When oil prices began surging late last year, it was widely believed that it was a temporary spike. Many countries, including India, did not believe it was necessary to pass on higher prices to consumers, preferring to absorb the impact by subsidising prices. As it turns out, the pattern did not sustain for very long. As a result of sharp declines in global demand, crude prices are now a half of what they were three months back, and indeed back to where they were a year ago. But even now, the government is not recovering the full cost of petroleum products from the consumer, and the cumulative subsidy bill has risen beyond all expectations, putting enormous pressure on government finances. In India, the subsidy bill has been further enlarged by the need to keep the issue prices of fertilisers low in the face of surging international prices, driven of course by rising energy prices. This double whammy, reinforced by other measures like the loan waiver, will take the effective fiscal deficit of the central government to more than double the budget estimate. While this has been known for some time, its significance has increased in the context of the liquidity crisis that the Indian financial system is dealing with today.
In order to cover the losses of the oil and fertiliser companies, the government issued them bonds. These bonds could, theoretically, have been traded in the market to raise cash. However, there were really no takers and the bonds could only be sold at a steep discount. This left the oil companies, in particular, with inadequate cash with which to finance their crude oil imports. They had to borrow from banks, which very soon took the system up to its upper limit for sectoral exposure. In response, the Reserve Bank of India (RBI) did two things. It raised the exposure limit for the petroleum sector and it initiated a Special Market Operation, in which oil companies could swap oil bonds for dollars, which would be used to finance imports. This measure accomplished two goals. It eased the pressure on the liquidity in the banking system as oil companies reduced their borrowing. And, it took the oil companies away from the spot foreign exchange market, since they could now buy dollars directly from the RBI. The rupee, which had been steadily depreciating until then, stabilised immediately.
However, those gains were short-lived. The oil companies exhausted their supply of bonds in a few weeks! No new bonds have been issued during 2008, a problem that has still not been rectified. Oil companies, therefore, went back to borrowing from banks and buying dollars in the spot market. With all the other pressures on liquidity, this was one the system could clearly have done without. With Parliament about to reconvene, the backlog of bonds should be issued soon. The RBI has also declared its intention to resume the dollars-for-bonds swap as soon as feasible.
These developments should contribute to the further easing of liquidity pressures, but they highlight a fundamental concern. Bad fiscal management, apart from all its other consequences, also affects the functioning of financial markets by putting unnecessary pressure on the demand for funds. Fortunately, the pressure from oil prices is abating, which will reduce the subsidy bill; more importantly, it gives the government a chance to correct prices and to eliminate the subsidy entirely, thereby stopping the distortion of the liquidity situation.
