India: The populist trap

Core Case

The government’s 4 June announcement of increases in the retail prices of petrol and diesel is a case of too little too late (petrol rose by 10-12 per cent and LPG by 17 per cent). The price hikes bring relief to state-owned fuel retailers that had faced bankruptcy with prospective losses (at present oil price levels) of up to Rs2.45 trillion (US$58 billion) in FY09. While averting the risk of a disastrous interruption of fuel supplies, the price rises are not large enough to make a material dent in domestic oil demand and cover only about 9 per cent of the oil marketing companies’ projected losses.

So the government has also announced the issue of additional oil bonds to these companies to cover the cost of selling cheap fuel. And true to its electoral slogan of protecting the common man, the government has chosen to offset the fuel price increase with reduced customs and excise duties on crude oil and petroleum products, thereby overruling the objections of the Finance Ministry. This will result in a revenue loss of Rs227 billion, equivalent to 4.5 per cent of the tax collection budgeted for FY09. The combined effect of the tax cut and the new oil bond issue will be a near 2 per cent increase in the fiscal deficit over budget projections.

The politics of domestic fuel pricing

The root of the problem is the Congress-led coalition’s decision to shelter the domestic economy and consumers from the take-off (since 2005) in the world oil price by all but freezing domestic fuel prices. India is not the only country suffering from record prices of oil, but the scale of its domestic fuel subsidies is materially larger than that of China, to take a particularly relevant comparison. The government’s previous price hike (in February 2008) of 3-5 per cent for petrol and diesel followed nearly 19 months without any increase whatsoever, even as global oil prices rose 42 per cent.

As the table below reveals, the Congress could have avoided the abrupt and unpopular price hike of June 2008 if it had implemented the small incremental increases that the BJP-led government introduced during its term in office. The total size of the fuel price rises approved by the Congress government is very similar to the sum of the BJP’s changes over its term (except in the case of the kerosene price, which the Congress has, in effect, frozen). Yet the increase in the global oil price has been four times greater during the term of the Congress government than during that of its BJP predecessor.

Fuel price hikes: BJP- versus Congress-led governments

Instead of following its predecessor’s example, the Congress government shelved the BJP policy (which itself was never wholly implemented) of allowing state-owned oil product marketing firms to make limited changes to fuel prices every two weeks without seeking government permission. Instead, after coming to power in 2004, the Congress party’s Petroleum Minister at the time, Mani Shankar Aiyar, announced a policy of sharing price pressures equitably among consumers (through price rises), oil product marketing companies (via lower profits) and the government (through the issuance of bonds to oil firms and consumer subsidies). That policy has proved a facade for outright populism since in practice, it has meant lots of bond issuance and company losses but few price rises.

The Congress is now paying the price for its populism. The 4 June fuel price increase was necessary to avert the political disaster of a full-blown energy crisis, but the political damage inflicted by even this inadequate increase will be bad enough in what is an election year (with key state polls scheduled and a national election due by May 2009).

Inflation is always an important determinant of voting intentions, and the closely-tracked WPI was at a seven-year high of 8.8 per cent year on year at the end of May. In any case, the Congress goes into this election season with the disadvantage of incumbency – now made worse by the effect of a fuel price-related jump in headline inflation.

The BJP – invigorated after an important election victory in the southern state of Karnataka in late May – is staging public protests against the fuel price rise, as are the government’s Leftist allies. The Congress party has responded by asking opposition parties to reduce state taxes on domestic fuel that account for around a fifth of the retail price; and some states have done so. The ruling party hopes to deflect voter anger onto other parties in opposition ruled-states where it aims to make gains in the forthcoming general election. This is a damage-control exercise, and there is no certainty that it will work.

Even now, the Congress-led government has not announced a coherent policy to deal with future oil price rises, although a Petroleum Ministry official has publicly stated that the government will revisit domestic fuel prices in four to five months. In the meantime, a committee appointed by the Prime Minister will examine, among other things, whether the oil companies are, in fact, overstating their losses.

The government’s response to a continued tough external environment – that is, the world oil price staying at the present record high levels or rising even higher – is likely to be more of the same: partial price increases accompanied by further widening of the budget deficit to dampen the unpopularity caused by those increases. This amounts to no more than continued muddling-through designed to stave off a crisis as long as possible – in other words, till the next government is sworn in by mid-2009.

In effect, the electoral timetable prevents the Congress from digging itself out of its own populist policy hole. This leads us to the main question of how this state of affairs will affect the economy and financial markets and what the longer-term prospects for effective policy remedies are.

Sudden fiscal deterioration

To start with the economy, the most serious damage of the Congress’s populist trap comes on the fiscal front. In its eagerness to minimise the pass-through of the rising world oil price to the domestic economy, the government has for all practical purposes abandoned the fiscal targets mandated by the Fiscal Responsibility and Budget Management Act. In our March 2008 budget analysis (Successful fiscal escapism), we highlighted how the government had been able to get away with its loose fiscal policy because of buoyant tax collections. This fiscal escapism is now coming unstuck.

Although the revenue side remains supported on the whole by the domestic growth momentum, the risk of an industrial slowdown – which we flagged in that same note on fiscal policy – is now materialising. In the meantime, the customs and excise tax cuts to offset the fuel price increase will hurt the central government’s revenue collections; and with many local governments announcing their own tax cuts on petroleum products to compensate for the fuel price hike, state deficits are unlikely to decrease either.

