The Indian Economy Blog

September 2, 2008

Oil Subsidies Now Get Real

Filed under: Business,Energy,Fiscal policy,Politics — Pragmatic @ 3:34 am

Now, this one is an interesting situation. The Indian government likes to tom-tom the oil subsidy bill as a proof of its socialistic credentials; the media targets the government for unfairly subsidising the expenditure of the middle class; and most economists lay the blame at the door of the government for distorting the free market mechanism of price determination via these subsidies.

There are three duties/ taxes collected by the government on the sale of petroleum products. The state governments collect the sales tax while the excise and custom duties go into the kitty of the central government.

 

Product Excise Duty Customs Duty(%)
Crude 2500 (Rs/MT) Cess

5

Petrol Rs. 14.35/litre

7.5

Diesel Rs 4.60/litre

7.5

Now, let us take a look at the actual revenue collected by the government from excise and customs and subsidies provided via the oil bonds and direct subsidies on LPG and PDS kerosene. During the last three years:

(In Rs. Crores) 2004-05 2005-06 2006-07
Revenue from customs and Excise 54738 61221 68864
(i) Fiscal subsidy for PDS kerosene and domestic LPG 2956.34 2682.96 2606.17
(ii) Oil Bonds —- 11500.00 24121.00
Total (i +ii) 2956.34 14182.96 26727.17
Subsidy as a % of revenue 5% 23% 39%

The government has now announced that it will issue oil bonds worth Rs 94,600 crore in the fiscal year 2008-09. If the revenue collection rises at the same rate, it would be to the tune of around Rs 77,000 crore in 2008-09. The subsidy for kerosene and LPG is at around Rs 3000 crore. So, the government will suffer a net loss of nearly Rs 20,000 crore in providing petroleum products to the citizens of India. Phew! 0.4% of GDP wiped out in one go.

These figures might themselves portray a wrong picture. For the first quarter of 2008-09, the government had decided to issue bonds worth Rs 24,500 crore while estimated losses of the Oil Marketing Companies (OMC) were at Rs 52,000 crore during the period. Moreover, the government’s share of meeting under-recoveries through oil bonds is now 57% from the earlier 42.7% of the total under-realisation on fuel sale. Another 33 per cent comes from upstream companies like the ONGC, GAIL and OIL. The remaining losses are borne by the OMCs themselves.

These oil bonds are a very neat short-term solution that pledge our tomorrow for a cosy today. The interest rates at these bonds are estimated at around 8.75 to 9.5% and reports suggest that the RBI has now stopped purchasing them under the special market operations(SMO). Under the SMO, the central bank used to buy the oil bonds directly from the OMCs and pay them the equivalent amount in dollars, allowing them to buy supplies. In the current year, the interest burden on the oil bonds is budgeted at Rs 5520 crore. With the  issue of oil bonds this year, this burden will become onerous and will cost the exchequer around Rs 13,000 crore in the next fiscal.

All this will add to the burgeoning fiscal deficit this year. But the finance minister, with his wizardry, of keeping the oil bonds out of the official fiscal deficit, will still be able to peg the the fiscal deficit at 2.5% of the GDP.

The more prudent mechanism of granting statutory liquidity ratio (SLR) status to the oil bonds has also not been accepted by the government. The SLR status gives immediate relief to OMCs by way of liquidity induced by participation of bigger players like banks, gilts and mutual funds, apart from existing pension, provident fund and insurance players that trade less and hold on to the papers till maturity (around 10 years). The SLR bonds are highly secured and liquid in nature as they are sovereign guaranteed. SLR bonds are those issued by the government at market rates to fund its various borrowing activities every year. Banks are required to subscribe to them, as they are mandatory requirement stipulated by the Reserve Bank of India. Currently, banks maintain 25% of their net demand and time liabilities in SLR.

Thus, while free pricing mechanism for oil products in India remains a pipe dream, granting SLR status to oil bonds seems to be the judicious course of action. However, the bonds that typically come under SLR, or statutory liquidity obligation, form part of the fiscal deficit. The government, bound by the FRBM act, is thus avoiding the SLR status for oil bonds like a plague.

