Economics Blog

There is a lot being said these days about rising commodity prices, in particular oil prices. Yesterday, after 2 consecutive sessions of price fall, oil prices jumped to record highs, fleeting close to the $140/bbl mark. While loads of market participants are blaming speculators for manipulating the market, others point to the constraint supply not matching rising demand as the key reason. It is undoubtedly true that emerging economies like India and China’s unquenched thirst for oil has more than offset any slowdown seen in the US, and with the Olympics coming up in China, things are unlikely to change, at least in the short term. Moreover, OPEC is reluctant to pump in any oil, even at these ridiculous prices and non-OPEC supply is faltering.

Of course, yesterday’s move up was primarily due to Israel’s comments that an attack on Iran’s nuclear facilities is inevitable. The likelihood of that, well, remains to be seen, given that the US is in its election year and given the failure of the Iraq war, the US will think more than twice before attacking anywhere really! (more on this to come later…).

Nonetheless, whatever the cause of the price rise, what’s interesting is that higher prices have actually failed to dent demand massively in any part of the world. Which brings me to India’s recent hike in fuel prices. There was a huge row in India when the government raised prices earlier this week. There were threats of strikes and boycotts all over India, and of course people were very upset. Understandably so, because 40% of India’s population is still well below the poverty line. But, interestingly, the people created all the havoc were probably some of the richest in India! I am probably one of the very few people in the world who agrees with the Indian government’s decision of hiking prices, at a time when international prices are going through the roof. But that is because I am an economist.

The Indian government’s budget deficit is increasing due to the heavy subsidies it provides on petroleum products, and this is no longer sustainable at a time when oil prices are near $140/bbl. What people fail to understand is that a big budget deficit is a lot more harmful for the economy, compared to rising energy costs. With the latter, hopefully, people will restrain themselves from using cars unnecessarily and make use of public transports like buses and trains more. But with the former, the consequences can be devastating. An increasing budget deficit will inevitably lead to the rise in taxes (not necessarily income tax, as some of you will argue that the poor don’t earn enough to pay taxes!, but also VAT), and often that is likely to hurt the poor more. Since the poorest in India are unlikely to have a car, they are less likely to get affected by rising petrol prices. Of course, gas price hikes (though kerosene prices are unchanged) will eat into their budget, but definitely by less than if taxes were to increase. Also, a rise in government’s deficit can put off foreign investment in India, a factor that has definitely contributed to the economic boom in the country. At a time when the government needs to spend on improving India’s infrastructure, if India is to compete with China in becoming the new super power of the world, India’s roads have to improve. And this is costly no doubt!

Fuel price increases will impact inflation adversely, and that can be damaging to the prospects of economic growth, especially if the Reserve Bank of India is to raise interest rates. However, this is where the government should/could do some work. By raising fuel prices, they are hoping to reign in on demand, and recover substantial amounts of taxes, since the majority of India’s fuel costs are excise duties and sales tax, and then they could subsidise the poor in an environment of rising prices.

Tags: China, election, India, inflation, interest rates, Iran, Israel, nuclear, oil, OPEC, tax, US

This entry was posted on Saturday, June 7th, 2008 at 2:10 pm and is filed under Commodities, Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.