Reform of fuel subsidy program amid fall in global oil prices is credit positive

Atsi Sheth, Senior Vice President, Sovereign Risk Group, Moody's Investors Service Singapore 

On 18 October, the Government of India (Baa3 stable) responded to the slide in international oil prices by fully liberalizing diesel prices and easing controls over natural gas prices, allowing the latter to increase by about 33%. These steps are credit positive because they allow the Indian market to adjust to global commodity price trends and reduce the exposure of government finances to those trends. The stable outlook on India's Baa3 sovereign rating is based on our expectation of incremental credit positive policy changes in multiple areas over the coming months, and our assumption that the fuel subsidy reforms, which were introduced some years ago, will continue. 

Since September 2012, the Indian government has implemented various reforms to the fuel subsidy program, including allowing oil marketing companies to increase diesel prices incrementally, withdrawing the subsidy on diesel sold in bulk, and limiting subsidized consumption of LPG. Despite these steps, rising commodity prices actually led to a significant increase in the subsidy outlay. In fact, the petroleum subsidy bill grew nearly six-fold over the last five years to INR 855 billion in 2013-14, from INR 150 billion in 2009-10. 

The decision to fully deregulate diesel prices signals fiscal discipline on the part of the sovereign, which we view as credit positive. Diesel price deregulation will reduce the subsidy burden for the government, although fiscal savings are likely to be limited. Total fuel subsidies accounted for less than 1% of GDP and under 3% of total government expenditures in 2013-14. 

Global crude prices have fallen by more than 20% in the second half of 2014, making it an opportune time to liberalize fuel prices. Because India is a heavy net importer of energy, with crude oil making up around 30% of total goods imports in 2013-14, lower crude prices ease pressure on the country's current account and reinforce the current disinflationary trend in headline CPI growth, providing room for subsidy reform. Implementing reform at a time of low international oil prices reduces the potential for inflationary pressures from a jump in domestic fuel prices. Moreover, petroleum products have a small weight in India's consumer price basket and we therefore expect energy product price liberalization to have a benign impact on CPI inflation. 

Lower oil prices are also likely to benefit India's macroeconomic balance. Diesel price deregulation was accompanied by a 5.7% drop in diesel prices, further mitigating the potential inflationary impact of subsidy reform. However, a future rise in diesel prices could contribute to food inflation (or the food subsidy bill) as companies begin to charge more for freight transportation services, and the cost of fuel-intensive machines used for the production of wheat increases. Policies to address supply constraints by improving agricultural productivity could, however, mitigate some of the potential pass-through effects of fuel price liberalization on food inflation.