Modi has clearly signalled that subsidies will have to be reduced — which means higher oil prices will be passed on to consumers

Less than a month of being sworn in, the Narendra Modi government is encountering its first headwinds on the economy front. While the monsoon has failed to recover from a delayed start, the rising price of food commodities, especially vegetables, and a sharp rise in global oil prices have all combined to present a major challenge to the new government.

Consequently, even as Finance Minister Arun Jaitley is busy putting together the new government’s first budget, he is forced to firefight more recent problems. Oil prices are at a nine-month high, having risen by more than $6 a barrel in the last week alone corresponding to the advance of the jihadi group ISIS in Iraq.

The Indian crude oil basket is now at $111.25 a barrel, up from $106.72 early this month. This has major implications for the oil companies and sadly comes just when the situation on the under-recoveries front was beginning to improve (Under-recovery refers to the difference between the landed price of petroleum products and the prevailing retail price and is a notional metric that is used to arrive at retail prices).

The combined daily under-recoveries of the oil marketing companies — Indian Oil, Bharat Petroleum and Hindustan Petroleum — was hovering around Rs. 250 crore in the first fortnight of June. This is now bound to increase. The options are limited for the government and Mr. Modi has clearly signalled that subsidies will have to be reduced.

This in effect implies that the higher oil prices will be passed on to consumers and rightly so, as bloating subsidies cause other problems in the economy. Yet, if prices of transportation fuels such as petrol and diesel are increased, they will have a cascading impact on the economy.

The alternative to not passing on the higher prices to consumers will mean an increase in subsidies and under-recoveries. As it is, the combined under-recoveries of the oil companies is projected at Rs. 91,665 crore for 2014-15. Finding the resources to fund this subsidy will be difficult at a time when the government’s aim is to keep the fiscal deficit well under 5 per cent. An increase in the fiscal deficit will attract adverse attention from the international ratings agencies.

Keeping a poll promise

Fighting price rise was a major plank on which the Bharatiya Janata Party fought the elections and therefore the pressure is on the government now to keep prices under check. As luck would have it, inflation in May was 6.01 per cent, a full percentage point higher than in April and this was well before news of a sub-par monsoon became known.

To be sure, the government initiated measures last week to quell inflationary pressures in the initial stage itself by ordering release of rice from the government stocks, selling onions through Mother Dairy and fair price shops in the national capital and asking States to crack down on hoarding of vegetables.

The problems for the government are not so much on the food grains front where it has more than adequate buffer stock to release in the event of a failed monsoon, as in vegetables. Here it needs the cooperation of the States to check middlemen and prevent hoarding.

These problems are critical distractions for the government at a time it is drafting the budget which is being keenly awaited by industry and the corporate sector. A sustained rise in oil prices over the next few weeks will mean a higher import bill and the consequent impact on the current account deficit.

The rupee’s fall below the 60-mark reflects the market’s concerns over the international developments and their impact on the economy. RBI Governor Raghuram Rajan has already said that the central bank is watching the developments closely and will act when necessary. One thing is certain though: the events of the last couple of weeks have ensured that there will be little chance of a return to an easier interest rate regime any time soon. And that should be disappointing for industry.

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