The Hindu Business Line : Is crude price logic not just crude logic?

Even as crude oil prices have risen 40 per cent since January, the rupee has depreciated by almost 10 per cent against the dollar. The fuel price hike could have been deferred and inflation reined in had the RBI not been buying dollars from the market and instead released from its reserves the oil firms’ requirement of the greenback, argues S. GURUMURTHY.

“Ninety-four per cent of the weekly jump is on account of the fuel prices” — this is how the Finance Minister, Mr P. Chidambaram, has attempted an instant explanation for the demon of rising inflation. Many analysts, under pressure from the media for a quick response, have also found it easy to name the fuel price rise as the culprit. On a closer look at the facts, the fuel cost logic seems more like the instant reactions to Budgets without reading the fine-print that conceals the truth.

For a beleaguered government shocked by the huge jump in inflation numbers the fuel logic seems to have come handy as an easy escape. The Opposition parties have fared no better. They have, as usual, blamed the government without saying what it could have done.

In this game of escape and blame, the ordinary people are totally confused. Feeling the pinch of the real inflation in the market, and seeing the difference between actual inflation and the sarkari index, they wonder whether the figure, fixed at just 11.05 per cent, is true at all! Thus the national debate on inflation is more a game between those blaming and those escaping the blame, leaving the truth and the people as casualties.

The issue for debate is not what is causing the high rise in inflation but whether the government could have moderated its cause and contained its rise. But the shocking rise in global crude prices seems to have convinced the government that it is ridiculous to even think of seeking answers elsewhere for the unprecedented inflation.

Even if it were a ridiculous venture it seems worthwhile to ask, and attempt to answer, the question of whether inflation could have been moderated or contained by the government, rather than helplessly accept the crude price logic as final. Look at the background to the June the 7 figure of 11.05 per cent inflation.

INVERSE RELATION

After dilly-dallying for months and citing the global crude prices of over $128 per barrel, the government raised the petrol prices by Rs 5 and diesel prices by Rs 2 a litre in June 2008. What seems to have escaped the attention of many is something as obvious as the apple that Newton saw falling and others did not.

And that is, even as global crude was on a mad rise of 30-40 per cent between January and May this year, in the same period the rupee too depreciated against the dollar from Rs 39.20 to Rs 43.00 — almost 10 per cent. More, in just seven weeks from April 2, 2008, the rupee depreciated from Rs 39.95 to Rs 43.00 to a dollar — that is, by about 8 per cent.

Many seem to have missed the effect of this inverse relation between the rupee value and the crude cost. One per cent fall in rupee value in terms of dollars increases the cost the local fuel prices by 80 paise per litre. That is, the 10 per cent fall in the rupee value means a rise in oil prices by Rs 8 per litre; and the 8 per cent fall means a rise of Rs 6.40 per litre of petrol, in both cases without accounting for global crude rates.

It means this: the rise of Rs 5 for petrol and Rs 2 for diesel effected by the government in June 2008 does not offset the full effect of the fall in the rupee value on local fuel cost. It does not contribute a single paisa to the higher global crude prices.

Now, imagine that the rupee has not fallen in terms of the dollar. The rise in petrol/diesel prices made in June 2008 could have been deferred, at least for now, as taming inflation is undoubtedly the Government’s top priority. Even in respect of imported petro-products not subject to administered prices, the fall in rupee value has increased their cost to the domestic market.

It is evident that if the rupee had not depreciated, the petrol/diesel prices, which have triggered the high inflation, could have been deferred.

The next question now is: Could the government or the RBI have prevented the fall in rupee value from Rs 39.20 to a dollar in January 2008 to Rs 43 to a dollar in May 2008, where it stands even today? The answer is: Yes.

Undoubtedly the RBI and the Government could have prevented the fall in the rupee value at this critical time, and at least for the time being. When global crude is in a mad state, to allow the rupee to fall against the dollar would have the effect of adding the fall rupee value to the crude price in terms of rupees.

In fact, the Government and the RBI ought to maintain the rupee value. But a look at the exchange management by the RBI in 2007-08 reveals that the Government and the RBI were doing the very opposite, namely they had worked to ensure that the rupee fell in value and the dollar rose.

RBI’s dollar purchases

The greatest damage occurred in exchange management during the 12 months ending March 2008. In this 12-month period, the RBI bought dollars in the spot market for $78.2 billion.

To compound it and make it worse, in the six months from October 2007 to March 2008, shockingly, the RBI began buying dollars in the forward market too — taking positions of $4.99 billion (October), $7.55 billion (November), $8.2 billion (December), $16.6 billion (January), $18.2 billion (February) and $14.74 billion (March) to strengthen the dollar and weaken the rupee.

Thus, during the year 2007-08 the RBI bought and took forward position in dollars for a shocking amount of $94 billion for the year, at an average of $8 billion per month.

Ironically, the dollar purchase by the RBI for the entire year 2005-06 was just about that figure — $8.1 billion! Again, for the whole year 2006-07, the net total dollar purchase by the RBI was $26.82 billion, less than 30 per cent of the dollar acquisition in 2007-08. Had the RBI not supported the dollar and not suppressed the rupee as intensely as it has done, the rupee, which was around Rs 39-40 per dollar in 2007-08, would have risen to a band of Rs 35-37 per dollar.

This would have meant a huge cut in fuel prices in India. In fact, only because the rupee was less than Rs 40 to a dollar for most part of the year 2007-08 did the oil firms in India survive, their crude cost less by at least Rs 40,000 crore.

The RBI exchange management policy to keep the rupee around 40 to a dollar not only kept the rupee undervalued, but also caused the sudden appreciation of the dollar in April and May 2008 to Rs 43. Why did the dollar appreciate in April and May 2008? A look at the Reuters and MSN news reports on forex dealings in India from March to May 2008 brings out the fact that huge purchases of dollars by oil firms in India to pay for highly priced crude resulted in huge demand for dollars in April-May 2008 and that caused the dollar to appreciate, and the rupee to fall.

But could the RBI have prevented this? Yes. It could have released from its huge foreign currency holdings of over $300 billion — more than a third of which it had built during the 12 months ending March 2008 — a few billion dollars to the oil firms to bring down the demand for dollars in the spot and futures markets.

But this is precisely what the RBI and the Government did not do. Instead, even in April and May, the RBI kept buying dollars and increased its forex currency holdings from $299 billion at end-March 2008 to $305 billion at end-May 2008 — a rise of $5 billion.

Had the RBI stopped buying dollars in April and May 2008, and released from its dollar stocks the requirements of the oil firms’ dollars, the rupee would not have depreciated, and the rise of domestic petrol/diesel prices could have been deferred for better times. Undoubtedly this would have directly moderated the inflation. So, Mr Chidambaram, is not the crude price logic just crude logic?

(The author, a corporate adviser, can be reached at guru@gurumurthy.net)