There is big trouble with this sanctimonious approach of the government towards maintaining the fiscal deficit within the stipulated target. A similar exercise at fudging the balance sheets by a corporate house would have attracted the ire of the government auditors. Keeping the ethics of governance apart, the present approach has far-reaching implications for the oil industry. OMCs will continue to bleed and the cost of burden-sharing on the part of the upstream companies will rise. Both will become victims of a serious financial crunch, which will adversely hit their plough back and investment plans.

The government, too, will not emerge unscathed. This resort to oil bonds, besides being blatantly unethical, is neither fiscally prudent nor does it tackle the problem posed by spiralling oil prices, falling growth rates and rising inflationary pressures effectively.

Update – Vikram S Mehta in today’s Indian Express asks some pertinent questions on oil pricing:

…why does the government persist in appointing committees comprised of professionals to address what is essentially a political subject? Surely they must know that no individual worth his professional salt can help the government skirt the political conundrum of volatile petroleum prices. Why does the government not now contemplate kicking the ball into the court of the politicians? After all if there is to be progress it can only be if the politicians resolve somehow the political dilemmas of oil. My suggestion is that the next committee on petroleum should comprise of politicians and should be asked to come up with bold and practical suggestions on ‘how’ to implement what everyone knows must be done.

Update 2 (September 04) – Urjit Patel, writing in the Business Standard, highlights the dangers of RBI acting as an oil spigot and contends that the scenario is emblematic of the insidious distortions in virtually the entire energy chain.

It is estimated that oil bond issuance over the current fiscal could be about 2 per cent of GDP; therefore, the money due to the oil companies from the Union government is expected to be huge for the foreseeable future. Unless there is a sharp correction in oil prices or a policy combining adjustment in domestic retail prices and reduction in government duties, the oil companies will continue to require help to source the foreign exchange to import crude oil (although the SMO has been ascribed as a temporary facility). If demand does not adjust, supply will; reports of long lines at diesel pumps in several states show that the oil companies are responding in a manner that is feasible for them. In some parts of the country, demand for diesel for generation sets has increased after the recent price hike because electric supply shortages have intensified. The whole scenario is emblematic of the insidious distortions in virtually the entire energy chain in India.

Several conclusions and observations can be made. First, the dire fiscal situation that the central government finds itself in has now sucked the RBI in its vortex, but it is to be hoped that a durable alternative mechanism will be put in place with alacrity to ensure that the SMO is not further resorted to; it can be argued that some of the hard work over the past decade to ensure that the RBI’s proximate objective for conducting monetary policy is not compromised — by getting stuffed with government paper — has been undone. Secondly, we would be hard-pressed to name another country (even among those that subsidise fuel) that has had to resort to the central bank in this manner. Thirdly, praying for international crude prices to adjust sharply downwards soon does not constitute government policy, sound or otherwise. Fourthly, the proceeds of the oil bonds upon maturity will be in rupees, hence the RBI, if it wants to rebuild official foreign currency assets to make up for the decline on account of the SMO, will have to intervene in the market at the time and buy foreign currency at the ruling market exchange rate (the central bank shoulders an exchange rate risk if rebuilding foreign currency reserves is an objective).

4 Comments »

  1. [...] [Crossposted at The Indian Economy Blog] [...]

    Pingback by Pragmatic Euphony · Oil subsidies now get real — September 2, 2008 @ 9:49 am

  2. [...] IEB has a superb post on political economy of [...]

    Pingback by Assorted Links « Mostly Economics — September 5, 2008 @ 9:43 am

  3. I would like to know that evaluating and comparing India’s Fiscal policy measure, of injecting Rs 34000 crore in the economy to push the aggregate demnad and generate employement,with China’s $586.00 billion
    and US $700.00 billion baliout plan is right??
    Keeping in view the overall decline in tax revenues,excise and custom duty.
    Moreover I want to know which are the core investment sectors where the government can invest??
    The point of concern is we, after Indo-US civil nuclear deal, are expecting to generate only 7.4% of electricity with nuclear energy.I am a bit sceptical about this future forecast keeping in mind the loopholes in electricity transmission where 40% of the electricity generated by hydro-elect pwr get waste during transmission

    Comment by Himanshu — December 27, 2008 @ 12:11 pm

  4. Proposal to raise FDI from existing 26% to 49% in Insurance setor is a right decision???

    Comment by Himanshu — December 27, 2008 @ 12:17 pm

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