Raising prices sensibly can reduce inflation

The Kelkar Committee report has painted a dire picture of government finances. It emphasizes the need to phase out unwarranted subsidies (such as those on diesel, cooking gas and urea) while maintaining warranted subsidies (on education, health, food) and targeting the poor. The committee has warned that India must curb its high fiscal deficit, which is spilling over into a record trade deficit.

Critics sneer that the committee has ignored the inflationary consequences of its proposals. They claim that raising the price of subsidized items (like petrol, diesel, kerosene and urea) will have a cascading effect on all prices, hitting the common man.

The committee should have anticipated this criticism, and countered by saying that sensible price decontrol will not worsen inflation, and can indeed reduce inflation. Sounds paradoxical? We are already seeing evidence of this.

Overdue increases in the price of diesel and cooking gas-which fall far short of the ideal of price decontrol- have nevertheless changed the entire investment climate. Along with new measures like allowing FDI in retail, they have created the image of a government leaping out of paralysis into action. One consequence has been an influx of dollars from foreigners (and Indians with foreign accounts) who think India is finally reforming. This dollar influx has, in less than two weeks, strengthened the rupee by 8%, from Rs 56 to just Rs 51.50 to the dollar. In rupee terms, all imports (including oil) have become 8% cheaper.

That\’s not all. Domestic producers of goods that compete with imports-dal, vegetable oil, metals, plastics, coal and fibres–will be obliged to hold or cut prices since rival imported goods will now be 8% cheaper. To some extent, this will squeeze exports but that should be bearable, given the offsetting impact on inflation. The outcome should be, at last, a fall in overall inflation to the RBI target rate of 5%.

This will reverse the trend of the last year, when political paralysis, soaring oil subsidies and a soaring fiscal deficit led to a loss of confidence, globally and locally, in Indian economic policy. Consequently, the rupee fell by 24%, from Rs 45 to Rs 56 to the dollar. This automatically raised import prices by 24%, putting great upward price pressure on all Indian goods competing with imports. Naturally, inflation stayed high.

Politicians did not realize this. They thought they would tame inflation by keeping oil and fertilizer prices unchanged despite rising global prices. But the rest of the world saw clearly that this would send subsidies to record heights, creating unsustainable trade and fiscal deficits. So, the rest of the world began pulling money out of India, causing the rupee to crash. This created new inflationary pressures that more than offset the government\’s price controls. Inflation stayed high.

The lesson is clear. Do not look just at the cascading effect of a higher diesel price on the price of goods moved by road. Please also look at the cascading effect of unsustainable subsidies-on diesel and everything else- on the exchange rate. The world understands that a poor country should subsidise the poor. But it also understands that such subsidies must be well-targeted, and not lead to unsustainable fiscal deficits. When rich households consume hundreds of cylinders of cooking gas over a year, a cap of six subsidised cylinders per household surely makes sense.

The next step should be ending the kerosene subsidy. Around 40% of cheap kerosene is used to adulterate diesel and petrol. This benefits crooks, ruins vehicle engines, and kills thousands through higher respiratory ailments caused by pollution. Cheap kerosene is supposed to help poor villagers who use kerosene lanterns. Instead, the government can give villagers free solar lanterns. That will provide them light, while ending the ills of cheap kerosene.

Many economists and politicians wring their hands at rising household purchases of gold, an unproductive use of savings. Bullion imports shot up to $ 61.5 billion last year, the second largest item after oil. This too was caused partly by the earlier policy paralysis and inclination to subsidise oil and other items without limit. Those bad policies caused the rupee to crash by 24%, providing a 24% windfall to gold speculators at a time when global prices were rising anyway. This further fuelled the speculative frenzy. The government tried combating this with a 2% increase in import duty. Far more effective will be the recent 8% rise in the rupee\’s value. That will hopefully dampen speculation and encourage households to shift back from gold to bank deposits and other financial instruments. That will help both investment and the balance of payments.

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