Rising prices pile the pressure on India’s UPA

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In December 2004, the year his government took office, Manmohan Singh warned that India’s system of subsidies, particularly those covering fuel and energy, was unsustainable. “Today, we are offering subsidies to a wide range of users without a proper analysis of their economic and social rationale,” the country’s prime minister said.

The following year, in a speech marking the first 12 months in office of the United Progressive Alliance, the Congress party-led ruling coalition, Mr Singh once again railed against “wasteful subsidies”. He returned to the theme in 2006, questioning whether such state support was consistent with India’s “economic security”.

But the government, restrained by its Communist allies in parliament, was unable to implement anything beyond token cuts in its fuel subsidies even as crude oil prices continued their rise, nearly quadrupling during the UPA’s four years in power.

Mr Singh has been proved right. In a country that depends on imports for more than 70 per cent of its oil and charges retail consumers of petrol and diesel less than half the global market price, the rise in crude this year above $140 a barrel has delivered an economic shock. India’s cherished high rates of growth are under threat from soaring inflation and widening deficits on the fiscal and current accounts.

These threats have reared up as the UPA government’s own survival is in jeopardy. After a 10-month stand-off with Mr Singh, the UPA’s leftwing allies on Wednesday withdrew support for the coalition because of differences over a nuclear energy pact with the US. Led by the Communist party of India (Marxist), the leftists demanded that India’s president call a vote of confidence in parliament, which could trigger early elections months before May 2009 as planned.

Snap polls would force the UPA to face famously price-sensitive voters at a difficult time. Inflation climbed to a 13-year-high of 11.6 per cent in June, up from just 4 per cent in February. So quick has been the deterioration in conditions that even cabinet ministers – used to boasting about the country’s strong economy, which grew at 9 per cent in the year ending March – at times seem hardly able to believe it. “It is a fraught situation,” says Shankar Acharya, former economic adviser to Mr Singh. “The combination of inflation and a very steep oil price is making a mess of public finances.”*

The inflation rate is more than double the “comfort level” of the Reserve Bank of India. The central bank has announced two interest rate rises in recent weeks, taking its key lending rate up by 75 basis points to 8.5 per cent. “Until the mid to late 1990s, 7-10 per cent inflation was considered standard for India and many closed economies,” says Suman Bery, director-general of the National Council for Applied Economic Research. “Tolerance for inflation has gone down significantly.”

The government increased the retail prices of petrol, diesel and liquefied petroleum gas by an average of 10 per cent but this is a drop in the ocean of its subsidy bill, which officials recently estimated at $60bn. Economists say that together with other fiscal largesse, such as an $18bn loan waiver for indebted small farmers and a civil service pay rise, the oil subsidy bill will take India’s government budget deficit to near all-time highs this fiscal year. Morgan Stanley is predicting a fiscal deficit of about 10 per cent this year, assuming an average oil price of $120 a barrel.

The central bank, nervous that real interest rates are negative, is likely to remain hawkish. If oil prices continue to rise, it will also need to act decisively to halt further falls in the rupee and stop the current account deficit from exceeding its comfort zone of 3-3.5 per cent. This means reducing demand for non-oil imports by further monetary tightening.

Ultimately, the cost to India will be lower growth. Economists are now predicting a return to the growth rates of four or five years ago – about 7.5 per cent. This would be by no means disastrous but it would not be fast enough to fulfil the UPA’s dream of ending poverty in a generation and creating enough jobs for the hundreds of millions of unskilled youngsters expected to join the workforce in the next 10-20 years.

“The economy has to expand, industry needs to expand to absorb these people, otherwise this entire demographic dividend can become a demographic time-bomb,” says D.K. Joshi, principal economist with Crisil, the Indian affiliate of Standard & Poor’s.

In the meantime, the UPA is trying to rally the support of new allies to retain a parliamentary majority and salvage the government. Congress has already suffered a string of defeats in recent state elections, and inflation only adds to the opposition’s arsenal ahead of the forthcoming general election. Congress is “betraying the common man”, the rival Bharatiya Janata party (BJP) declared, while the Communist party of India blamed the UPA for the “dismal situation” of double-digit inflation.

Inflation is most painful of all for the 240m Indians who live below the poverty line – and form a critical voting base. Congress’s Indira Gandhi was elected prime minister in 1980 on a populist campaign that railed against rising onion prices.

In an effort to deflect criticism, the finance ministry last week said inflation in the prices of 30 essential commodities had moderated to 6.55 per cent and that prices of staples such as pulses, onions and potatoes had declined. Some analysts agree that food prices should moderate following what is expected to be a good monsoon this year.

But if oil rises to $200 a barrel, as some analysts have suggested, the government will need to raise fuel prices again to save India’s finances from ruin. That would spell “near disaster” for the government, says Mahesh Rangaranjan, a political analyst at Delhi University, because rural dwellers depend on diesel to run tractors, pumps and generators.

Even boosting diesel prices by just Rs3 per litre, about 10 per cent, in effect wipes out the political benefits of expensive Congress populist measures such as its rural jobs and farm loan write-off schemes. “Politics is all about timing. Do you want to go into elections when things are looking grim for the government?” asks Mr Rangarajan.

Does this mean the battle is already lost for Congress? “Certainly the incumbent pays for inflation,” says Shekhar Gupta, editor of the daily newspaper The Indian Express. “But voters don’t make up their minds so early. The winds can change.”

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