India’s government finally admitted defeat in subsidizing diesel prices and will repeal the subsidy in the near future.  More than 80 percent of India’s fuel needs are fulfilled by imports. Petrol prices were liberalized by the government in June 2010 but the government has constantly tried to prevent prices from rising to insulate the Indian economy from ever-increasing oil prices on global markets. Fuel consumption in India increased 5 per cent in the last fiscal year, its fastest since 2007-08.  If you subsidize something you get more of it.  The Indian government has finally bowed to this simple economic reality. 

Oil companies increased the price of diesel by 45 paisa (1/100 off a Rupee) excluding taxes immediately. The decision came few hours after the government allowed oil marketing companies to set the diesel price.  Previously the price of diesel was fixed and the government compensated the sellers for their losses. Now with the subsidy gone, the government is allowing retailers to increase the price of diesel by small amounts every month. If the rumors are too believed, the retailers are allowed to increase the price by 50 paisa every month until a market price is achieved.  This will quell the political fallout in the short term and put the brunt of the losses back on those who had nothing to do with the problem in the first place, the sellers.

The government clarified that the diesel prices will not be regulated from now and retailers are allowed to make minor changes.

There is no politically easy way for the Indian government to spin this especially when in another move the government but they will try by increasing the cap on the number of subsidized cooking gas cylinders (LPG) available to consumer from six in a year to nine for the fiscal year 2013-2014. The government however made it clear that there would be no refund on any LPG domestic cylinder which has been already delivered at non-subsidized price since September 2012.  Along with increasing the cap, there has been a hike announced in the non-subsidized LPG cylinder by Rs 46.50 per cylinder. The only good news for Indian consumers is their dropping the price of petrol by 25 paisa. 

This increase in LPG cap is expected to increase the losses for all oil marketing companies to Rs 10000 crore ($18.3 billion). But the removal of the diesel subsidy will be cut by Rs 3,400 ($622.7 million) crore per year after March 2013 when the hike in diesel price will take effect according to Indian oil.  The diesel subsidy was a major contributor to the Indian government’s structural budget deficit which caused the massive depreciation in the Rupee in 2012.  In order to stave off a credit downgrade and stabilize the Rupee this move had to happen.

The subsidy for diesel has dramatically altered the structure of the automobile market in India with Honda (NYSE:$HMC) and others falling over themselves to bring new diesel variants to the country. This will seriously impact potential car sales figures for 2013 and beyond for nearly all of the major manufacturers, including Suzuki, Toyota (NYSE:$TM) and Mahindra.

The downside, of course, is domestic price inflation which cannot be avoided at this point without putting more curbs on domestic bank credit.  That would be draconian measure that the current sitting government would not survive.   So, the CPI is going to rise, asset prices will fall as some business loans will fail and GDP growth will slow down because of this as prices need to adjust significantly. 

The process of cleaning up this pricing mess will not be swift and it will come with a lot more give and take, as evidenced by the price hikes but also the increase in the number of gas cylinders to be subsidized.  This will limit the rise in food costs while putting the brunt of the readjustment on the transportation sector.  The decision came after intense political pressure from other parties as well as congress was applied. The current number of six subsidized LPG cylinder to per household was taken set forth by the Singh government in September 2011. That decision came following other reforms which led to the Trinamool congress to quit the majority coalition.

India was warned by the rating agencies last year that its investment grade credit rating will be lowered if it fails to take step to decrease its fiscal deficit. The Indian officials have vowed to limit fiscal deficit to 5.3% of GDP.  The diesel subsidy was more than 40% of that. 

The Oil Ministry earlier advanced options for meeting a record Rs.160,000 crore ($29.4 billion)  deficit arising from selling auto and cooking fuels below costs.  The Oil Ministry has advanced the plan to increase diesel prices by Rs 3 – 4.50 (7-10%) and the price of LPG by Rs 100 per non-subsidized cylinder, since the Finance Ministry has pretty much said ‘No More’ to paying for fuel subsidies. 

The real bright light in this is that the Rupee will slowly gain in the foreign exchange markets lowering the import costs for oil.  The net benefits will outweigh the pain but it will be a difficult readjustment for the Indian economy.  This is a major event that, if followed through upon, will improve the structural integrity of India’s economy over the next decade.