Viewpoint: Diesel price, Inflation and Deficits: Turning points of economic spiral

Intro:

Diesel prices are on the rise so inflation is at higher levels. Will there be further increase in diesel prices and inflation? Probably not. Here is the reasoning.

Background:

Diesel prices are on the rise. Almost Rs. 15 per litre (approx. 30%) increase in the last 3 years is observed. This increase makes the transportation costlier, input costs rise and the burden is passed to consumer so we witnessed persisting inflation at 11% in 2013 (average CPI).

Why diesel prices went up?

If we take a look at Brent Crude chart, it has remained in a narrow range in the same time frame. Then what is causing Diesel price rise?

USD/INR chart reveals the secret. It is not the international crude prices but the fall in Rupee made the import costlier by around 20% or so. And rest of the rise has come from increase in diesel prices by 0.5 rupee a month with Government’s initiative to reduce the burden on Oil Marketing Companies (OMC). This would continue and further accelerated to reduce the subsidy burden and bleeding of OMC's.

Why diesel prices will top out in a year or two from now?

Even if crude prices remains flat, diesel prices can go up if Rupee weakens further and fuel subsidy withdrawal speeds up. But the Rupee’s weakness has roots in Trade deficit (a gap between exports and imports) and Current Account Deficit (CAD, a gap between outflow and inflow of foreign exchange).

Diesel prices contribute to both deficits. Oil being the second biggest import of the nation, increases the import bill. And fuel subsidy is one of the biggest Government spend that increases Fiscal Deficit (a difference between Government's spend and earnings). But reducing the subsidy and bringing the diesel prices to market levels helps in reducing Fiscal Deficit, reduces Government's borrowings and strengthens rupee. Stronger rupee reduces the import bill and makes the crude import possible at lower prices reducing the trade deficit and further strengthening the Rupee further in the process.

Diesel would cost another Rs. 12 more a litre (approx.) if subsidies are withdrawn. But this would have reduced the current account deficit to the tune of Rs. 100,000 crores a year or approx. 30% of CAD. This will help Rupee appreciate, reduce the import bills and narrow the trade deficit. And the benefits of importing crude at lower prices can be passed back to consumers offsetting the price rise caused by subsidy withdrawal.

Conclusion:

In a narrower time frame, diesel prices can go up but not consistently as the benefits of deficit reduction start paying back. Moreover, oil supplies are on the rise all over the world so there are good chances that international crude prices may see softening with time. And oil discoveries within India are on the rise, any increase in domestic production will only help to reduce the import bill and strengthening of Rupee. So we may actually see Diesel prices coming down in a couple of years. But what about inflation? It too may soften. If it does not, there could be other reasons driving it and Diesel would not be the one behind it.

References:

1, Diesel price chart: http://www.moneycontrol.com/news/market-edge/chartthe-day-how-diesel-prices-have-doubledlast-decade_757880.html

2. Brent Crude and USD/INR: http://www.investing.com/

3. Subsidies: IMF working paper http://www.imf.org/external/pubs/ft/wp/2013/wp13128.pdf