Fuel subsidies hand an opportunity to Modi but a burden to Widodo

Of all the problems facing the newly minted leaders of India and Indonesia, few are as contentious as fuel subsidies, on which both countries have spent tens of billions of dollars a year in a bid to help their poorest citizens.

But while circumstances have aligned to hand India’s Narendra Modi a perfect opportunity for reform, Joko Widodo, who takes the reins as Indonesia’s president next week, faces a bigger dilemma.

India: perfect moment for deregulation

Narendra Modi and his team like to emphasise the economic mess they inherited from India’s previous Congress government, writes Amy Kazmin. But on the highly sensitive question of diesel fuel subsidies, India’s new prime minister has inherited a historic opportunity.

Two years ago, as global oil prices surged, India was facing the prospect of a $34bn annual fuel subsidy bill. Indians were paying just about 75 per cent of the market price of diesel fuel, with the government, and state-owned oil companies, picking up the tab for the remainder.

At that time the Congress administration bit the bullet and raised prices of highly subsidised diesel fuel by 14 per cent in a bid to curb the yawning fiscal deficit then threatening India’s credit rating. It also announced – and mostly stuck to – a plan to raise diesel prices by half a rupee a litre every month until prices hit market levels.

Nevertherless, during that financial year fuel subsidies amounted to almost Rs1tn, or about 1 per cent of GDP.

Thanks to lower global oil prices, India has now reached a milestone: its oil companies are selling diesel to Indians at, or even slightly above, the actual cost. The question is whether Mr Modi will seize the chance to end state control over diesel prices, allowing them to rise and fall with global market levels.

“This is the ideal time to deregulate, so in the future the government doesn’t have to take any administrative decision with regard to diesel prices,” says Sunil Kumar Sinha, chief economist for India Ratings, the local arm of Fitch Ratings.

India ended state control over petrol prices in 2010. However, it declined to take a similar step for diesel, traditionally seen as a “poor man’s fuel” that powers buses, trucks and irrigation pumps used by millions of farmers to water their fields when rains fail.

The widening gap between market-linked petrol prices and subsidised diesel in the first years after petrol prices were allowed to float at market levels led to surging demand for diesel cars and pushed consumption of the subsidised fuel to record levels.

Sonal Varma, chief India economist at Nomura, agrees that Mr Modi should extricate the country from the tricky task of having to set prices. “We should depoliticise diesel prices and they should use this opportunity to announce that from now on, it’s going to be market-determined,” she says.

However, Ms Varma says Mr Modi so far seems to be “playing it safe”, perhaps unwilling to commit to such a step until after upcoming assembly elections in several large, politically important states.

Ms Varma says the government may be waiting for guidance from a newly created expenditure reforms commission, which can serve as “an anchor” for any policy change.

Even if New Delhi ends its diesel subsidies, it will still have big bills for subsidising both cooking gas cylinders and kerosene, which poor rural families use for night-time lighting in the absence of electricity.

However, Mr Modi’s government plans to move away from directly providing subsidised goods to a system of direct cash transfer of the subsidy into intended recipients’ bank accounts, a move that could help curb leakages and reduce spending in the long run.

“We will continue to have subsidies,” says Jahangir Aziz, chief economist for Asia at JPMorgan. “The vision of is a more efficient India, doing the same things more efficiently.”

Indonesia: politics likely to trump economics

When the government increased the subsidised fuel price by 33 per cent last June, the subsistence farmers on the remote island of Sumba had to jettison the four-hour truck journey to sell betel nut in the nearest market town, writes Ben Bland.

To survive, they were forced to eat the iwi, a poisonous wild potato that requires hours of boiling to detoxify, according to Asnat May Ana Amah, a 29-year-old farmer and mother of three.

While the car-driving middle class benefits most from the $21bn the government will spend this year to give Indonesians some of the cheapest petrol in Asia, the poorest are always hit the hardest by fuel price rises.

As he prepares to take office as president next month, Joko Widodo is struggling to balance the need to repair the country’s tattered finances by slashing subsidies while protecting the poor in a better targeted manner.

In his way stand an entrenched subsidy culture, with Indonesians expecting the government to provide cheap fuel and electricity, and the corrupt officials and entrepreneurs who take advantage of cut-price petrol to make huge profits from smuggling and other arbitrage opportunities.

“When you increase the fuel price, inflation will impact poverty,” says Chatib Basri, Indonesia’s outgoing finance minister. “But Mr Widodo has a blank cheque to do it this year because we’ve already allocated funds for a cash transfer to the poor.”

The government will spend Rp350,000bn ($29bn) on energy subsidies this year, equivalent to 19 per cent of the budget. With Indonesia having become a net oil importer in 2004, cheap petrol – at just Rp6,500 ($0.55) a litre – has driven a surge in imports, leading to a current account deficit that has worried international investors.

In spite of pressure from the market, outgoing President Susilo Bambang Yudhoyono has refused to increase fuel prices before he steps down, leaving the decision to Mr Widodo, who recently told the Financial Times he would do so “gradually”.

Euben Paracuelles, an economist at Nomura in Singapore, says that Indonesia should consider reforming the whole subsidy system rather than implementing one-off price rises when pushed by investors.

He points out that in the 1990s, Indonesia produced twice as much oil as it consumed. That situation has now reversed, with southeast Asia’s biggest economy consuming twice as much as it produces.

To improve the balance in the medium term, he says the government needs to promote investment in the upstream oil and gas industry, which has been declining because of nationalistic regulations.

The problem, says Mr Paracuelles, is that subsidies are not an economic issue but a political one.

Even though Indonesia is not a net oil exporter, “it is very difficult to take away subsidies in a country that is producing oil”.

Additional reporting by Taufan Hidayat in Ngadulanggi, East Sumba