The central bank has repeatedly asked the Centre to mitigate fuel prices’ inflationary impact. Who will blink first?
This is not the first time in recent memory that the central bank and the Union government have held seemingly divergent views on important issues related to the Indian economy
Finance Minister Nirmala Sitharaman was in Mumbai last month and concluded her two-day visit by addressing a press conference. Initially, there were a slew of questions about the recently-announced National Monetization Pipeline (NMP) and the criticism that surfaced following the scheme’s announcement. She fielded these with rehearsed ease, at times, pulling out a document and waving it at eager press photographers while lashing out at the opposition.
Then came a few questions on elevated fuel price and what the government was doing to contain it. Just a few days prior to the Mumbai press conference, Sitharaman had indicated that slashing central government taxes on fuel was not a viable proposition. The government had repayment obligations on the oil bonds that had been issued during the tenure of the previous Congress-led government, she had claimed.
“Previous government(s) have made our job difficult by issuing oil bonds. Even if I want to do something, I am paying through my nose for the oil bonds," she was quoted as saying by PTI on 16 August. On 25 August in Mumbai, she reiterated her stand. The Mumbai meeting with the press was the second time in two weeks when Sitharaman had to parry pointed questions about rising oil prices.
In response to the final question thrown at her, Sitharaman merely smiled and left with a curt ‘thank you’.
Sitharaman’s statements highlight the government’s reluctance to cut fuel prices despite mounting public criticism. Interestingly, the position is also in direct conflict with the Reserve Bank of India’s (RBI) monetary policy committee (MPC). The committee, which meets every two months, has repeatedly highlighted the need to lower fuel prices in order to contain inflation.
For instance, the MPC said in its statement on 6 August that “with crude oil prices at elevated levels, a calibrated reduction of the indirect tax component of the pump prices by the Centre and (the) states can help to substantially lessen cost pressures".
Experts are quite unequivocal in their dismissal of the argument that oil bonds are a major impediment. In effect, oil bonds are promissory notes issued by the government to compensate public sector oil marketing companies (OMCs) in lieu of cash for offsetting losses. Issuing bonds was a common practice when the government used to fix petrol and diesel prices. When crude oil prices skyrocketed, oil companies would sell fuel to customers at a loss. They would then get compensated by the government through oil bonds that could be redeemed at a later day (15-20 years).
As of March 2014, the total outstanding value of oil bonds stood at ₹1.34 trillion. By March 2015, it came down to ₹1.3 trillion and has stayed at this level till March 2021. No oil bonds matured between March 2015 and March 2021. Annual interest amounting to ₹9,990 crore, however, had to be paid.
Thus, during the six-year period that the National Democratic Alliance regime has been in power, the government has paid ₹59,940 crore interest on these bonds. During the same period, it has earned ₹14.6 trillion as excise duty on petroleum products. According to oil company officials, central excise duty is contributed largely by petrol and diesel.
India’s retail price for petrol is currently among the highest in the world in terms of US dollar per litre. Care Ratings has an interesting take on how to realistically gauge comparative petrol prices across different countries. The rating agency believes that a comparison with the price of a staple item such as milk is more appropriate. This comparison shows that, in India, the ratio of petrol price to milk ($ per litre for both) is the highest in the world—1.91.
“Milk is a unique commodity which is consumed everywhere. In India, it has the feature of witnessing a constant increase in price every year, and unlike other perishables where prices can move down when there is excess supply, it is not the case with milk," Care Ratings said in a report on 8 July.
MPC member Shashanka Bhide also believes that one of the key drivers of the present inflation is the price of fuel. As per the minutes of the latest MPC meeting, Bhide highlighted how the year-on-year inflation in consumer price index (CPI) for fuel is up from 4.4% in March 2021 to 12.7% in June 2021. “The sharp rise in the prices of fuels used for transportation feed into core inflation through transportation services prices," Bhide said.
The belief among a section of economists is that while inflation might ease in the coming months, there is very little room for the government to cut fuel prices. Simply put, a substantial amount of revenue is involved (the Centre mopped up ₹4.18 trillion in FY21 alone).
Economists, including Madan Sabnavis of Care Ratings, also say that singling out fuel among an array of items that go into the CPI basket is incorrect, especially since a slew of other commodities—from pulses to edible oil—are also recording higher inflation.
“I am against the idea of trying to slice inflation," he said. “The legislative order (to retain inflation within a 2-6% band) is that you are supposed to target headline inflation. Merely because this number cannot be addressed, attention has turned to a particular component," said Sabnavis. “Based on projections, it looks like we are looking at an inflation of 5.7% in FY22," he added.
