Fuel on Fire

Modi shouldn’t buckle under poll pressure in the wake of rising oil prices. But, had he properly used surplus rupee received during lower oil prices, situation could have been different

By Asit Manohar

The rising fuel prices in India have become a fresh tool for the opposition parties to create further headache for the Narendra Modi government. The government too looks disturbed not on the political front but on the economic front too as the rising fuel prices have caused fall of national currency by near 7 percent in last three months — a variable that can push the CAD (Current Account Deficit) that decides nation’s balance of trade.

According to a senior official in the Ministry of Finance, the CAD in percentage is likely to be around 2.5 percent of the GDP till the end of 2018-19 — a jump of near 1 percent from 1.5 percent in FY 2017-18. However, this number too looks optimistic as majority of the economists have forecasted much poor CAD than the government official. But, an international rating agency supports the government’s optimism for maintaining the CAD at 2.5 percent. A Moodys report says the current account deficit will widen, but will not jeopardize India’s strengthened external position. Higher oil prices will also contribute to a wider current account deficit, but the current account gap will remain significantly narrower than five years ago.

Moodys said, overall, we continue to assess India’s external vulnerability risk as low. We expect the current account deficit to widen to 2.5 per cent of GDP in the fiscal year ending March 2019, from 1.5 percent in fiscal 2018, driven by higher oil prices and robust non-oil import demand. But, we shouldn’t forget that Nomura and SBI has predicted CAD for the same period at around 2.8 percent while India Ratings prediction is at 2.6 percent for the same.

RUPEE FREE FALL

The Indian currency has been one of the worst performers in the Asian region, losing nearly 13 percent this year. The rupee started the week at 72.18 against the dollar on Monday, losing nearly 50 points from its last close at 71.75. The weak global trade sentiment, rising crude oil prices and higher demand for the US dollar has pulled down the value of the rupee.

Union Finance Minister Arun Jaitley attributed the rupees fall to global factors, and stressed that the domestic unit was better off as compared to other currencies. The government, however, says foreign exchange reserves are still high and that India has the capability to cushion the widening of the deficit.

In August 2018, India’s foreign reserves stood at $400.1 billion. But due to market intervention to support the falling rupee and the heavy outflow of Foreign Portfolio Investors (FPI), $ 24 billion is expected to have been flown out of the reserves since March 31, 2018.

A SBI research report says: The financial account surplus is expected to come around $59 billion, lower than previous fiscal ($91.4 billion) due to foreign portfolio outflows which have already amounted to $9.3 billion till June 18. Portfolio outflows have happened this year since the US economy and dollar started strengthening. This is expected to turn India’s overall Balance of Payment into deficit mode after 6 years, thereby implying forex (foreign exchange) reserves depletion of $16 billion (0.6 percent of GDP) in the current fiscal.

However, it doesn’t mean only Modi government has failed to handle the fuel fire in India. Various state governments have done no justice to their responsibilities towards the public in general. They have constantly enhanced the state levied VAT on petrol, diesel, LPG and other petroleum products when the global crude oil price was lower. However, when the prices skyrocketed they shied away from lowering the VAT. Some of the state (it includes BJP ruled states too) even increased VAT when the central government tried to give relief to the public by lowering the central excise levied on petroleum products.

An analysis of central and state finances shows that most Indian states are making a killing with fuel prices touching all-time highs in India. The Modi government has lobbed the ball in the court of various states to control fuel prices by slashing their respective sales tax or value-added tax (VAT) on petrol and diesel. While certain states have reasoned that any tinkering in this department would hurt their finances, a closer look at their accounts show that despite the windfall from fuel tax collections, their fiscal position has deteriorated over the years — and this, even though state fuel taxes are ad valorem and the revenues there from increase or decrease every time fuel prices rise or decline.