But the real problems are, of course, on the spending side. In addition to the main negative factor of the Rs946 billion in oil bonds that the government plans to issue to keep fuel prices subsidised, the state-sponsored Pay Commission has recommended salary hikes for government employees (although these have yet to be implemented), and the government has increased from Rs600 billion (US$14.1 billion) to Rs710 billion (US$16.6 billion) a farm loan waiver programme announced in the February budget. And although the exact impact on the fertiliser subsidy bill is not yet known, the cabinet approved a new policy on 12 June that will substantially lower prices of some fertilisers.

In a modest attempt to restrict the fiscal slippage, the Finance Ministry on 5 June asked all the government departments and ministries to cut back expenses to save Rs60 billion (while making clear that there would be no reduction in salaries or, of course, interest payments on all its bonds – the largest categories of spending). We estimate that the combined fiscal deficits of the states and the centre, including off-budget liabilities, will amount to no less than 8 per cent of GDP in FY09.

The prospect of a fiscal deficit in the current year of at least 8 per cent of GDP (and quite likely higher) significantly increases risks across the board. The government remains fixated on minimising the effect on headline inflation of its enforced timid retreat from the policy of freezing domestic fuel prices (if fuel prices had been raised by the entire amount required to cover the oil marketing companies’ losses, then according to the government’s own estimates the WPI would have shot up to nearly 13 per cent). But all the while, underlying inflationary pressures will be stoked by the further loosening of fiscal policy.

This points to a vicious circle where the financing of the higher deficit will crowd out the private sector and so negatively affect economic growth, in turn deterring capital inflows and putting further depreciation pressure on the rupee. In this environment, the risk of a crisis of confidence in India’s financial markets is real.

Monetary policy

The Reserve Bank of India (RBI) has responded in orthodox fashion to the government punching a big new hole in its public finances. This response took the form of a 25 bps hike in its main policy rate on 11 June. Under present circumstances, the tightening of monetary policy is important for more than just combating inflation – which the authorities in any case reckon will abate. This optimism is based on the bumper harvest in the agricultural year ending June 2008 (with food grain and oilseed output projected to rise 4.6 per cent and 16 per cent year on year, respectively) as well as on seasonal factors such as the good progress northwards of the crucial June-to-September rains and the slowdown in construction activity during the monsoon season. Still, inflation is likely to rise to more than 9 per cent in the next two months before easing to between 7 per cent and 8 per cent during the rest of the year – well above the RBI’s official target of 5.0-5.5 per cent.

From the perspective of the overall risks to confidence, rising interest rates are perhaps most important of all for defending the rupee and facilitating capital inflows. The RBI has been taking various other steps to this end, such as easing limits on domestic companies’ foreign borrowings as well as on holdings of government bonds by foreign investors. Financing from abroad will be particularly important at a time when the government’s expanding deficit financing requirement will tend to crowd out private sector borrowers in the domestic banking system.

Investment conclusion

Assuming that the RBI does succeed in preserving precarious investor confidence – and this is our base case assumption – the outlook for Indian asset markets still looks very far from rosy in the present pre-election political and policy environment. For every debt financing and IPO that gets away, several more may remain blocked.

The bottom line is that India’s financial markets now offer a binary and leveraged bet on the oil price. If the oil price were to fall back durably below $100/bbl, this would trigger a rapid reverse in the sell-offs seen in the equity market and the currency. Conversely, the combination of further oil price surges and the government’s petrified populism would have the makings of an old-fashioned emerging market crisis.

The Congress party has, in effect, stumbled into the same bet. Its political fortunes are now closely tied to the world oil price. To some extent, the same applies to its opponents. In many of the major states due to hold elections this year, the BJP is incumbent and the Congress party’s gamble is that voters will blame the local government for inflation linked to fuel price increases. But even if the Congress looks better placed for some of the forthcoming regional races, it is now on the back foot overall, having mismanaged fuel price policy and having lost the Karnataka state elections. As a result, the BJP is set to take full political advantage.

The importance of all this for investors hinges on the medium-term prospect of populist policies giving way to serious structural reform. A BJP-led coalition government formed at the national level would be more likely to implement such reforms than the Congress, if the latter again needs the support of its populist leaning Leftist allies to return to power. At the same time, there are not too many differences between the Congress and the BJP owing to the ingrained reluctance of Indian politicians to inflict pain on voters. More often than not, any crucial reform in India depends on the nature of the crisis – the worse the situation, the more likely a new government will act. From this perspective, the scenario of classic panic in an emerging financial market could lead to an equally familiar emerging market bounce-back.

Assumptions and Evidence

The background to fuel price losses, rising inflation and interest rates, slowing industrial growth, exchange rate and current account trends

The fuel price increases may be politically controversial, but they fail to compensate for the losses caused by the retail price remaining far below the average cost of India’s oil imports, which has moved in line with the global spot price.

Even as global crude oil prices rose from one record level to another in late 2007, fuel price inflation in India was negligible – even declining – as the government did not increase domestic prices of petrol, diesel and LPG. But WPI inflation has climbed sharply since beginning 2008, driven by higher prices of food and other commodities such as steel, iron ore and cement. The 4 June fuel price increase will lead to a further spike in inflation in the short term, although inflationary pressures will ease towards the end of the year.

The RBI has been running a tight monetary policy over the past three years.

That policy has contributed to an industrial slowdown.

India’s oil dependency caused the rupee to depreciate sharply when the global price of oil suddenly spiked to US$130/bbl, but the currency has stabilised now partly owing to the RBI’s actions to prevent a further slide.

Although there has been an outflow of portfolio investments – an important contributor to the capital account, as the next chart shows – India’s balance of payments is healthy and the current account deficit, in particular, will be sustainable.