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The decision to implement a cost reflective pricing policy for fuel was a rare instance of political courage in economic decision making. This unpopular decision to increase the price of petroleum products on May 9 was in the interests of the economy. It was an act of political courage at a time when the Government is required to regain its popularity in the run-up to elections in 2019 and 2020.

Had domestic prices not been increased, the Government would have had to incur losses that would have increased the fiscal deficit and caused considerable economic instability. Furthermore, keeping domestic fuel prices low means that fuel imports would remain high and cause a serious dent in the trade balance, and would in turn affect the balance of payments adversely. Given the country’s balance of payments situation and the impending large foreign debt repayment next year, restraining import expenditure on oil is imperative.

International prices
Keeping domestic prices in line with fluctuations in international prices is essential to contain the fiscal and trade deficit. Unfortunately successive governments have not followed this practice.

Prior to 2014 when oil prices were low, the gains were not passed on to consumers. In 2015, as part of the new Government’s promise to bring down the cost of living, fuel prices were reduced. This was at a time when international prices had fallen. Since then the domestic oil prices were kept low despite international prices rising. International prices that were around US$ 35 in 2015, had risen to US$ 77 on the night the decision to increase prices was taken.

The next price revision would be in July. International prices may rise or fall by then. Most predictions are, however, of a further increase in prices towards US$ 100. Trade restrictions on Iran, sluggish oil production in some Middle Eastern countries, and speculation are expected to increase international fuel prices.

The country’s balance of payments predicament is such that even if international prices fall, the reduction of domestic prices is ill-advised as oil import expenditure is an important reason for the country’s large trade deficit.

Impact
Overall price increases are inevitable owing to the increases in fuel prices. The increase in fuel prices would increase the cost of living, both directly and indirectly. Transport costs would increase for persons and goods. Consequently articles of mass consumption, including food, would increase by more than the actual increase in transport cost, as is usually the case. Furthermore even when the price of oil is reduced, other prices are likely to remain at the original level. Economists call this phenomenon of prices tending to remain at the level it reached as the “ratchet effect”.

Expectations
The twin expectations of the cost reflective pricing are the avoidance of a government subsidy on fuel consumption that will not increase the fiscal deficit and curtail oil imports so as to not strain the trade balance and balance of payments.

The first objective will be achieved if the entire cost of the price increase is passed on to consumers. The second objective of curtailing oil consumption and import is difficult to achieve owing to several reasons.

Inelastic demand
The general law of demand is that when prices rise, consumption or demand decreases. However in the case of fuel consumption it has an inelastic demand. When prices rise the demand does not decease proportionately. This is due to fuel being an essential consumer item and having few substitutes. For instance the fuel price increase that increases the cost of bus travel will not reduce transport needs proportionately, as travel is essential. Some travel would of course be curtailed.

The second reason for the price increase not leading to a substantial decrease in fuel consumption is that the number of vehicles is increasing. For instance, vehicle imports increased by more than 100 percent in February this year, in comparison to figures for February last year. This increase in vehicle imports implies new demand for fuel.

Furthermore, the increase in fuel prices was, in fact, marginal and most motorists will continue to run their vehicles in much the same way. The huge number of luxury and high powered vehicles implies that these consumers are not likely to curtail their consumption of petrol and diesel.

Government consumption
That the Government is a large consumer of fuel is a huge constraint to reducing fuel consumption. The security forces, politicians who use helicopters, nearly 100 ministers and deputy ministers who use big fleet of large luxury vehicles are consumers without constraints in spending on fuel.

Public sector
If a serious curtailment of fuel imports is to be achieved there must be a control on such public sector fuel consumption. Quantitative restrictions on government use of vehicles are essential to contain fuel consumption. Unless there are measures to contain fuel consumption by the public sector, the cost reflective policy is unlikely to reduce imports of fuel. The Government must concern itself on the vast expenditure on oil imports and not only the fiscal expenditure on an oil subsidy. The proportion of expenditure on oil imports is rising sharply to increase the trade deficit. It is likely to be over 30 percent of total imports.

Summing up
Despite the unpopularity of increasing domestic prices of fuel in line with international price increases, the Government must be congratulated on a politically courageous correct economic decision. While it will, no doubt, increase the cost of living, there are reasons to doubt that the much-needed reduction in fuel imports may not be realised owing to the inelasticity of demand and the large government expenditure on fuel. It is important for the Finance Ministry to devise complementary policies to ensure that fuel imports are contained at about 25 percent of the import bill.

The opposition would, no doubt, exploit the unpopularity of the increase in prices to gain political mileage. A more responsible opposition concerned with the economic interests of the nation would have lauded this correct economic decision.