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.