We’re really subsidising Opec

on Sunday, June 8, 2008

Crude oil costs $135/barrel globally, but Indian prices of petroleum products have long been linked to barely $60/barrel. This has meant underrecoveries — explicit and implicit subsidies to consumers — of a whopping Rs 2,45,000 crore.
So, the government has reluctantly increased the price of petrol by Rs 5/litre, diesel by Rs 3/litre and cooking gas by Rs 50/cylinder. These timid increases will plug barely one-tenth the implicit gap. Even this has been cushioned by cuts in excise and customs duty by the centre, and in VAT by state governments.
Yet, political parties have launched agitations in protest. Politicians cynically pretend that high oil prices are the fault of the government, not Opec or global trends.
Back in 1974, when Opec first sent oil prices skyrocketing, India had no giant consumer subsidies or agitations against oil prices. The price of petrol doubled overnight, inflicting much pain. India was very poor then. Today, it is much richer, and better able to pay the full world price. Yet, that prosperity has also brought the capacity to subsidise on an unprecedented scale.
Five years of near 9% growth have yielded a revenue bonanza — central tax receipts have risen by over Rs 100,000 crore per year. Instead of spending this bonanza on cash transfers to the poor, and beefing up our pathetic infrastructure and social sectors, the government has chosen to provide implicit or explicit oil subsidies worth over Rs 200,000 crore. To put this folly in perspective, the main anti-poverty scheme, the employment guarantee scheme, spends just Rs 16,000 crore/year.
Critics argue that estimates of subsidies are grossly exaggerated. Central and state governments have long taxed petroleum products, and oil companies have been making good profits. So, the critics declare, the common man must be protected at a time when inflation is already high. The same critics castigate the West for global warming, yet wish to subsidise India’s own emissions.
Resistance to raising domestic prices is common across developing countries. Rich countries have let prices rise in line with market trends. But many developing countries have raised prices only partially and haltingly. After a long price freeze, Malaysia has just hiked its prices by 41%, and Indonesia by almost 30%. Oil exporting countries have maintained exceptionally low prices: petrol in Venezuela costs Rs 2/litre.
Politicians say higher oil prices will hurt the poor. Yet, an IMF study of five emerging economies showed that the richest 20% of people got 42% of oil subsidies, and the bottom 20% less than 10%. Even this analysis misses the big picture. The main beneficiaries of these subsidies are not the local rich, but the oil exporting countries.
The price of oil is determined by supply and demand. When prices go up, consumers reduce demand, and eventually this leads to a fall in prices. We see this upand-down price cycle in many commodities.
But much less in oil. Why? Because many governments subsidise oil consumption, and so keep demand artificially high. This then keeps world oil prices artificially high. Each developing country believes it is virtuously subsidising its own consumers. But when many developing countries do so, notably highly populated ones like China and India, they push up global demand for oil, and so push up global prices high too. They become victims of their own subsidies.
Back in the 1970s, rich countries cut domestic taxes and imposed price controls to protect consumers after Opec quadrupled prices. This kept oil demand (and prices) high. Only when the US abolished price controls progressively after 1979 did imports crash, and later world prices crashed too. It was a signal lesson on the folly of trying to shield consumers from the reality of high oil prices.
Rich countries have learned from history, but developing countries have not. The demand for oil in rich countries is slowing today with rising prices. Petrol consumption has fallen in the US as the price has risen to $4/gallon. US demand for gas-guzzling large cars has collapsed, and General Motors wants to sell its Hummer brand, the largest car of all. All these positive outcomes flow from passing on the burden of Opec to the consumer.
But China, India and many developing countries have tried to keep oil prices artificially low. Thus, they have kept demand artificially high (they now account for a big chunk of world demand). And that is why Opec is able to sell oil at $135/barrel, despite a global slowdown.
Ideally, India should pass on the full cost to consumers, as it did in 1974. But for politicians who view high subsidies as electoral necessities, here is a proposal. First, abolish all implicit and explicit subsidies on oil. Use the money saved to cut excise duties on other items of common consumption and provide cash to poor families. Overall inflation and government revenue will be unchanged. Yet, the poor will benefit, and high oil prices will encourage energy-efficiency. India’s oil use will fall, helping lower Opec’s prices. That will be better than today’s policy, which ends up subsidising Saudi Arabia.



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