It Isn’t Gas: If You Fix The Price, You Pay a Price

Dhiraj Nayyar is chief economist, Vedanta Ltd, and the author of Modi and Markets: Arguments for Transformation
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How the UPA’s muddled economic policies have
Delhi Chief Minister(1) Arvind Kejriwal is crying conspiracy, once again. He claims to have smelt something odorous in the pricing of natural gas. He wants to prosecute Union Petroleum Minister Veerappa Moily, his predecessor Murli Deora, former Director General of Hydrocarbons VK Sibal and Reliance Industries’ Mukesh Ambani for ‘fixing’ the price of gas. Kejriwal is on to something, except that his conspiratorial mind and desperation to grab headlines clouds his ability to identify the real problem.

The real problem is that the Government, whether Moily or Deora or anyone else, has no business setting the price of gas or of any other commodity. But the Congress-led UPA has insisted on doing precisely that in a gamut of crucial sectors, be it gas, diesel, spectrum, coal mines, land and agriculture. It is this penchant for fixing prices by administrative fiat that has saddled the Congress and its allies with twin issues that could cost them the next General Election: corruption and inflation.

Economics is an imprecise, dismal science. Still, it holds out some wisdom for the world. It tells us, for instance, that market mechanisms are far superior at discovering prices than bureaucrats or ministers are. Those who have defied this elementary truth have paid dearly: the Soviet Union found itself bankrupt and quite literally broken after decades of price-fixing by sundry administrators. India too paid a heavy price for the Government’s dabbling in price-setting all the way up to 1991. If there was one thing Liberalisation achieved, it was ridding us of the notion that bureaucrats knew best. Until that point, even steel prices were set by Delhi’s Udyog Bhavan.

How ironic it is that the man who presided over the dismantling of several price controls in 1991, Manmohan Singh, is the same man who has presided over the fixing of so many prices some 20 years after Liberalisation. It is his successors in the Congress, led by Rahul Gandhi, who will now pay the price for fixing prices.

Take the case of gas. In 2009, the UPA decided that Reliance would sell the gas from its KG Basin fields at the rate of $4.2 per unit. In 2013, it was decided that this price would be doubled to $8.4 per unit from 1 April 2014 onwards. It is this doubling that Kejriwal is furious about. The point, however, is this: how does Kejriwal or anyone else know if this is the right or wrong price? In Kejriwal’s worldview, his administrative fiat is better than that of the Congress or BJP because he is not corrupt. Histrionics aside, that is hogwash.

For one, contrary to Kejriwal’s claims, the UPA raised the price of gas based on a formula proposed by C Rangarajan, Chairman of the Prime Minister’s Council of Economic Advisors, and not on ministerial whim. But Rangarajan is not the market. The right price of gas can only be determined by the forces of demand and supply, not just in India, but at a global level. That may mean that Reliance would earn a price greater than $8.4 per unit or less than $8.4 per unit, depending on global factors—which change every hour, unlike bureaucratic decisions which change every five years.

Sure, natural gas is a national resource and the Government must get a share of its profits. The right way to do this is to charge royalties based on the market price of gas. There may be a case to subsidise end consumers (say, of power based on gas) when international market prices are high. Again, the way to address this is to target a subsidy at those consumers who need it, not control prices.

There are other ways to ensure that prices remain moderate. The best way is to ensure competition. Again, the way to do this is to encourage more private sector and foreign investors in the gas sector, something the Government has been loath to do. And if a firm tries to overprice gas, there should be an independent regulatory mechanism, not the captive (to ministerial whim) Petroleum and Natural Gas Regulatory Board, which should play referee. The UPA has invested in none of these propositions. It has just fiddled with prices, waiting to be burned. Kejrwal certainly wasn’t going to miss an opportunity.

It is incredible that the UPA did not learn its lesson on transparent pricing mechanisms despite the damage it incurred over its 2G spectrum allocations. It was in January 2008 that then Telecom Minister A Raja overruled Prime Minister Manmohan Singh’s request for an auction of 2G spectrum and doled out 122 licences based on a whimsical version of a first-come-first-serve policy, whimsical because procedures were manipulated at the last minute to ensure than even the first-come-first-served principle was brutally violated.

Even in the 2G scam, it is important to distinguish the conspiracy from the arbitrary fixing of prices. The conspiracy involves procedural violations and money trails that suggest a quid pro quo. The fixing of the licence fee at a rate determined fit by the Government is not a conspiracy in itself. It is just old-fashioned socialist planning of the bureaucrat- knows-best kind.

