Corporate Study Circle: An interesting read...

Petrol at Rs 30 a litre? Possible, but...

S. Gurumurthy

Both Marxists and the BJP perhaps feel shy to find themselves together on the petrol price hike. But little do both realise that the economics of petrol prices needs deeper reflection and is not simply a subject of slogans and agitations. There is a process link between crude and petrol, yes. But there is a missing link between the cost of crude and the price of petrol. What is that missing link? We pay for crude supplies from outside in dollars. But we sell petrol and diesel refined out of the dollar-based crude for rupees. Thus there is an intermediary between the prices of dollar-based crude and rupee-based petrol and that is the exchange rate between the dollar and rupee. So petrol prices in rupees not only depend on the price of crude in dollars but also the price of dollars in rupees. How this missing link between the crude and petrol prices works? The global crude price today is over 70 dollars per barrel. With the dollar rated at Rs 46, the cost of one barrel of crude is Rs 2,842. Imagine the price of one dollar is not Rs 46 but just half of it – Rs 23. Then the price of one barrel of crude becomes half in rupee terms, namely Rs 1,421, even though in dollar terms it is the same, that is, 70 dollars. So if the rupee appreciates in value we need to pay less rupees for dollars. Consequently, the crude will cost less in rupee terms. What is the issue now? Currently the dollar price in rupee terms highly undervalues the rupee whose real value is more. This compels us to pay more rupees for dollars. This makes the imported items, including the crude rated in dollars, costly in terms of rupees. How did the rupee get undervalued in the market? It is the Government of India which has exerted pressure to have the rupee undervalued. Surprised? It is not a well-kept secret that in the post-reform period, whenever the rupee rose against the dollar, the Government intervened to support the dollar against the rupee and kept the rupee in the market at lower than its real value. But why should the Government do it? And how to determine the real value of the rupee and prove that the Indian currency is undervalued in the market? A slightly complex subject, but can be simplified for the uninitiated. Experts would counsel that 'in the long run', that is over a period, the value of a currency would be equal to its purchasing power, regardless of the short-term fluctuations in its prices in the market. The real determinant of the exchange value between two currencies, they say, is the relative purchasing power of both, known as Purchasing Power Parity (PPP).

Between 1955 and 1985 the real value of the Indian rupee and its exchange rate with the dollar were similar. In 1982 the real value of the rupee on PPP terms was Rs 15 to a dollar and the exchange rate was less, Rs 9.3 to a dollar. But between 1985 and 1992, the situation reversed; the real value of the rupee became lower than its actual exchange value. This led to a 20 per cent corrective depreciation of the rupee in 1991. However, from 1993, the policy was to leave the rupee largely market-determined for trade and current transactions and except for capital account. This is where the present story starts. Particularly from 1994 when investments by Foreign Institutional Investors were allowed, the rupee began appreciating in real terms. But the Finance Ministry and the RBI began intervening repeatedly to keep the rupee priced in the market at below its real value. Obsessed with the export-driven growth model of East Asian economies, the fashion then, the Government had opted for this strategy. As a crisis management formula for a while it was okay. But, on durable basis, this is unsuitable to an economy like ours which largely works on domestic activity. More, with the unprecedented dollar cost of fuel it is devastating the domestic economy now. That the rupee has been deliberately kept undervalued in the market is self-evident. First, take the rise in foreign exchange reserves and fall in rupee value. In principle if the foreign exchange reserve – that is foreign currency assets – rises, then the value of the rupee too will rise. Indian foreign currency assets have increased from 26 billion dollars in 1993 to 160 billion dollars today – an increase of 615 per cent. Surprisingly, thanks to the RBI interventions during this period to help the dollar and suppress the rupee in the market, the rupee did not rise at all! On the contrary, it has fallen from Rs 31 per dollar to Rs 46 per dollar now, that is, by 50 per cent! Next, take the Purchasing Power Parity between the rupee and the dollar. The actual GDP for 2005 measured in market determined rupee-dollar rates is 746 billion dollars against which GDP in purchasing power terms is 3699 billion dollars, that is, five times the market exchange-rated GDP. It means that the buying power of rupee is five times its actual exchange rate. Consequently the price of the rupee in the market is one-fifth of its real value. Theoretically then, the real exchange value of the rupee for the dollar should be Rs 9 to a dollar against Rs 46 to a dollar in the market today. Thus both in terms of rise of foreign assets and purchasing power of the rupee, its value should be higher than in 1993, but it is actually less! If the dollar-rupee exchange value today were the same as in 1993, when the Indian economy was not faring as well, the cost of the imported crude will be half of what it is in rupees today. This would halve the petrol prices. Then it is possible to sell petrol at Rs 30 per litre. But this will happen only if the policy makers get over their obsession of the 1990s for export-led growth.

Imagine the energy prices are halved today. What would be the competitive advantage of India? Is there any need to promote exports then? Exports will rise automatically once such cost advantage is built in. We are undervaluing the rupee to promote exports, and damage the domestic economy with artificially high energy cost which in turn hurts our export competitiveness. Ridiculous is the word. This has to be reversed. Today a strong rupee will make a stronger economy as some one put it. The reversal process can be calibrated over a period so that it does not cause shock. Will the Government and the RBI rethink? Will the Opposition, the BJP and the CPM, think rather than strike?

Comment: gurumurthy@epmltd.com


P.S: There are three kinds of lies: lies, damned lies, and statistics. But this is interesting... http://www.kshitij.com/research/petrol.shtml

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Cheers,

Corporate Study Team