Economics behind Petrol rate hike- a critical analysis

There has been outrage among the general public about the price hike of petrol. The common man already burdened with inflationary pressures, increased petrol prices will further shrunk the real household incomes. There have been strong reactions from the opposing political parties as well as sharp reactions from the general public against the price rise. Before holding responsible anyone for this rise, let’s try to understand the economics behind this.

Rupee has been continuously depreciating for the last few weeks and has touched an all-time low of 56 to dollar. Even though the price of crude oil has not increased in the international market, the cost for the oilmarketing companies (OMC) like Indian Oil Corporation (IOCL), Bhart petroleum (BPCL) has been increasing on the account of increased value of dollar. The oil marketing companies have lost around Rs 4300 crores for selling petrol below the cost in the last six months.  Since 2010, the petrol has been deregulated and OMCs can increase the price of petrol if there is large variation in their costs.

The main reason behind increase in the petrol prices is the rise of dollar against rupee. We need to understand why rupee is depreciating against dollar like a free fall. One of the many reasons cited for the depreciation is the ongoing euro crisis. Many institutional investors have moved out their investments in euro to dollar as dollar is considered to be safe haven. In order to be safe, some investment has also moved out of India. But the euro crisis only cannot justify the free fall of rupee. If we see the other currencies like Pound, Yen, Brazilian Real, there has been no significant depreciation, in fact yen has gained against dollar considering one year time frame.

So what are the other significant reasons for depreciating rupee. One of prime reasons is our burgeoning fiscal deficit (difference between revenue and expenditure). The fiscal deficit for the year 2011-2012 stood at Rs 5,21,980 and it is targeted at Rs 5,13,590 crores for the 2012-2013. This huge deficit is primarily because of subsidy offered on food, fertilizer and petroleum. The oil subsidy for the year 2012-2013 is estimated to be Rs 43,580 crores. But we project the losses suffered by OMCs for the current year, this subsidy will come out to be Rs 1,14,000crores.

According to twin deficit hypothesis, there is strong linkage between fiscal deficit and trade deficit (imports – exports). The government’s fiscal deficit is increasing i.e. government is spending more than it is what it is earning. This is because increased expenditure is not matched by the increased tax rates. Hence, people are left with more money, out which some of the money is diverted towards the imports which results in more imports than exports leading to trade deficit. The major portion of our imports is oil. Since oil imports have to be paid in dollars, the importers need to buy dollars and sell rupee leading more demand of dollar and excess of rupee in the market. Considering the demand supply, rupee is continuously losing value; the OMCs have to shell out more rupee for same amount of oil imports.

Now if the prices of oil products are not increased, the deficit will keep on increasing further impacting our economy. An increase in price will result into fall in demand which means that fewer dollars will have to be paid for the oil imports, leading to lower trade deficit which will in turn lead to release of pressure on rupee-dollar rate.

Another effect of not increasing the prices oil products is that, government will need to compensate the OMCs for the subsidy offered. Government will finance this deficit by borrowing from the market leading crowding out of the private investment which will slow down our economic growth. It may lead to higher interest rates which will increase the common man’s EMIs.

The prices of petrol have been increased. This will have some effect on trade deficit and rupee-dollar value but in order to have more pronounced effect, the government needs to increase the price of diesel, LPG and kerosene. An increase in prices of these will help government reduce its fiscal deficit, meaning less borrowing from the market leading to more funds available for the private investment. Hence better economic growth.

In the age of coalition politics, these are harsh decisions which the government may not be willing to take. But these decisions will have to be taken, to prevent our economy from stagnation. As the saying goes “Good economics is bad politics and vice versa”, Mr Prime minister has to decide whether he is good at politics or good at economics.


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