Gutsy as well as powerful reform

The government showed strong political resolve by taking firm steps towards deregulation of energy prices. While the increase in petrol prices was mostly along expected lines, the rise in prices of diesel, LPG and kerosene definitely surprised the market. Structurally, it is probably one of the biggest reforms the government has pushed through.

The fuel price rise may inflict some pain on consumers in the near-term and may impact inflation adversely. But, over the longer term, these measures would potentially generate significant economic benefits. When India is on such a strong growth path, there is no economic logic for continuing such a mass subsidy burden on the exchequer.

If the government has liberty of resources on the fiscal front, it would be better to direct the subsidy to the needy sectors and sections of the society through such programmes as the NREGS. This reform, coupled with projects like UID, definitely and clearly exhibits the government’s intention to have a subsidy structure a lot more efficient and targeted.

Also, deregulated prices would lead to a more price-sensitive and efficient use of energy and, thus, lead to investments in fuel-saving technologies. A McKinsey study estimated that, by raising energy productivity, developing countries could reduce their energy demand growth from 3.4 per cent to 1.4 per cent a year over the next 12 years.

In the near term, this move will have implications for monetary policy. It would push the headline inflation up by nearly 150 basis points when both direct and indirect impact of the fuel price increases are taken into consideration, thereby triggering additional challenges for monetary policy.

While the policy rates are ineffective tools to counter a one-time increase in fuel prices, the chance of inflation rising further cannot be ignored, especially when headline inflation is already in double digits. In fact, this might question the timing of the reform itself!

The immediate impact of this on the capital markets might be somewhat adverse, taking into account the upward pressure on headline inflation and possibilities of an interest rate increase by RBI. But this reform, structurally, gives out a very positive signal to the markets as, the agenda of economic reforms, in general, crosses a significant hurdle with this step.

Better fiscal control and efficient energy usage will strengthen India’s long-term economic prospects. Capital markets, therefore, should cheer the move.

The writer is the executive vice-president and head (institutionalequities) at Edelweiss Securities