New Delhi: The price of oil is fast turning out to be the biggest threat to the government’s bid to rein in the fiscal deficit in 2010-11. The recent increase in the price of international crude has come at a time of high food inflation, thereby squeezing the political space the government might have had to insulate its coming budget by increasing the retail price of petrol, kerosene or diesel.

“From a purely unknown perspective, oil is the biggest risk (to the fiscal deficit)," said Samiran Chakraborty, head of India research at Standard Chartered Bank, while identifying the factors that could cause a slippage in the fiscal deficit in 2010-11.

Graphics: Sandeep Bhatnagar / Mint

Fiscal deficit is the excess of government expenditure over revenue, which is met through borrowings. Governments typically aim to keep the fiscal deficit under control as a slippage increases their debt, which translates into higher interest rates and an adverse environment for private investment.

The danger posed by oil prices to the fiscal deficit was quantified in a 15 January report by Citigroup Global Markets, which said that assuming no change in domestic prices, every $1 (Rs46) increase per barrel of oil raises the government’s fuel subsidy bill by $1 billion. The report assumed the average price of oil in the current fiscal to be $70 per barrel and $78 per barrel the following year.

For most part of the current fiscal year, the price per barrel of the Indian basket (a mix of international crude varieties) has been low. However, an increase in oil prices over the last few weeks has sent negative signals just ahead of the next budget.

According to petroleum ministry data, the average price of the Indian basket between April and 16 January was $68.27 per barrel. Following the recent increases, the average price of the Indian basket in January was $79.11, and on four days breached the $80 per barrel mark.

A spike in commodity prices, including crude, would make macromanagement difficult, said Pronab Sen, chief statistician of India. “I don’t think you can build that (spike in oil price) into your budget, but you have to keep instruments available because that does seem like a possibility," Sen said.

In 2008-09, following a sharp surge in the price of crude, the Union government subsidized prices of petrol, diesel, kerosene and cooking gas for retail consumers, and fertilizer for farmers to the extent of around Rs95,792 crore, or 1.8% of GDP, by giving bonds to oil and fertilizer companies.

The bonds help the Union government avoid an immediate cash payment, but annual interest on the bonds and their eventual redemption would show up in the government’s budget.

One of the challenges in factoring oil into macroeconomic models is the difficulty of trying to predict the price trend. Economists with foreign banks or brokerages with international affiliations rely on forecasts made by their global commodity analysts to make macroeconomic forecasts.

When the volatility in the global crude price trend is married to the administered pricing of petroleum products in India, deficits can widen significantly in a few weeks. “The main unknown is the crude oil price," D.K. Srivastava, director of the Madras School of Economics and a member of the 12th Finance Commission, said about the risks facing next year’s fiscal deficit estimate.

In the case of crude oil, the average price of the Indian basket in December was $75.02, which rose to $79.11 in January (as of 16 January). For every dollar increase in the average price of the Indian basket beyond a threshold, under-recoveries of oil marketing companies, or the losses they tot up by selling at government-mandated prices, runs into a few thousand crore rupees.

In the current fiscal, even at an average price of $68.27, the oil companies have complained of under-recoveries of at least Rs47,000 crore, according to a petroleum ministry official who did not want to be named.?Under-recoveries?show up in the fiscal deficit because of the controlled price regime followed in the retail pricing of petrol, diesel, kerosene and cooking gas.

Public sector oil marketing companies are not allowed to pass on the increase in the price of crude to retail customers of downstream products. The under-recovery in this case is offset by the Union government, thus widening the fiscal deficit. Not everyone felt crude oil was likely to be the biggest threat to fiscal deficit estimates. One of the economists Mint spoke to said a weak monsoon posed the biggest risk.

According to D.K. Joshi, director and principal economist at rating agency Crisil Ltd, the food subsidy bill spiralling out of control on account of an inadequate monsoon was a bigger risk than crude oil prices. Joshi’s macroeconomic forecast for 2010-11 is based on oil at $70 a barrel.

Utpal Bhaskar contributed to this story.