Substantial energy price adjustment is the likeliest outcome of the IMF negotiations. It will be interesting to see if the authorities and IMF agree on a well-thought-out plan to phase price increase. The or-nothing approach when dealing with energy price subsidies has long been an issue, that mostly stems from often long periods of inaction, and acting only when absolutely necessary.
Petrol, diesel, electricity, and gas price changes are under consideration. The degree of the subsidy varies from one product to another. In the case of petroleum, while there may be no explicit subsidy, there is ample room in terms of forgone taxes as GST remains zero.
In the case of electricity, ad hoc announcements during the fiscal year have given rise to an unfunded subsidy that runs close to half a billion dollars. The cost of system inefficiency is besides that. For gas, the implied subsidy could be higher than electricity, as a combination of delayed adjustment, criminal price disparity among consumer categories, and hundreds of billions stuck due to litigation –all come to a party.
Here is an attempt to look at the impact of energy subsidy reform on inflation. It is trickier than what it looks on paper, but still worth considering while making pricing calls on energy products. Energy subsidy reform will always have a first-round effect, which can be termed short-run. In some cases, there will be a second round of inflation beyond the 12-month base period, especially when inflation expectations are not well-anchored.
The IMF has dealt with energy subsidy reforms more than any other body in the last 20 years across Africa, emerging markets, and MENA – and the literature suggests that second-round effects in the medium term tend to have a higher chance when there are indexation mechanisms in the country. What will matter is also if the effect is transitory or persistent. When a price rise leads to higher inflation in other products, core inflation tends to rise, as the second-round stretches.
How is persistence determined? One way is to look at the size and pace of the required price increase. A large price gap would invariably lead to large adjustments. How you decide to time the reform will have a bearing on the extent of the second-round effect. Usually, a very large adjustment in a short period of time runs the risk of more persistent inflation with the second-round effect kicking in, almost always.
The respective weights in the consumption basket will determine the degree of direct impact on inflation. The use as an intermittent input will determine the extent of indirect impact on inflation and can be loosely marked by weights in the WPI consumption basket. For example, a change in gas price would have a very low indirect impact, given its usage as in intermittent input. Compare that to electricity, and you will have the highest impact on both direct and indirect inflation. Diesel on the other hand, will be higher on the indirect impact and lower on direct.
Another consideration while making energy pricing adjustments is existing inflation in the country and the stage of the commodity cycle. In the last 20 years, IMF workings show the second round effect is higher when high adjustments are carried out during a commodity boom cycle or high inflation. The central bank’s response to the timing, extent, and breadth of the energy subsidy reform then becomes critical.
Here is hoping the painful adjustments do not come without due consideration and that there is enough learning on how subsidies should or should not be phased out.
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