The government’s decision to allow oil companies to increase pump prices of diesel in small increments will help it kill many birds with one stone. Ministers and bureaucrats may not want to call it deregulation given the political implications but the fact is it is indeed that, for oil companies can now charge market prices to bulk consumers of diesel.

While there are obvious positive economic implications, the most important gain for the government from this move will be on the political front. How can an increase in prices be politically gainful?

Part of larger political game-plan

Simple. The gradual increase in pump prices of diesel will ease the subsidy burden on the government and free up precious funds for its social programmes, increasing food subsidy and providing for the cash transfer scheme. Importantly, all this can be done without attracting the disapproval of the rating agencies or the central bank.

The total subsidy on petroleum products in 2011-12 was close to Rs 70,000 crore. With petrol prices already marked to market, cooking gas subsidy pruned by capping the number of subsidised cylinders per connection and now gradual elimination of diesel subsidy, the government has probably freed up at least Rs 50,000 crore in the coming fiscal for spending on its social programmes which are politically more rewarding. Imagine the ballast that this will provide for the government to dish out the lollies in the approach to elections in 2014!

If the economy picks up, as is the general expectation, then the government will have greater elbow room to spend on the social sector programmes that proved so rewarding for the UPA in the last general elections in 2009. So, there is obviously a larger game-plan that is being played out; diesel deregulation is only one part of that. Of course, there is going to be the inevitable political opposition to the move in the short-term which can be managed. We should also not forget that the government has attempted to mollify consumers by increasing the number of subsidised cooking gas cylinders per connection to 9 a year from 6 and by reducing petrol prices by a marginal 25 paise a litre.

Prudent economic decision

Even so, the fact is that the decision couldn’t have come at a better time for the economy. The Reserve Bank of India has been impatient with the government for not carrying out necessary fiscal corrections and the ratings agencies have put India on watch for a possible downgrade. The twin deficits have kept the markets nervous and the rupee under pressure. Small wonder then that on Friday the rupee shot up by 69 paise to close at a two-month high versus the dollar.

The RBI will announce its quarterly monetary policy later this month but it will be interesting to note how it views the diesel price adjustment. Will it be seen as a step towards fiscal consolidation (and hence add to the argument for cutting rates) or will it be seen as an inflationary move (and hence work against a rate cut)?

Though it might not help prune the fiscal deficit this year materially, the decision to free diesel prices will be seen by rating agencies as a signal of the government’s determination to rein in the fisc. And hopefully, put off any chances of a downgrade too.

Competition in oil industry

In the oil industry, the move is likely to unleash competitive forces. This is of course assuming that the government does not chicken out from its policy of gradually increasing retail pump prices till the subsidy is wholly eliminated. There have been at least two occasions in the past when deregulation of petroleum products were announced but not carried through.

For a start, we could begin to see competition in the bulk consumers segment where the oil companies now have the freedom to charge market prices. Reliance Industries and Essar, the two large private players, can charge a price lower than that of the oil companies and cut into the bulk supplies business. These two companies own large, state-of-the-art refineries that can process crude oil of inferior grades which are cheaper than that used by the national oil companies.

There is also Shell which has the licence to retail petroleum products and has been keeping a symbolic presence the last few years. The real competition, of course, will begin when retail prices are fully linked to the market. That is when the national oil companies will feel the full impact and consumers begin to reap the benefit.

Fuel-pricing flaw

Finally, the decision will also correct a serious flaw in fuel pricing because of which the upper classes that drive high-end saloons and SUVs powered by diesel engines enjoyed subsidy while the middle-classes driving petrol cars and two-wheelers ended up paying free-market prices. The elimination of artificial price difference between petrol and diesel will probably be the biggest gain from the government’s decision. And it will, hopefully, restore the balance between petrol and diesel passenger cars which was tilted towards the latter.

More In: Economy | Business