>INDIA STRATEGY: Road to reforms

■ Government acts with a strong resolve; delivers path-breaking reform: The Government of India (GoI) displayed strong political resolve by taking firm steps towards partial deregulation of petroleum product prices (based on Kirit Parikh Committee recommendations). While deregulation of petrol prices was on expected lines, a step towards deregulation of diesel prices, which until recently was considered completely outside the realm of deregulation, and price hikes in LPG and kerosene, definitely surprised the market. Furthermore, what is notable is that the aggressive move came at an unlikely time when inflation is running into double-digits and the government is gearing for assembly elections in key states of West Bengal and Tamil Nadu in 2011. Therefore, it is one of those rare moments in the process of India’s economic reform where economic logic took precedence over short-term political considerations; such moments tend to deliver path-breaking reforms. This reform is no less, if one could see beyond the immediate adverse impact on headline inflation.

■ Move will unleash energy efficiency gains in the economy…
First and foremost, the deregulation of petroleum product prices will lead to efficiency gains in energy consumption (i.e., reduced energy intake per unit of economic output). Market determined prices will induce rational behavior among economic participants. While households will curtail consumption during high and rising energy prices, businesses will be motivated to invest in efficiency enhancing technologies or even in alternate sources of energy. Private sector participation in the oil sector will increase and so will competition. Furthermore, efficiency gains
will directly lead to reduction in the country’s overall energy needs. A recent Mckinsey study estimated that by raising energy productivity, developing countries could reduce their energy demand growth from 3.4% to 1.4% per year over the next 10-12 years. Such efficiency gains are crucial, given India’s heavy dependence on imports to meet energy needs. If such gains materialise, India will be able to reduce its current account deficit meaningfully and to that extent its
reliance on foreign capital to fund the deficit will also ease.

■ … and, support government’s fiscal position
Benefits of deregulation do not stop with efficiency gains. Deregulation, if fully extended to diesel prices; combined with implementation of the direct tax code (DTC) and Goods and Services Tax (GST) could meaningfully alter the country’s fiscal landscape in the coming years. This is particularly important because fiscal deficit has been the long-standing chink in the otherwise robust Indian macro story. Indeed, one of the key messages from the global financial crisis is that
sovereign risk (even in western economies) can come under question. Persistent fiscal deficits not only weaken government’s ability to deliver timely fiscal stimulus during recession, but also lead to build up of debt over time, hurt the economy’s potential growth rate, increase chances of credit rating downgrade, and undermine global investors’ confidence—something that is currently playing
out fully in peripheral Europe. In that sense, the Indian government is sending out confidence-building signals to the global investor community and is adhering to what Rahm Emmanuel, President Obama’s advisor, famously said, “don’t waste a crisis”.

To read the full report: INDIA STRATEGY