Of the 22 large states with the highest fuel tax collections and the Union Territory (UT) of Delhi, at least 17 have seen their VAT collections from the sale of petroleum products rise by more than 30 percent from 2015-16 to 2017-18. This was the period when the price of the Indian crude basket also started inching upwards after falling by more than half during 2014 and 2015. The price of the Indian basket of crude oil, which consists of three-fourths of sour grade Oman and Dubai and the rest the sweeter grade Brent, has risen by almost 57 percent during the period when most Indian states made a killing. The retail prices of petrol and diesel, meanwhile, have risen by a third and 48 percent respectively during the same period. The almost concomitant rise of retail fuel prices, along with the price of Indian crude, shows that Indian consumers haven’t been shielded from its impact by their state governments through reduction on taxes.

DOUBLE WHAMMY

In fact, a look at the fuel tax structures would show that some states have gone as far as increasing tax rates when fuel prices have increased and in the process have dealt a double blow to Indians. At least 13 of the 22 states have seen some form of increases in sales tax rates or VAT rates on petrol between June 2015 and September 2018. Only eight states reduced these taxes on petrol during this period while Haryana was the only state that did not tinker with the tax rates on petrol. At least five of these states saw double-digit increases in taxes on petrol. Particularly notorious were Maharashtra and Delhi, where the taxes on petrol rose by 11 percentage points and seven percentage points, respectively, during this period. Maharashtra has a dual-tax structure under which Mumbai, Navi Mumbai and Thane are taxed higher than rest of the state.

Other states that saw double-digit tax hikes on petrol during this period were Madhya Pradesh, Tamil Nadu and Assam. Surprisingly only a handful of non-BJP ruled states such as West Bengal, Telangana, Punjab and Andhra Pradesh reduced taxes on petrol during this time when fuel prices were rising due to global pressures and the weakening of the Indian rupee. The scenario was a bit different with diesel, which is electorally a more crucial commodity, considering its dominance in the transport sector and whose price rise also leads to a rise in prices of essential commodities from vegetables, milk and fast moving consumer goods.

At least six of the 21 states increased VAT on diesel in double digits. Particularly opprobrious tax increases were seen in the Delhi, Haryana, Punjab and Assam. In Haryana, tax on diesel was hiked by more than five percentage points between June 2015 and September 2018. And any cut in tax rates has been spurred by political calculations more than citizen-focussed policy making. With elections due in a few months, Rajasthan has announced a four percent cut in VAT. Andhra Pradesh and West Bengal too have announced fuel price cuts the past few days.

NO FISCAL RELIEF

The rise in fuel prices led to a windfall for all states during a period when Indian consumers were battling high fuel prices. In fact, certain states which had introduced moderate increases in tax rates saw astronomical jumps in their VAT collections from 2015 to 2018. Odisha’s collections more than doubled while Delhi, Uttar Pradesh and Rajasthan saw their fuel tax collections rise by almost a fourth. But if some states were hoping that the buoyancy in fuel tax revenues would help in narrowing their fiscal deficits, they were mistaken. Odisha’s fiscal deficit rose from 2.1 percent to 3.5 percent during this period. Maharashtra and Madhya Pradesh, two other states that had increased taxes, saw their fiscal deficit deteriorating during this period.

Tamil Nadu, which failed to reduce taxes on sale of petrol, saw no improvement in its fiscal deficit, while Bihar which had marginally increased VAT on petrol on diesel saw its fiscal deficit more than double. Clearly, for certain states that thought that they could turn around their financial fortunes by letting ordinary Indians bear the brunt of rising crude oil prices, the experiment seems to have failed miserably.

WHAT NEXT

It is especially ill-advised today because emerging markets (EMs) like India are on the edge of a financial precipice, and must take care not to fall off.

 

Some are in deep financial trouble: Turkey, Argentina, Venezuela and Pakistan. These four have terrible macroeconomic fundamentals, unlike EMs like India. Nevertheless, contagion from the sinking countries has begun spreading to all EMs, causing a flight from their currencies even as the dollar strengthens as a safe haven. The rupee is not alone: all EM currencies are sinking.

