Government raises fuel prices—positive move, higher near-term inflation ::Goldman Sachs

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Government raises fuel prices—positive move,
higher near-term inflation
The government raised administered fuel prices on June 24, a notch higher than expected, to
reduce the difference between international and domestic oil prices. It raised the price of diesel by
8% (Rs3/litre), kerosene by 16% (Rs2/litre), and LPG by 14% (Rs50/cylinder). Although markets
have been expecting some increase in local administered prices for the past 2 months, the quantum
on diesel, and the increase in kerosene and LPG were ahead of expectations. The last increase in
these fuel prices was in June 2010, when crude was at US$72/barrel. Diesel, kerosene, and LPG
together account for 60% of domestic fuel consumption. With this revision, the domestic diesel
price has moved to US$3.92/gallon compared to US$3.95/gallon in the US.


We raise our WPI inflation forecast for FY/12 to 8.6% from 8.1% as a result of the
government’s move. Our earlier estimates had built in a 5% increase in diesel prices and no
change in kerosene or LPG. We estimate the direct impact on headline inflation of the June 24
increase to be 0.6 percentage point (ppt), and an overall impact of 0.9 ppt for FY12. We therefore
raise our WPI inflation forecast to 8.6%, with most of the increase likely in the near term. We
project the July and August headline inflation numbers could be in the double digits, higher than
expected, but we continue to expect inflation to peak in September.

The fuel price hike is largely neutral for the fiscal deficit due to the tax cuts. To reduce the
impact on consumer prices and the losses of the oil companies, the government eliminated custom
duties on crude oil and all petro-products by 5%. It also decided to reduce the excise duty on
diesel from Rs4.6/litre to Rs2/litre. Taken together, these entail a revenue loss of Rs490 billion
(US$10.9 billion). These revenue losses negate the savings from lower subsidies to oil companies.
Assuming that the government bears 50% of the losses, we estimate the fiscal deficit in FY12 may
increase a notch to 5.5% of GDP from our earlier estimate of 5.4%. Of course, if the government
decides to lower its share of the subsidy burden, then the fiscal deficit could be commensurately
lower.  We see the government’s net market borrowing at Rs4.0 trillion, significantly higher than
the Rs3.4 trillion budgeted in FY12.
The fuel hike adds to our view that the Reserve Bank of India will hike policy rates by 50 bp
in total, twice by 25 bp each this summer, in the face of uncomfortably high inflation. The
near-term upward revision to inflation suggests that there is little prospect of a pause in the hiking
cycle over the next 3 months, and the market will likely price in two hikes instead of one that it is
currently pricing. With minimal impact on the fiscal deficit, we continue to think that the
significantly larger-than-budgeted fiscal financing needs will exert upward pressure on long end
bond yields. We continue to like paying 5-year OIS, unless the global growth outlook worsens.
We view the move to bring domestic fuel prices more in line with international prices as a
positive move. It will reduce the losses of the state oil companies, and more importantly, allow
the necessary adjustment to demand which higher crude prices entail. The move is also a powerful
signal to markets that the government is still able to make difficult decisions, in the light of a
stalled reform process. This move, along with global oil prices coming off and monsoons on track,
are positive signs for the economy and for the equity markets. However, they have to be
buttressed by a policy push on infrastructure, FDI, and the financial sector, and clear signs that
inflation is easing before we can take a more constructive view on India’s macro environment.