India: government bites the bullet – increases prices and slashes duties on oil products:: JPMorgan

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India: government bites the bullet – increases prices and slashes duties on oil products

Government finally increases the retail prices of key petroleum products; diesel increased by Rs 3/litre (7%), LPG by Rs 50/cylinder (14%) and kerosene by Rs 2/litre (16%) The cumulative impact on inflation from these increases is expected to be about 90 bps over the next two months; inflation is expected to peak close to 11% in August In a reformist move, government also slashes customs and excise duties on crude oil and petroleum products, thereby explicitly fiscalizing oil-subsidies and injecting greater certainty and transparency into the process Even after these moves, however, authorities indicate that under-recoveries from the sale of these petroleum products could exceed 1% of GDP at current crude prices The fiscal slippage from the duty cuts and compensation of future under-recoveries, however, is expected to be contained to 0.5 % of GDP     Government raises petroleum product prices, finally….   Caught between the devil and the deep sea, and after much discussion and uncertainty over the last few weeks, authorities acted boldly by increasing prices of key petroleum products and also made sharp cuts in excise and customs duties so that oil subsidies are both lower and also more explicitly fiscalized.   Specifically, diesel prices were hiked by 7 % (Rs 3/litre), liquid petroleum gas (LPG) prices by 14% (Rs 50/cylinder) and kerosene prices by 16% (Rs 2/litre). While the hikes are moderate and do not take care of all the under-recoveries by any means, this is perhaps the best that one could have hoped for in the current inflationary environment, with headline inflation running in double-digits and core inflation in double digits on a sequential basis.   …and, in a reformist move, explicitly fiscalizes the cost of oil-subsidies   Equally importantly, and in a positive and long-awaited move, the government eliminated the 5% customs duty on crude oil, reduced the customs duty by 5 percentage points on other petroleum products, and slashed the excise duty on diesel from Rs 4.60/litre to Rs 2/litre. Authorities estimate that the revenue losses from these move would approach about Rs 49,000 crore or 0.5 % of GDP for the full fiscal year (the fiscal implications of this are discussed in more detail below).   This is, however, a positive and reformist move because it explicitly fiscalizes the cost of oil subsidies on the budget, and thereby brings more transparency, certainty and clarity into the government’s financing of oil subsidies. Recall, the imposition of these duties, in the wake of fixed end-consumer prices, served to increase the under-recovery of oil marketing companies. Ultimately, these under-recoveries were subsidized, in large part, off the central government budget through direct cash compensation, but this entire process of first taxing and then re-compensating the oil marketing companies (OMCs) generated significant uncertainty about the financial impact on the central government budget, as well as the upstream and downstream oil company balance sheets. Authorities must therefore be commended on ending this convoluted system of duties and subsidies.   Price hikes to pressure inflation by 90 bps over the next two months   One of the reasons that authorities have delayed these price increases until now is that their impact, especially that of diesel, on inflation is non-negligible. The direct impact of today’s moderate price hikes on inflation will be 60 bps in July. The cumulative impact on inflation (first and second round effects) is expected to be 90 bps over the next 2 months.   An increase of this magnitude had been built into our model, and so we maintain our forecast of headline inflation accelerating to about 11% by August and staying elevated in the 9-10 % range till November before beginning to moderate as the impact of the fiscal consolidation and a slowing economy gradually cause inflationary pressures to moderate.     Under-recoveries to linger but fiscal slippage expected to be contained to 0.5 % of GDP   As indicated above, authorities indicate that the sharp reductions in taxes and duties is expected to shave off about Rs 490 billion in tax revenues (0.5 % of GDP) for the full fiscal year (presumably they are computing this at current crude prices though it is not immediately clear what crude price assumption was used to arrive at this figure). Given that the duty cuts are only applicable for the remaining three quarters of this fiscal (since one quarter is over) and the budget assumptions of crude oil were more conservative, the fiscal slippage (compared to the budget estimates) from today’s cuts is expected to be less than 0.5% of GDP.   However, it is important to emphasize, that despite today’s duty cuts and price hikes, oil marketing companies will still experience significant under-recoveries because retail prices are still not in sync with international crude prices. Authorities’ estimate that, even after today’s measures, the under-recovery could exceed 1% of GDP if crude remains broadly around today’s prices. These under-recoveries will have to be shared between the upstream oil companies, OMCs and the government. As such, even though the fiscal slippage (compared to budget estimate) from today’s duty cuts is lower than 0.5 % of GDP, we expect it will rise to about 0.5 % of GDP after taking into account the governments’ share of future under-recoveries.   However, we do not believe it will significantly surpass 0.5 % of GDP, since tax revenues in 1Q continue to surprise on the upside (as they did all of last fiscal), and the government is expected to find savings in other programs given its repeated desire to demonstrate significant fiscal resolve this year and contain the fiscal slippage.   It is important to emphasize that fiscal slippage on account of oil subsidies is something that we have been highlighting ever since the Budget was presented four months ago (see, “FY12 budget surprises positively but beware of the fine print,” MorganMarkets, February 28)) and is central to our hypothesis of an “accidental soft landing” which we believe is on track to being played out in India. Once more details become clear on the finer points of today’s proposals, we will discuss the medium– term implications on the fiscal deficit and growth more holistically.