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August 23 2019
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08 October 2018

High CAD, rising oil prices and depreciating rupee need a strong response from policymakers

The government is currently in an unenviable position. Whereas there are demands for taking strong steps to tackle the problems facing the economy, the Centre is seen handling the situation with kid gloves.

Most of the afflictions of the economy — a high current account deficit (CAD), rising inflation, poor exports, expensive imports, and concerns over meeting the fiscal deficit target — are on account of depreciating rupee and rising oil prices, which are largely influenced by external factors.

The government had already taken some steps to control the CAD, such as increasing import tariffs on several non-essential items, and sought to ease the burden of higher oil prices by cutting petrol and diesel prices for consumers. But these steps are akin to small dams tackling huge floods. The problem is the government can’t do more without risking damage to other important macroeconomic indicators such as the fiscal deficit.

Reversal of deregulation

The government’s recent action of directing oil marketing companies to take a ₹1 per litre hit on their finances was viewed as a reversal of deregulation of oil prices in 2014. The Finance Minister had since sought to reassure everybody that this wasn’t the case. But the situation reveals the constraints the government is facing.

The Centre has few choices when it comes to cushioning the oil price blow. First, it can do nothing more than the ₹2.5 per litre cut in fuel prices it has already implemented. Second, it can cut the price of fuel further by reducing the excise duty even more than the Rs. 1.5 per litre recently implemented. Third, it can use the finances of the oil marketing companies to absorb the impact of a price cut. Fourth, it can ask all the States — and at least expect the BJP-led ones to agree — to further reduce VAT on fuel.

Doing nothing is naturally an attractive option. But the issue this time is that the high oil prices are more linked to political causes, which are much stickier than a demand-supply mismatch, which in the age of shale oil and gas has become a less vexing issue. Prices could likely go up further, increasingly making ‘doing nothing’ a painful way forward.

The idea of taking a further hit on excise duty collections must certainly be very discomfiting for Mr. Jaitley, who has repeatedly and vociferously maintained that the government will keep to its fiscal deficit target of 3.3% of GDP. With the Centre’s GST revenue coming in about ₹5,000-₹7,000 crore lower than it should, and the States facing an average 13% shortfall in GST revenue this year, the only bright spot is direct taxes.

Net direct tax collections grew 14% in the April-September 2018 period, which is pretty strong compared to the trend. But strong direct tax collections cannot shoulder the burden of lower indirect tax collections both due to GST and a further cut in excise duties on fuel. A further excise duty cut will, in short, increase the likelihood of missing the fiscal deficit target.

Apart from the economic reasons why this might not be a good idea, a slippage two years in a row will give the Opposition political brownie points which is probably not something the government can afford in an election year. Likewise, forcing the oil marketing companies to take another hit to their finances will also not go down well. Oil company stocks will plummet more than they already have.

Whether the States will be willing to reduce VAT rates is a more political than economic question, one that only they can answer. Most can probably afford it, especially since the Centre will be compensating them for any losses due to GST for 3.5 more years.

Mitigating the impact of high oil prices on the current account deficit, and therefore the currency, is more of a medium to long term game. The reason high oil prices hurt India so much is that we import about 80% of our oil requirement. The solution to this is simple but not easy — we need to import less oil.

The government is already doing quite a bit towards this by trying to boost renewable energy production, and also ethanol blending in petrol, diesel, and aviation turbine fuel. Policy certainty in the solar sector will only further help this along.

In the early part of the government’s tenure, low oil prices gave it the luxury of cruising along by making only minor tweaks. Now, in the last few months of its term, a reversal of fortunes has meant the very most it can do are minor adjustments.

 

 

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