The sharp drop in global oil prices is good news for India. The country is heavily dependent on crude oil imports to feed its growing economy. The latest data from the commerce ministry shows that India spent $55 billion in the first six months of this fiscal on oil imports; the same figure for the corresponding period of 2007-08 was close to $35 billion.

Illustration: Jayachandran / Mint

There is little doubt that a large part of this 60% increase in the oil import bill was due to the sudden rise in the price of crude oil in the global markets in the middle of 2008. The subsequent collapse in crude oil prices will slash the import bill and also offer some relief in terms of a more moderate trade deficit.

The global oil price roller-coaster and the domestic policy response to it offer several sobering lessons. The government refused to let domestic fuel prices rise in tandem with global prices, pushing oil companies into a crippling cash crunch as well as sending fuel and fertilizer subsidies sky-high.

Both these developments are cases of bad policy and misguided incentives. High oil prices usually make drilling and refining crude oil a very profitable activity, and thus create incentives for higher production and more oil prospecting. Our fuel pricing did the very opposite: It starved oil companies of funds for new drilling while encouraging consumers to keep buying relatively cheap petrol and diesel. In other words, this policy is a threat to long-term energy security.

There are similar problems in the impact on government finances. One of the most basic rules in economic policy is that deficits should shrink during good times and go up during bad times. Most Western countries have such automatic stabilizers in their fiscal policy. We saw precisely the opposite happening over the past year in India as higher fuel subsidies pushed up the fiscal deficit.

The drop in global crude oil prices provides relief on both fronts. Oil companies are now making a profit on every litre of diesel and petrol they sell. That is welcome. That fuel can now be sold at a profit means that domestic consumers are no longer subsidized, which will take pressure off public finances.

Lower oil prices are a lucky break for the Indian economy. But the experiences of the past year tell us that there are sobering policy lessons to be learnt. Fuel needs to be priced by the market rather than the government. It is risky to do otherwise.

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