India’s Oil Subsidy Mess

It is well known that India, like several other developing countries, has been using price controls to subsidize oil. In an effort to keep the costs of the subsidy off the government’s budget, it has resorted to special “oil bonds,” which are illiquid, leading to central bank support being necessary. A couple of interesting pieces describe the resulting mess. Urjit Patel, a leading Indian economist, describes the outcomes:


“On May 30, the RBI announced a Special Market Operations (SMO) scheme…The RBI, between June 5 and August 8 in effect provided US$4.4 bn to government-owned oil companies in exchange for oil bonds (outright purchase or collateralised repo). The SMO from the perspective of the RBI is effectively a swap on the assets side of its balance sheet, specifically, rupee-denominated oil bonds for foreign currency reserves.”


“Several conclusions and observations can be made. First, the dire fiscal situation that the central government finds itself in has now sucked the RBI in its vortex, but it is to be hoped that a durable alternative mechanism will be put in place with alacrity to ensure that the SMO is not further resorted to; it can be argued that some of the hard work over the past decade to ensure that the RBI’s proximate objective for conducting monetary policy is not compromised — by getting stuffed with government paper — has been undone. Secondly, we would be hard-pressed to name another country (even among those that subsidise fuel) that has had to resort to the central bank in this manner. Thirdly, praying for international crude prices to adjust sharply downwards soon does not constitute government policy, sound or otherwise.”


A post on Ajay Shah’s blog by “Jeetendra” follows up with further analysis and an even starker conclusion:


“We started with the core problem: price controls. Then, there had to be special bonds, with a forced fragmentation of the bond market. Then, the SMO had to be created, undermining monetary and exchange rate policy. We keep scrambling from one problem to the next.”


With elections looming, there doesn’t seem to be any way the government is going to get out of the mess quickly. Raising domestic oil prices would only fuel inflation and be politically disastrous.  The only partial solution seems to be to replace the special, illiquid oil bonds with regular government bonds, taking the hit to the budget deficit explicitly. That would at least separate the central bank from the problem and allow it to conduct monetary policy more effectively. After all, running explicit fiscal deficits doesn’t have a political cost, as far as I can see. Though it may run afoul of fiscal responsibility legislation, that, too, is bearable. Better to explicitly own up to the problem of the oil shock and the need to increase the fiscal deficit, than to play accounting games that damage other institutions.

49 Responses to "India’s Oil Subsidy Mess"

  1. Anonymous   September 10, 2008 at 2:51 am

    This is why the rating agencies are so worried.It’s not just a matter of off-budget subsidies … but also the socialization of its costs (by bringing in upstream companies and refineries to share costs of under-recoveries, forcing asset sales at downstream companies, pressuring local banks to buy oil bonds, etc).Now, we also have what clearly smacks of deficit monetization – with the RBI getting stuffed with oil bonds in exch for its FX assets. The stock of net domestic assets is going up relative to FX reserves as a result of this action, and the pressure on the Rupee is increasingly structural in nature and arises mainly from fiscal channels. All of this also against the spirit, if not the letter, of the much trumpeted FRBM Act.Viewed from a historical perspective… first GoI got rid of Administered Price Mechanism (APM) in 2002-03 at which time it was widely believed that automatic price adjustments of POL products would start to measure market moves in 3-5 years.Then, with help from 11th finance commission, GoI formulated the FRBMA in 2003-04, which resulted in lower and lower budget allocations for fuel and fertilizer subsidies, which led more people to believe that greater price flexibility was just around the corner.However, by 2005-06 the Indian economy’s high growth was starting to surprise most people. And, concurrently, demand side pressures grew. Around this time the government quitely shelved the plans for more frequent (and upward) adjustments of fuel prices as it was desperate to keep prices low (and dismiss overheating theories!).When critics questioned such moves, GoI responded as it usually does… by constituting a commission! The Rangarajan commission advocated automatic price adjustments with retail prices targeted not at the import price of oil, but at the trade parity prices (as india had begun to export refined products as well). This was supposed to bring down the extent to which retail fuel prices would need to rise. However, this raised concerns about the profitability of the private refining sector which would now have to bear the brunt of the oil price differentials. In turn, it was feared that these losses may dissuade investments into a rapidly growing sector.Thus, the Rangajaran committee’s recommendations were not fully implemented. So here we are with yet another commission -the 12th finance commission- being called up to present its recommendations to slay this beast.So the question to ponder is…how many commissions does it take for India to change a light bulb?