New Delhi: In a bold political gambit, the Congress-led United Progressive Alliance (UPA) government decontrolled petrol prices and raised those of diesel, liquefied petroleum gas (LPG) and kerosene.

The decision will further stoke inflation, which is already running in double digits, and leave the alliance politically vulnerable weeks before the monsoon session of Parliament.

The long-awaited decision will help the government trim its fiscal deficit, strengthen the finances of oil marketing companies (OMCs) and promote the use of more energy-efficient technologies.

Petrol prices went up by Rs3.50 per litre, diesel by Rs2 per litre, kerosene by Rs3 per litre and LPG by Rs35 per cylinder at midnight.

Fears that higher inflation could force the Reserve Bank of India to raise interest rates earlier than expected spooked the bond market. Yields on benchmark 10-year paper opened at 7.59%, jumped to 7.68% intraday and closed at 7.65%.

Importantly, the government has retained the option to intervene if international oil prices turn volatile. Petroleum secretary S. Sundareshan said: “While the periodicity of revision in petrol prices has not been fixed as petrol is a sensitive item, in cases of extreme volatility of international prices of crude, the government will intervene."

Graphic: Yogesh Kumar / Mint

This is the second time in 13 years that a government is revisiting the idea of linking domestic and international fuel rates. India first moved towards decontrolled fuel prices in 1997, in the dying days of the United Front government. The decision was incrementally rolled back by the Bharatiya Janata Party (BJP)-led National Democratic Alliance after it came to power for the second time in 1999.

The UPA government created the context for reforms after a committee chaired by former Planning Commission member Kirit Parikh submitted its findings in February. Its key recommendations, which have been partially accepted, included complete deregulation of petrol and diesel pricing, increase in kerosene prices by Rs6 per litre and LPG by Rs100 per cylinder.

In end-April, the UPA constituted an empowered group of ministers (eGoM), headed by finance minister Pranab Mukherjee, to take up the Parikh committee recommendations. Other members of the panel were agriculture minister and Nationalist Congress Party chief Sharad Pawar, fertilizer minister M.K. Alagiri of the Dravida Munnetra Kazhagam, Trinamool Congress leader and railway minister Mamata Banerjee, roads minister Kamal Nath, petroleum minister Murli Deora and power minister Sushil Kumar Shinde.

Banerjee, Nath and Montek Singh Ahluwalia, deputy chairman of the Planning Commission, did not attend the eGoM meeting on Friday.

Banerjee criticized the fuel price hikes, but said she would not leave the ruling coalition. The BJP and the four Left parties demanded that the price rise be rolled back.

Its diminished numbers in the Lok Sabha could potentially leave the UPA vulnerable when Parliament resumes. In the 543-member Lok Sabha, the UPA has a total strength of 259. With some outside supporters, its strength goes up to 280-plus. When it regained power last year, the UPA had the support of over 300 members in the House.

Though most Congress leaders believed the move was inevitable, a section of party leaders was critical.

“The hike will definitely give rise to resentment against the government among the middle class. Having said that, what is also true is that after the hike in CNG (compressed natural gas) prices, this was inevitable," said a senior Congress leader, who did not want to be identified.

Economists believe the fuel price hikes could result in a one-time push to inflation by about 0.9 percentage point. Wholesale price inflation was 10.16% in May. But the projection by the Met department of a normal monsoon is expected to dampen inflationary sentiment.

Graphic: Yogesh Kumar / Mint

Arguing similarly, Kaushik Basu, chief economic adviser, said, “Since these changes will cause the fiscal and revenue deficits (through a reduction in subsidy payments) to decline, they will exert a downward pressure on prices."

Basu also dwelled on the reform aspect of the UPA’s decision and argued: “If there is a global shortage and the international price of crude rises, this signal will be transmitted to the Indian consumer. It will rationalize the way we spend money, the kinds and amount of energy we use, and the cars we manufacture. It is an important step in making India a more efficient, global player."

Another government official, who did not want to be identified, maintained that the move would give an impetus to companies to invest in energy efficient technologies and a shift towards public transport. “To be honest, what decontrol means in the Indian scenario is increase in cost. And energy efficiency obviously increases," he said.

Manufacturers of raw materials maintain that the increase in freight prices would force them to raise prices.

“Freight is a major cost component for cement companies and this hike will increase the cost by at least 6%. Prices may go up by Rs40 per tonne especially for regional players who use trucks for transportation. Companies may not be able to pass on the hike to consumers till the end of the monsoon, so I expect about a 25 basis points impact on cement margins," said Rupesh Sankhe, analyst at Angel Broking Ltd.

Similarly, the Railways will have to absorb an increase in operating expenses of about Rs500 crore. The total fuel bill of the Railways was Rs4,500 crore in 2009-10.

At the same time, companies such as Reliance Industries Ltd and Essar Oil Ltd will potentially be able to re-enter the business of marketing fuel products. These companies had, after initially making an entry, exited when the government reintroduced administered pricing and a subsidy regime, which was reserved only for government-owned OMCs.

“The company was earlier looking to expand its fuel retail outlets to 1,700 from 1,473 at present, by March 2011, but following the deregulation, the process of expansion would be advanced," said S. Thangapandian, chief executive (marketing) at Essar Oil.

Joel Rebello, Aveek Datta and Anup Roy from Mumbai, and Bhavna Raghuvanshi, Tanya Mendiratta, Ruhi Tewari and Rahul Chandran from New Delhi also contributed to this story.