that corporates do not understand something as basic as this.
This was also pointed out in a recent research report titled Will a rate cut spur investments?Not really, brought out by Crisil Research. (I had referred to this report in detail on an earlier occasion).
In this report it was pointed out that investment growth in fiscals 2013 and 2014 fell to 0.3%, despite negative real interest rates (repo rate minus retail inflation). The real interest rate during the period was at minus 2.1%, whereas the real lending rate was only at 2.8%.
In contrast for the period between 2004 and 2008, had a real interest rate of 7.4%, and the average investment growth stood at 16.4% per year, during the period. Why was that the case? “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out.
This is precisely the point Galbraith makes— Business firms borrow when they can make money and not because interest rates are low.
To conclude, Indian businesses seem to have great faith in monetary policy doing the trick, when there are too many other factors holding back growth (I haven’t gone into these factors partly because they are well known and partly because that’s a separate column in itself).
Indian businessmen are not the only ones who seem to have great faith in monetary policy. This is a trend that is prevalent throughout the world. The central bankers are expected to use monetary policy and come to the rescue of the beleaguered economies all over the world.
Where does this faith stem from? Galbraith explains this beautifully in The Affluent Society: “There is no magic in the monetary policy…[It] is a blunt, unreliable, discriminatory and somewhat dangerous instrument of economic control. It survives in esteem partly because so few understand it…It survives, also because active monetary policy means that, at times, interest rates will be high – a circumstance that is far from disagreeable for those with money to lend.”

The article appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 8, 2014

Of BJP and Congress: Why governments hate markets

light-diesel-oil-250x250Vivek Kaul

Over the years I have come to the conclusion that governments don’t like markets. Markets are too unpredictable for their taste. And they don’t do what the government wants them to do. They don’t move in directions the government wants them to. In short, markets can’t be controlled. Or to put it even more simply, markets have a mind of their own.
And no government likes that.
Hence, when the diesel price was decontrolled in October earlier this year, I had my doubts about how long will it last. The finance minister Arun Jaitley had said on that occasion “Henceforth, like petrol, the price of diesel would be linked to the market and therefore depending on whatever is the cost involved …the consumers will have to pay.”
At times things sound too good to be true. This was one of those statements. And now only a few weeks later, the government has sideline the market and decided to go about setting the price of petrol and diesel.
Earlier this week on December 2, 2014, the government decided to raise the excise duty on petrol and diesel. This was the second time the government increased the duty in less than a month. The excise duty on petrol was increased by Rs 2.25 per litre and that on diesel by one rupee per litre.
This increase in duty will not be felt at the consumer level. Nonetheless, if the government had not decided to increase the duty it would have meant that consumers would have benefited from a further fall in the price of petrol and diesel. Hence, the government is essentially creaming off the consumer surplus.
This also explains why the price of petrol and diesel in India hasn’t fallen as much as the global oil prices have. And that means the petrol and diesel prices are no longer linked to the market, as Jaitley would have had us believe only a few weeks back. As an editorial in the Business Standard points out: “If the government is forcing the oil marketing companies to set prices according to the dictates of political masters, then it can hardly claim deregulation has happened.”
The government is having a tough time meeting its expenditure and this is a very easy way to raise its income. The fiscal deficit for the first seven months of this financial year (April to October 2014) was at 89.6% of the annual target. Last year during the same period, the number was at 84.4%. Fiscal deficit is the difference between what a government earns and what it spends.
Hence, if the government has to meet its fiscal deficit target it has to increase its income or decrease its expenditure or possibly do both.
An editorial in The Indian Express points out that the two hikes in excise duty, will help the government earn an additional Rs 10,000 crore. This should come as a welcome relief for the government given that estimates now suggest that indirect tax collections will see a shortfall of around Rs 90,000 crore in comparison to what had been assumed at the time the budget was presented in July this year.
The editorial goes on to suggest that instead of increasing the excise duty the government could have levied a cess and collected that money to go towards a specific purpose like a national highway fund. But that hasn’t happened and the increase in the excise duty will just disappear into the consolidated fund of India.
But that’s just one part of the story. Every government has the right to increase or decrease taxes, after taking into account the situation that it is operating in. Nevertheless, if the government had allowed the market to operate, the oil marketing companies would have been allowed to pass on this increase in excise duty to the end consumer. The fact that they haven’t been allowed to do so means that the government is deciding on the price of petrol and diesel.
Further, now that the government has decided to set the price of petrol and diesel, it will be interesting to see what happens when the price of oil starts to go up again (That may not happen immediately with Saudi Arabia looking determined to drive down the price of oil to make US shale oil unviable, but its a possibility nonetheless).
The previous Congress led United Progressive Alliance(UPA) government did not allow the oil marketing companies to sell petrol and diesel at a price which was viable for them.
Instead, the government along with the upstream oil companies like ONGC and Oil India Ltd, compensated the oil marketing companies for their “under-recoveries”. This drove a huge hole into the government finances. The total oil subsidy bill during the period the Congress led UPA government ruled the country was a whopping Rs 8,30,000 crore. This along with other subsidies pushed up the government expenditure and in the process its fiscal deficit.
Once the government was borrowing more, it crowded out other borrowers as there was a lesser amount of money available for others to borrow. This pushed up interest rates. It also led to a rupee crisis between late May and August 2013, when the value of the rupee crashed against the dollar.
It had other repercussions as well. But before we get into that it’s important to repeat what Henry Hazlitt writes in Economics in One Lesson: “We cannot hold the price of any commodity below its market level without in time bringing about…consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are tempted to buy, and can afford to buy, more of it.”
This is precisely what happened in India. The demand for diesel went up because for a very long period of time the government completely delinked diesel prices to international oil prices. Hence, there was a substantial difference between the price of petrol and diesel. This led to a huge market in diesel cars. Given this, rich consumers ended up consuming more than their fair share of diesel.
As Hazlitt writes in this context: “Unless a subsidized commodity is completely rationed, it is those with the most purchasing power than can buy most of it. This means that they are being subsidized more than those with less purchasing power…What is forgotten is that subsidies are paid for by someone, and that no method has been discovered by which the community gets something for nothing.” So, while the rich went around in their diesel cars, the nation ended up with a huge subsidy bill.
Like the Congress led UPA before it, the current BJP led National Democratic Alliance (NDA) has decided to set the price of petrol and diesel and not leave it up to the market. There will be great pressure on the government to hold back the price of petrol and diesel, once oil prices start to go up again. And that as we have seen can be disastrous for the economy. 

The article was published on www.equitymaster.com on Dec 5, 2014