Macroeconomics Report

I. ABSTRACT

This report attempts to analyze various aspects of price movement with respect to international prices, government's subsidy burden, and deregulation of prices of petrol, diesel, LPG and kerosene and how such rise in prices would cause a downward pressure on inflation, by presenting both the factual picture and the economic logic behind them.

The four key variables affecting aggregate demand have been studied and the impact of rise in international crude oil prices has been analyzed as a part of the introduction to the report. These variables include Net Exports, Household Consumption, Government Consumption and Private Investment. The high crude oil prices have led to fall in GDP growth rate, thus causing the unemployment levels to shoot up. The RBI's conservative approach towards tackling inflation has been discussed. The report further analyses the effect of transmission of international oil prices and domestic oil price pass-through policy on major Indian macroeconomic variables. The three prime channels of transmission viz. import channel, price channel, and fiscal channel are explored.

The contribution of the petroleum sector to the exchequer of both Central and the State governments combined was 2.8 percent of GDP in 2009-10, with more than 60 percent share of the Central exchequer. Although, the direct subsidy figures vary widely from source to source, the bulk of the revenue expenditure of the Central government on petroleum consists of petroleum subsidy. The contribution of this sector through taxes to the central as well as the state governments was estimated and contrasted with the total subsidies provided by the government.

In order to assess the financial burden that may arise from rising under-recoveries of OMCs in the face of another price spiral in the international market, we extracted the projected consumption from the Kirit Parikh report (2010) that was based on two assumptions: (i) the annual average compound growth rates of petrol, diesel, kerosene and LPG during 2002-03 to 2008-09 apply to 2020-21 and 2030-31. (ii) The current level of prices set by the government will continue. The need to change the existing policy which can strike a balance between the capacity of the consumer to bear higher prices and fiscal stability of the government seems imperative.

II. RATIONALE BEHIND THE ANALYSIS

International oil prices have seen frequent sharp increases since 2002, spiking to more than $140 per barrel in mid-2008. UNCTAD (2008) calculations showed that in developed countries the fuel import bill increased from 1.6 percent of their GDP in 2002 to 3.6 percent in 2007. In developing countries, the fuel import bill rose from 2.7 percent of GDP in 2002 to about 5 percent in 2007. These ratios were estimated to amount to about 6 percent of GDP and 8 percent respectively at an average oil price of $ 125 per barrel in 2008 in the same study. In India, similarly, the net oil import to GDP ratio has gone up from less than 3 percent in 2003-04 to more than 5 percent during 2008-09. Though oil prices fell in the interim, current trends again show significant increases, with analysts predicting high oil prices in the foreseeable future (IMF 2011). Combined with the world-wide slowdown in economic activity and political instability in the MENA countries, the implications of a further rise in international oil prices could be alarming for oil importing economies.

While the oil importing countries, even large ones like India are price-takers in the international oil market, countries usually exercise discretion in passing on international price shocks to domestic prices. In India the administered price system has traditionally offered a mechanism to cushion the international price changes and achieve domestic policy objectives on inflation, growth and equity. The administered price system for oil is supported by budgetary expenditures (subsidies), even as revenues from oil constitute a significant portion of the overall revenues for the government. The pass-through policy, presently on the reform agenda, thus has important implications for the way international oil price changes impact the macroeconomy.

As the entire country, particularly the poor people, are reeling under heavy pressure of inflation, the UPA government has hiked the prices of diesel, kerosene and LPG by Rs 3 per litre, Rs 2 per litre and Rs 50 per cylinder respectively. The reasons given for this move can be broadly categorized as follows:

* The prices have merely moved in tandem with the international prices.

* The government could not take the burden for it more than what it already takes in the form of heavy subsidies for various petroleum products.

* There is a case for deregulation of prices of these three products on the lines of petrol as it is becoming unsustainable for the exchequer and the public sector oil companies who are facing 'under-recoveries' for a long time. This step is a forward movement in that direction.

* In a period of inflation, such increase in prices would bring the demand down and, hence, would put a downward pressure on inflation.

This note attempts to analyze these arguments by presenting both the factual picture and the economic logic behind these arguments. In this regard, there are four major findings. Firstly, it is found that despite deregulation of petrol, the prices in India are significantly higher than the world prices. Secondly, a large portion of the retail prices that the consumers end up paying consists of taxes levied by both the central and state governments. Thirdly, the government is heavily subsidizing the petroleum products and hence deregulation is the only way forward. In fact, we find that government's receipts through taxes are markedly higher than the subsidies that they provide on petro-products. Lastly, we address the last point mentioned above that this step would help ease inflation.

III. INTRODUCTION

International Crude Oil prices have risen steadily over the past two years. If one were to visualize the web of interactions among the relevant variables one would have to consider the Dollar Value and Volumes of Crude Oil imports, Forex rates, Household consumption, Private Investments, Government Investments and Consumption, Net Exports (Exports minus Imports), Inflation, Interest rates besides other factors like business sentiments, fiscal deficit, etc.

Aggregate Demand is composed of four components, namely Household