Pump Jack Pressure

• Firefighting is on by states to mitigate impact, but 0.5-0.7% rise in inflation is expected within weeks
  
• Industry's costs will go up, could further impact manufacturing and consumer spending
  
• Better food position, normal monsoon, fiscal measures expected to ease inflation in a few months' time
  
• If inflation doesn't start cooling, it would put immediate upward pressure on interest rates at the cost of economic growth
  
• Oil firms remain vulnerable if crude price rises above $130/barrel, no long-term strategy in place
  
• Galloping demand for petroleum products could reduce, energy efficiency could gain importance

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"The government has only taken a bite off it. You can't pile up debt. We'll have to solve it." Saumitra Chaudhuri, PM's Council

"There'll be a 0.5-0.7% rise in inflation. That will begin to decline by September." N.R. Bhanumurthy, IEG

"It won't matter much as the government keeps the domestic markets insulated." Ashima Goyal, IGIDR

"A good monsoon will ensure a downward pressure on prices of primary goods." Shashanka Bhide, NCAER

"This package will help us meet much of our under-recoveries—till it's $130 per barrel." S.V. Narasimhan, Indian Oil

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t's been a while coming. The spectre of a hike in petroleum product prices has been hanging over the UPA government for several months now. But, true to form, the government diligently built up its case over the past few weeks, fuelled by gentle murmurs and informed speculation. Suddenly, there was talk about rationing or petrol pumps running out of fuel. The sly signals finally attained the urgency of tom-toms with reports of divisions within the government on the options to bail out bleeding oil marketing companies (OMCs).

Meanwhile, global crude prices continued to scale new highs of over $125 per barrel—double from the $60 per barrel last year. The OMCs' under-recoveries—the gap between the actual subsidised selling price and the desired selling price—is estimated to be a staggering Rs 2,45,000 crore. A senior Congress politician describes the "half-hearted decision" aptly: "The government could no longer bury its head in the sand."

Yet when the "inevitable" hit came, explained by PM Manmohan Singh himself, the shockwaves were at the political boldness in raising the price of diesel by Rs 3 per litre and petrol by Rs 5 per litre, the highest ever. More surprising is the hike of cooking gas price by Rs 50 per cylinder, the steepest in a decade. It's another matter that a cooking gas cylinder still comes with a subsidy of over Rs 200. The government also restructured duties, increased subsidies and assured oil bonds worth over Rs 94,000 crore to the OMCs.

Economists and energy experts say the package is badly timed and has no long-term perspective. But Saumitra Chaudhuri, member, PM's economic advisory council, avers, "The government has only taken a bite off it. You can't pile up debt. On a continuing basis, the government will have to find a solution." Even with the present hike in retail prices, most of the burden of global volatility in crude oil prices is being borne by the government and the oil companies. Adds Ajit Ranade of Aditya Birla Management: "The price revision could have started some time earlier. Small doses of price revision would have been better for the situation overall—for the economy, industry and inflation."

The stakes are high, indeed. The polity is in poll mode. The timing of the price increase has also sent out mixed signals as various measures to tame headline inflation—currently at over 8 per cent—are yet to show results. Minister of state for PMO Prithviraj Chavan describes the package as "a balance between economic prudence and political compulsions." No wonder, within 24 hours, damage control measures were being taken by many states—like West Bengal, Maharashtra, Kerala, Bihar and Delhi—through cuts in sales taxes to minimise the burden of the hike on consumers.

The hike also raises concerns about the possible impact on an economy that is growing at the slowest pace since 2005. Despite the fire-fighting measures announced by several states—and more will follow—it will definitely have an impact on inflation. N.R. Bhanumurthy of the Institute of Economic Growth feels an immediate impact of the oil price hike "would be an additional 0. 5-0.7 per cent on the inflation rate within weeks. However, by September we can still expect some declining trend as the fiscal measures will start showing impact."

How well prepared is industry for an oil shock? Anil Bhardwaj, secretary-general of Federation of Indian Micro, Small and Medium Enterprises, feels a gradual petroleum price hike would have helped the economy adjust to it better. "Currently in a scenario of high raw material costs, the small guys will feel the heat more," says Bhardwaj. On the inflation front, he fears the "relief due to better food position will be offset by the spiralling effect of higher petroleum prices"

Though the railways have assured that no burden of the higher diesel bill will be passed on to consumers or industry, experts point out that freight rates of many products have already been hiked recently. On the road transport front too, there has been an immediate fallout. Director and principal economist of rating agency CRISIL Dharmakirti Joshi states that while the immediate impact could see inflation rate rise from 8.1 to 8.7 per cent, "the second round of effects in the coming weeks is hard to predict."

There are also fears that uncertainty due to high inflation may prove a dampener for investment plans of companies. At the same time, as the oil price hike is a global phenomenon, Indian industry is expected to get adjusted and remain competitive. For one, Ashima Goyal, professor at the Indira Gandhi Institute for Development Research, feels the economy and industry has become used to oil shocks. "Given that the government continues to keep the domestic market partly insulated from global spikes, the impact won't be too much," she says.

In general, inflation is expected to settle down within a few months—that's what the government keeps on stressing, asking for "patience". "The oil price situation is something new, but considering that the agriculture output is good, it will have a softening effect (on inflation) in the medium term," says Shashanka Bhide of NCAER. "Further, if the current monsoon is good, it will have downward pressure on prices of primary goods."

In this wait-and-watch environment, it is unlikely that the RBI will raise interest rates—even though the current inflation rates are way above its acceptable range of around 5.5 per cent. States R. Kannan of icici's Centre for Advanced Financial Studies: "Interest rates may not go up immediately—unless, the RBI mops up liquidity further to check inflation." Clearly, if inflation doesn't come down in the next three to four months, the RBI may be forced to act.

What is more worrying is that a persistent upward trend in crude prices could necessitate another review of prices within six months. Of course, it's safe to assume that no government will risk raising petroleum prices then. Says S.V. Narasimhan, Indian Oil director (finance): "This package will help us meet under-recoveries till it (crude oil price) is $130 per barrel." Unfortunately, there are few expectations that global prices will scale down appreciably. Crude prices have fallen a bit in the last few days, but global experts forecast $150 per barrel by the year-end.

The government will have to not only ensure that OMCs remain in good health, but also better target subsidies towards the real poor. Or else, the practice of diesel adulteration with kerosene, kept out of the price review, could rise. Chavan admits that several options for targeted subsidy have been explored "but the industry has failed to come up with any viable proposal". Either way, we are in an era of high-energy prices. That's why there needs to be long-term strategy to tackle this crude mess.