POLL PRESSURE

A clear risk exists that EMs may suffer a milder version of the economic meltdown of 2013, when the US hinted at raising interest rates. Then, the rupee went from Rs 55 to Rs 68 to the dollar, the stock markets and GDP growth crashed, and only emergency measures from RBI governor Raghuram Rajan saved the day.

At that time, the fiscal and current account deficits were very high, making India vulnerable. Today, thankfully, both the deficits are modest, although the current account deficit is rising and will soon cross the comfort line of 2.5 percent of GDP. US sanctions against Iran in November can drive oil prices much higher, worsening deficit across EMs.

To avoid a 2013-style meltdown, India must do nothing to exacerbate either deficit. Populist pre-election giveaways are common but do not win polls. Finance ministers typically produce election Budgets with freebies in their final year, yet up to three-quarters of incumbents lose elections.

Rahul Gandhi hopes to gain a few votes through his Bandh. Former Prime Minister Manmohan Singh, disgracefully, has echoed Rahul’s nonsense. But the need of the hour is a steady hand on the financial tiller to guide India through rough seas, with no surrender to populism or alarmism.

Cutting the excise duty on fuel, or restoring old subsidies, will widen the fiscal deficit while increasing the demand for imported fuel, widening the current account deficit.

Any populism on the fiscal or current account deficits can quickly snowball into falling foreign investor confidence, or even panic. The consequent exit of billions of dollars may not be as bad as in 2013, when India’s economic fundamentals were much weaker, but will suffice to sink the economy.

This will kill BJP’s election chances. Hence, even for purely electoral reasons, Prime Minister Narendra Modi must not give way to the populist demands of the opposition parties. Populism will be bad politics no less than bad economics.

Discussions on the issue on TV channels have focused on the impact of higher fuel prices on the middle class, as though they are a special class who should be subsidised by others. BJP representatives say oil revenues must be protected to invest in badly needed infrastructure. Okay, but they seem barely aware that a much more important reason is to maintain foreign investor confidence, and so, prevent a financial meltdown.

LOGIC AND TAX

Congress representatives complain that taxes on petrol and diesel were raised when the price of oil crashed after 2014. Yes, but taxes had earlier been cut by the Congress government after oil prices started spiralling in 2004, so BJP has been dead right to restore high taxes and decontrol prices. The Congress, including Manmohan Singh, seems blissful ignorant of the fragility of EMs like India today.

Some poll-bound states like Rajasthan and Andhra Pradesh have cut value added tax (VAT) on petrol and diesel. As a temporary pre-election tactic, that will not cause investor panic but needs to be reversed after the state elections.

Much less has been said in TV discussions on the falling rupee, the other reason for the Bharat Bandh. Yet, none other than former Congress finance minister, P Chidambaram, wrote a column in the Indian Express recently, titled Why India Should let the Rupee Fall.

He explained, “A weaker currency helps export growth, which has been weak in recent years.… A weaker rupee would also offset competition of cheap imports from countries like China, which could give domestic industries a much-needed boost.

“The RBI and India’s government, at present, are calm. This is a strong posture that must withstand the daily news, media pressure, lobbying and political taunting. In 2016, the RBI had been given a new mandate to meet its inflation target and maintain growth. Defending the currency at all costs isn’t part of the brief. This latest weakness will test its resolve.”

Rahul Gandhi has abandoned Chidambaram’s sage logic and gone for a populist outcry that views a strong rupee as a macho symbol rather than an albatross round the necks of exporters.

Many economists, including Shankar Acharya, Rakesh Mohan and Surjit Bhalla, have long demanded a weaker rupee to push stagnant exports. That has finally been forced on us by global events, and we should rest content with that.

Any move to try and artificially strengthen the rupee today will empty our foreign exchange reserves. That will surely convince foreign investors that it is time to leave.