India’s petroleum subsidy is a huge drawback for the economy. By some estimates, the off-budget “oil pool" deficit has been larger than the official deficit of the Union government. The domestic budgetary impact apart, the subsidies end up increasing imports and the trade deficit as well.

Also See: Indonesia’s Oil Production and Consumption (1986-2006) (Chart)

To see the damage that oil subsidies have done and how to reform them, it is instructive to take a look at Indonesia, which has had fuel subsidies for a long time. To begin with, in any economy, not allowing the retail price of petroleum products to rise when the price of crude oil goes up fails to check consumption. The price subsidy also reduces production and, more crucially, lowers investment in future capacity by making it unprofitable to do so.

As a result of such a subsidy, the supply-demand and production-consumption gap kept narrowing in Indonesia . Having joined the Organization of Petroleum Exporting Countries in 1961, Indonesia withdrew from membership recently, since it has stopped exporting petroleum.

Indonesia also moved to full capital account convertibility in the 1970s under the influence of the “Berkeley boys". Capital inflows (external borrowing) indirectly contributed to keeping these subsidies going and damaged its economy.

Unfortunately, India has also had fuel subsidies, coupled with liberal external borrowing, for the last 15 years. We are now paying the price, as Vivek Moorthy (“Petro pessimism about India", Mint, 10 June) has emphasized.

Also Read:Petro-pessimism about India

In Indonesia, matters came to a head during the East Asian currency crisis. Compared with the other affected countries, it suffered the most. The Indonesian rupiah dropped from 3,260 per US dollar in September 1997 to 14,800 in January 1998. Riots broke out amid rice shortages and soaring inflation. Petroleum consumption dipped in 1998 due to the fall in real incomes that year, but kept rising after that, while production kept falling (see chart). By 2000, the oil subsidy accounted for one-third of total government spending. The bulk of the subsidy did not go to the poor. Estimates are that about 49% went to industry, 33% to the transport sector, and only 19% to households.

Nevertheless, removing critical subsidies is easier said than done, and not just due to election pressures. Sharp price rises led to violent protest, even in authoritarian countries such as Myanmar. In its capital, Yangon, monks protesting a fourfold petrol price rise were shot down in September 2007. A 2006 review by the International Monetary Fund found that out of 48 emerging economies, only 16 could be classified as having liberalized petroleum pricing, while the rest were subsidizing petroleum products in some manner.

Back to Indonesia. The continuing crude oil price rises of 2004 and 2005 put a severe strain on the government’s finances and forced it to bite the bullet. The price of petrol at the pump was first raised by 29% in May 2005 and then by 114% in October 2005. Inflation almost doubled, from less than 6% in end 2005 to at least 10% in 2006. It is noteworthy that oil consumption in Indonesia, which was growing at an average annual rate of almost 3% from 2000, was flat in 2005 and dipped in 2006 (preliminary data), after prices were raised.

To mitigate the hardship due to the petrol price hike, the Indonesian government instituted a simultaneous $1.6 billion direct cash transfer programme. The programme involved disbursing $10 per month to 15.5 million families (around 62 million people), or 28% of the population, those who earn less than 175,000 rupiah per month (last month, one US dollar was 9,780 rupiah).

This is a standard textbook policy prescription: Replace a price subsidy that distorts consumption and production decisions with a cash subsidy to the poor to compensate them for the fall in real income due to the price rise. However, implementing it is a huge challenge. Undertaking a huge publicity campaign, the government used newspapers, television talk shows and notices on village announcement boards to get the message across. It distributed pamphlets and brochures with frequently asked questions to explain the cash transfer programme. Scrutiny of the programme by the media, national research institutes and NGOs ensured some transparency.

It is fair to say that the programme has been reasonably successful, allowing for moderate mis-targeting of some disbursements. In May, Indonesia again raised petrol prices by 29% and followed this up with a cash transfer programme. It is worth noting that even after this increase, the disparity between domestic and international prices was still about 50%.

The Union finance ministry should seriously consider learning about Indonesia’s programme and trying to implement such a market-based scheme. Retail energy prices need to be freed, with accompanying cash transfer to compensate the poor as and when prices are sharply increased. As consumers get used to decontrolled fuel prices, the transfers, hopefully, can be stopped.

Our economic policymakers have recklessly put far too much effort into attracting foreign debt and equity capital. They are now struggling to deal with the aftermath. Had a fraction of this effort gone into removing petroleum subsidies by offering suitable cash transfers, the Indian economy would certainly have been in better shape now.

Shyam Sanker and Vivek Iyer are second-year PGP students at IIM Bangalore. This article is based on their Contemporary Concerns Study project. Comment at