As per the monetary policy framework, the central bank’s MPC has to maintain CPI inflation in the 2-6% range, with the median target of 4%. On 31 March 2021, the government had retained this target for the next five years (April 2021-March 2026). Therefore, keeping inflation below 6% is crucial for RBI.
India is an economy which is likely to witness above 5% inflation for extended spells, and it is fortuitous that ever since RBI started entered the targeting regime, inflation has largely remained around the 4% mark, said Sabnavis, adding that reducing oil prices will definitely bring down inflation, but it is just one component.
Tax and trade-offs
In March 2020, the government moved an amendment in the Finance Act of 2020 to raise the cap on special additional excise duty by ₹8 per litre on both petrol and diesel, taking the cap to ₹18 a litre on petrol and ₹12 a litre on diesel. This allowed the Centre to further raise duties on the two transport fuels. Many states have also increased the value-added tax (VAT) to shore up their own revenues in the wake of covid-19. For instance, last May, the Delhi government raised VAT on petrol and diesel to 30% from the prevailing 27% and 16.75%, respectively.
“Given the trade-offs, some or the other stakeholder will have to bear the cost of price adjustment—either the oil marketing companies (OMCs) or the government (Centre and states), or the consumer," said Saugata Bhattacharya, chief economist, Axis Bank.
What this essentially means is that if the public sector oil companies take a hit by lowering prices, the government will lose out on dividend income. Alternatively, if taxes are reduced and consumers benefit, there is a direct loss of revenue for the government. One school of thought believes that a reduction in the prices of fuel will increase end-use and demand, thereby offsetting some of the revenue loss. Not everyone agrees though.
“Given (the) persistent work-from-home (culture), (the) demand elasticity of lower prices would probably not be very large. The upside on consumption is limited," said Bhattacharya.
Bhattacharya suggests that one viable course of action might be to allow OMCs more flexibility in increasing the maturity dates on their crude sourcing contracts, accompanied by more aggressive price and currency hedging, This could insulate public sector oil firms against price volatility, potentially resulting in demand stability. Since this move will increase the cost of sourcing and managing risks, the government could take on its balance sheet a part of the higher hedge costs through fiscal backstops. Oil companies are allowed to hedge on two counts. Foreign exchange hedging happens on a daily basis.
“Margin hedging (or the difference between crude oil and product cracks or prices) is practised as a risk management tool by almost all oil companies. However, oil companies are not expected to hedge for making a profit as RBI does not allow that," said a senior official of an oil marketing company while requesting anonymity.
According to the official, the government needs a continuous stream of cash in a financially difficult year and petrol and diesel are easy options. Due to the volume of the business, fuel sales have become the fastest and easiest way to mop up funds for any government.
“Only when the government finds alternate means of financing its needs can we see some respite in fuel prices," the official added.
The way forward
This is not the first time in recent memory that the central bank and the Union government have held seemingly divergent views on important economic issues. In 2018, the Narendra Modi government and the central bank were at loggerheads over a clutch of issues, including the decision on relaxation of prompt corrective action norms for weak banks, the necessity of a special liquidity window for non-banking financial companies, and the transfer of surplus reserves to the government. These differences culminated in the resignation of then-RBI governor Urjit Patel.
The conflict over the surplus reserves on RBI’s balance sheet was also motivated by fiscal pressures, which were amplified by a shortfall in revenue collections. The government believed that the funds could be used to meet its fiscal deficit targets and recapitalize capital-starved public sector banks.
The matter was finally settled in August 2019 when an RBI panel led by former governor Bimal Jalan recommended a set of changes to the surplus distribution mechanism. Thereafter, in 2019, the central bank transferred ₹1.76 trillion to the government; in 2021, its surplus transfer was at ₹99,122 crore.
With economic management becoming more and more complex in an uncertain environment, experts point out that the central bank and government must use a platform such as the Financial Stability and Development Council (FSDC)—first proposed by a Raghuram Rajan-led committee in 2008—where points of conflict and difference of opinion can be ironed out.
That apart, the central bank is in constant dialogue with the government and some solution might soon emerge. Rising fuel price is also a political concern in a country where citizens are extremely price sensitive.
“Inflation is as much an eyesore for the government as it is for the Reserve Bank of India. Let us hope they are able to arrive at a policy decision that not just protects the fisc (sic) but is (also) beneficial to end-consumers," an economist said on condition of anonymity.
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