Much was made of the report of the Comptroller and Auditor General (CAG), which in 2010 declared that the exchequer may have incurred a loss of up to Rs 1.76 lakh crore by not auctioning 2G spectrum. Some were outraged at Raja. He lost his job. Others were outraged at the CAG; how on Earth had he calculated such a huge figure? The truth is that the CAG, like Raja, would have no precise idea on the right price of spectrum. Only a free, competitive market can discover that price, not a bureaucracy, not an accountant. But the UPA had only itself to blame for facing the brunt of the CAG’s report. If it had reposed its faith in the market pricing mechanism, there would have been no scandal.

Incredibly, exactly the same thing was permitted in the allocation of coal mines in 2009, several months after the 2G scam had already raised its ugly head in media reports. Once again, Liberalisation’s father Manmohan Singh initially asked for auctions in the allocation of these mines, only to back off in favour of administrative allotments. Again, giving out coal mines free may or may not point to corruption. The Government may deliberately want to provide cheap inputs to power-producing companies. But in an atmosphere where the Government is distrusted and crony capitalism is rampant, it is a folly to rely on an administrative rather than free-market mechanism for such an allocation of resources. Again, it is impossible to say whether the CAG was right in estimating the losses from Coalgate at Rs 1.8 lakh crore. A free market mechanism may not have yielded the same figure had the mines been openly auctioned. But the UPA had only itself to blame for subverting the market.

Together, Coalgate and 2G destroyed the UPA’s credibility. They led to an unprecedented policy paralysis, which crippled the economy and saw economic growth fall from 8.5 to 4.5 per cent in a period of three years. It gave the opposition plenty of fodder to attack the UPA on corruption and its economic record. It gave Kejriwal the opportunity to attack the UPA on Reliance and gas pricing just two months before a General Election. And all of that because the UPA forgot that one golden rule of economics: let prices be determined by demand and supply.

If corruption—or at least perceptions of it—is the UPA’s black stain, then inflation (very real, no perception) is its Achilles Heel. The unabated price rise of UPA’s second term in office can directly be traced to food items, particularly vegetables, fruits, milks and protein that are produced by the country’s vast agriculture sector. The UPA has put forward a simple explanation for the persistent, usually double-digit rate of food inflation. It says that inflation is the price being paid for prosperity as a rise in incomes (particularly rural incomes courtesy the UPA’s welfare programmes) has outstripped the supply of agricultural commodities. In this explanation, the UPA is apparently embracing conventional economics: prices rise when demand exceeds supply.

Unfortunately, the UPA is peddling a half-truth. It says nothing about the supply side, even though it spends a lot of time and money fiddling with the market mechanism (particularly prices), which ultimately determines that supply.

The UPA’s favourite instrument in agriculture is the Minimum Support Price (MSP), a floor price the Government offers rice and wheat farmers to procure their produce. The aim of the MSP is noble, to guarantee farmers a good price, but its side effects are devastating. First, the MSP is unidirectional; year after year, it is only raised, not reduced even in times of a bumper crop. This affects inflationary expectations in the rest of the economy. Second, since the MSP is available only to producers of cereals, there is a perverse incentive for all farmers to grow rice and wheat at the expense of fruits and vegetables, which do not have any guaranteed price and are prone to high rates of damage. This creates a supply shortage in precisely those commodities that are growing fastest in demand (demand for cereals tends to grow much slower compared to vegetables and proteins as incomes rise). The fact is that the Government’s MSP policy is fuelling food inflation.

Unfortunately, the Government’s price intervention in agriculture does not end with the MSP. The UPA, more than any other Government, has used export bans of key agricultural commodities (such as onions and cotton) in desperate attempts to control domestic prices. These have been counter-productive. It kills the incentive for a farmer to produce more of a commodity if he is denied its global best price. This creates a vicious cycle of shortages. Ideally, the Government ought to loosen imports at times of shortage, but the mandarins of the UPA are addicted to playing havoc with proper price signals. It’s for the same reason that the temptation to ban futures trading in agricultural goods surfaces from time to time. All that a ban does is deny farmers a useful market price signal and the agricultural economy an automatic correction mechanism. If prices are high today, farmers will produce more, forcing prices down in the future. This is elementary economics, but it has been totally lost on the UPA.

It is too late for the UPA to course correct at this stage. Even the determined P Chidambaram can do little to reverse this cavalier rejection of the free market price mechanism as he rises to present his Government’s final (interim) Budget on the morning of 17 February.

The extent of systemic damage is so great that even a bonafide government decision is now viewed with suspicion. It will take more than a Budget for the next Finance Minister and Prime Minister to fix the system. It would help, though, if they made one concession, not to business, but to economics: let prices be determined by the market. It will bestow upon governance the credibility that this important business needs.

(1): This article was printed before Arvind Kejriwal resigned from the post of chief minister of Delhi