Adjustment in fuel prices:

The right economic intervention

by Dr. Jagath WELLAWATTE, Senior Lecturer, University of Colombo.

Government recently made a substantial upward adjustment in fuel prices. Though this increase is in line with the recent movements in international fuel prices, there have been several criticisers who suggest that the increased cost should not be passed to the consumers, but has to be absorbed by the central government.

Opposition political parties including the UNP, the JVP and newly formed JNP are with this view. An article authored by Dinesh Weerakkody, in the Financial Times on 2nd June 2008 under the heading “Government playing football with fuel prices?” discussed this topical issue.

Mr. Weerakkody’s article prompted me to address some of the popular arguments with regard to the government’s fuel price policy.

At the first part of Mr. Weerakkody’s lengthy article, he suggests that the Government should subsidise fuel prices by raising the question, “Why do we need a government if they do not know how to even cushion a price increase to help the poor?”.

He attempts to validate his pro-subsidizing policy using two arguments. First, the burden of high fuel prices on low income groups, which as he thinks, has to be compensated by the government. Second, he believes that the government has to pass the benefits of very buoyant economy and the steady growth in FDI.

However, the second part of Mr. Weerakkody’s article is completely contradictory to the first part. Transiting to an anti-subsidisation policy very quickly, he emphasizes “Passing the increase in global oil prices to the user without subsidizing the CPC is a good move since it would not have a lasting negative effect on the economy”.

Rest of his article includes arguments in favour of both policies and the only linkage between his pro-subsidization and anti-subsidisation arguments is that both are used to criticize government’s action.

Mr. Weerakkody concludes his article inviting the civil society and the business community to “exert much more pressure on the administration to at least to resolve the economic crisis”, leaving the reader with a doubt whether the civil society and the business community should exert pressure on government to continue passing fuel price increases to consumers or refrain from doing so.

Buoyant economy - the beneficiaries?

As stated in Mr. Weerakkody’s article, the Central Bank Governor has said that the GDP Growth has been very strong despite the rising cost of living and there was a steady growth in FDI.

Notwithstanding the fact that the Central Bank Governor or anyone has mentioned the statistics show that the GDP growth has been reasonably high during past 3-4 years, in comparison to the country’s own past, and Foreign Direct Investment (FDI) flows have been strong.

But, the point Mr. Weerakkody can’t understand here is that the economy is not a synonym for the ‘Government”. The private sector contributes over 80 per cent of our GDP growth.

Therefore, the government does not own the full credit of the recent economic development. At the same time, government is not the only beneficiary of economic growth.

The only way that a government can benefit from high economic growth is through increased tax revenue resulting from high personal income and high corporate revenue.

But, as everybody knows, the government’s tax revenue is only sufficient to cover its recurrent expenditure. Successive Sri Lankan governments have never recorded a budget surplus during the last three decades.

When our income levels have risen, so has our expenditure. What that means is high economic growth does not necessarily imply better fiscal positions.

Therefore, a government may struggle to manage its cash flows while the economy is recording strong growth rates.

Therefore, the argument that the government can afford to subsidise fuel because the economy is growing fast, is flawed.

The FDI flows too, similarly, are attracted to the economy, and not to the government. When a foreign investor commences the operations of a new factory, by bringing in foreign capital, it is recorded as an FDI flow. But, it doesn’t transfer money to government’s account to help a fuel subsidy.

Will the poor be better off by a subsidy?

Of course, everyone including the poor would enjoy the benefit of subsidized fuel, if there were no trade-offs. But, the bitter truth is somebody has to pay for the subsidy. As explained above, a higher economic growth or increases in FDI doesn’t guarantee that the government would have excess money to fund a fuel subsidy.

Therefore, the government has to tax somebody to cover its costs for a fuel subsidy. Now, who will benefit from such a subsidy? There’s no argument here. Those who consume more fuel will benefit more.

Are the poor consuming more fuel than rich? Certainly not. Any mindful person would agree that a subsidy on fuel would benefit the more affordable segments of the society than the low-income groups.

Will the price adjustment solve the problem?

As the government repeats in its electronic media, fuel prices have increased by 450% during the last four years. Everyone can observe that the prices are continuing on a rising trend.

What that means is, the Sri Lankan government may have to repeat several rounds of domestic price adjustments in the future, if it has to avoid the burden of subsidised fuel. Price adjustments would help the government’s financing and reduce, to some extent, the inflationary pressures in the long run.

But, will it solve the problems with our external sector? Even if the domestic prices are adjusted in line with international prices, our import bill of fuel will double, when the import prices double, unless the consumption drops substantially.

Therefore, policy-makers will have to take additional measures to discourage fuel consumption. I suppose that the government’s move to maintain petrol prices even above the cost level would help discouraging consumption, even if their primary motive is enhancing revenue.

Exchange rate policy

It has been suggested that allowing the Rupee to strengthen against the dollar can cushion the adverse impact of high oil prices. Mr. Weerakkody’s argument in this case is not fundamentally wrong. Recent exchange rate movements show that the Central Bank too believes in maintaining exchange rate stability to deal with high inflation.

But, the issue here is, can the exchange rate be maintained at this level continuously? According to economic fundamentals, when the domestic inflation is higher than external inflation, the domestic currency should depreciate.

This can be avoided only if there are continuous capital flows. At the same time, an over-valued domestic currency can impact adversely on exports. Therefore some balancing action would be required.

Right thing for wrong reason?

One might agree with Mr. Weerakkody in saying that the decision of the government to raise the fuel prices even beyond the cost levels is not a genuine attempt to discourage consumption.

It may well be a revenue enhancement initiative of the government. Yet, nobody can deny that it will result in some reduction in consumption. At least, it will discourage further increases in consumption at the cost of the subsidy, which is finally borne by all the users of domestic currency.

Mr. Weerakkody mentions that the primary reason for high inflation this year was poor monetary policy and printing money.

However, as I noted, the debate on money printing and inflation was concluded recently with strong conclusions that monetary policy or money printing has not contributed to the current high inflation.

Even the international organisations such as the IMF, rating agencies and research reports of global banks such as HSBC have recognised this fact.

It appears that Mr. Weerakkody has been advised by his friend and political analyst on monetary policy, Dr. Harsha de Silva who has been shouting himself hoarse about money printing.

Since Dr. de Silva has had to eat his words on economic theories, perhaps Mr. Weerakkody has now been appointed by the UNP leadership as the new economic spokesman. We can only wish this political party good luck if the party continues to rely on this type of economic advisers.