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Why India's fuel reforms are a big deal

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The Indian government announced two important fuel reforms – a deregulation of diesel prices and a hike in natural gas prices – over the weekend, a signal of Prime Minister Narendra Modi's commitment to tough economic reforms.

The price of widely-used diesel was deregulated effective midnight of October 18, while natural gas prices will be raised to $5.61 per million metric British thermal unit from $4.20 on November 1, and revised every six months.

So what are the implications of the fuel reforms for Asia's third largest economy?

Controlling the fiscal deficit

Freeing diesel prices from state controls and pegging them to international rates effectively eliminates the subsidy on fuel. This will lower the government's subsidy bill by around 0.3-0.4 percent of gross domestic product (GDP), DBS estimates, and shield the government's balance sheet from volatility in global crude prices.

The government's fuel subsidy bill was about $11 billion in the year ended in March, around half of which was for diesel. Diesel accounts for around 44 percent of total fuel consumed in the country.

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"The fuel reforms bode well for the fiscal outlook," said Sonal Varma, chief India economist at Nomura, noting that with both diesel and petrol prices now market-determined, the government will subsidize only liquefied petroleum gas (LPG) and kerosene.

India's fiscal deficit was 3.98 trillion rupees ($64.4 billion) during April-August, or about 74.9 percent of the full-year target.

Investment boost

Higher natural gas prices are set to encourage investment into the gas sector, say analysts.

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Artificially low prices have discouraged investment in developing production capacity, including the building of pipelines and terminals for more expensive liquid natural gas.

There have been growing calls by producers reeling from high production costs to hike natural gas prices, said Radhika Rao, economist at DBS. "With higher prices, one can expect more investment interest in that field," she said.

Inflation implications – not much

The fuel reforms will have a marginal impact on inflation as the consumer price index (CPI) basket is predominantly made up of food and services, says Rao. The CPI is the key measure of inflation for the Reserve Bank of India.

Nevertheless, higher natural gas prices could push up the cost of cooking gas and compressed natural gas used by buses, taxis and other vehicles.

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Finance Minister Arun Jaitley said the central government will urge state governments to cut local taxes to soften the impact of this.

Double-edged sword

While the recent decline in global crude prices along with the deregulation is positive for the economy, there's a caveat.

"Any sharp rebound in global crude prices will filter through as a negative trade shock, especially as petrol and diesel prices are now market-determined," said Rao.

"Such an event will truly test the government's resolve in keeping prices market-linked and not reviving state interference."