Impacts of Falling Crude Oil Prices and Reduction of Energy Subsidies on the Indian Economy: A CGE Modelling Approach

Abstract

This study analyzes the impacts of international crude oil fluctuations and energy subsidy (on LPG, petrol and diesel) removals on Indian economy. We have applied computable general equilibrium (CGE) modelling as our relevant methodology, following Shoven and Whalley (J Econ Lit XXII: 1007–1051, 1984) based on energy social accounting matrix (ESAM) of India for the year 2007–2008. It is seen that the international crude oil price fluctuations has a greater effect in determining gross domestic product (GDP) and exchange rate as compared to the effect of energy subsidy removal. With decrease in international crude oil price, GDP increases and exchange rate appreciates. On the other hand, with decrease in energy subsidy, GDP decreases and exchange rate appreciates. Moreover, with introduction of direct cash transfer scheme in lieu of subsidy for LPG, it is seen that the impact on demand of LPG (substitution effect) is negligible indicating that LPG is an essential commodity.

Keywords

CGE ESAM energy subsidy crude oil price

Introduction

Crude oil imports account for 21 per cent of India’s total import value.¹ In 2015, India imported 189.43 million tonnes (MT) which is around 70 per cent of its total crude oil requirements² and spent US$105 billion of foreign exchange on crude oil.³ The general perception in India for a long time has been that this huge dependence on import of crude has been one of the primary areas of weaknesses for the Indian economy. Foreign exchange reserves have been depleted disallowing the import of other essential goods including those that are required to bolster India’s industrial production and export casting a negative spell on the gross domestic product (GDP). The import bill considerably weakened India’s currency in the international market. It has also been conjectured that the cost push inflation during periods of rising crude prices has further aggravated the negative impact on GDP as well as the social sector. Finally, a plethora of subsidies especially in petrol, diesel and LPG that have been imposed to safeguard the interest of consumers has been a drain on the resources of the government limiting the government’s ability to spend both on the social sector and for boosting economic growth. Therefore, any fluctuations in global crude oil prices will affect price of petroleum fuels in India and other products as well as other macro-economic parameters due to interlinkages in the economy (as studied in a general equilibrium framework). So it is very important to study the effect of crude oil price fluctuations or any other factors (such as subsidy reduction) which affects the price of domestic fossil fuels in India and hence influences other economic indicators.

Between 2007 and 2015, crude oil prices have fluctuated between US$69 and US$52 per barrel⁴ with a general declining trend from 2012 to 2015. With the easing of crude oil prices some of the problems associated with the soaring oil import bill are expected to be mitigated. This period is also interesting as the Government of India took advantage of the fall in global crude oil prices to reduce subsidies on fossil fuels significantly. While this has pulled crude prices in the reverse direction negating some of the purported benefits from the falling crude prices, it has also eased the constraint on the fiscal deficit of the government expanding its capacity to allocate more funds to towards economic development. The net effect on the basic parameters of the Indian economy needs to be evaluated and understood. Note that the actual effect of these changes on the Indian economy is almost impossible to determine as the economic environment under which these changes occur is itself in a situation of continuous flux due to simultaneous changes in economic policies and exogenous variables affecting the Indian economy. However, what can be attempted is a series of ceteris paribus experiments that model fluctuations in crude prices and the concomitant changes in subsidies/taxes. The chief purpose of this study is to comprehend general equilibrium impacts of the fall of global crude oil prices and removal of domestic energy subsidies on the Indian economy.

In this study, we use the computable general equilibrium (CGE) framework⁵ to conduct three such experiments: (i) the impact of the fall in international prices of crude had taxes and subsidies on LPG, petrol and diesel remained constant at the 2007–2008 level; (ii) the net impact of the changes in taxes and subsidies on LPG, petrol and diesel on the Indian economy had crude oil prices remained constant at 2007–2008 level and (iii) the net impact of change in international crude oil prices and changes in taxes and subsidies on LPG, petrol and diesel between 2007 and 2015. Note that not only LPG subsidy fell from 72 to 25 per cent between 2007 and 2015 but also the nature of reimbursement of the remaining subsidy had changed in case of LPG from reimbursement during the time of purchase to reimbursement to the bank account of the customer at a later date. This change, which is basically a change from a fall in price of a unit of LPG to an increase in income by the amount of the subsidy, is expected to decrease the consumption of LPG due to the absence of the substitution effect of a fall in prices in the latter case. While conducting this experiment, we assume that all consumers consume less than 12 cylinders of LPG in a year so that everyone is eligible for the full subsidy.

Since crude oil price was an issue of concern for the Indian economy since its independence there is a long literature on the effect of crude prices for India. The main observation here was an increase in international crude oil prices lead to depreciation of the Indian currency vis-à-vis US dollar (Anandan, Ramaswamy, & Sridhar, 2013; Ghosh, 2009; Hidhayathulla & Rafee, 2014; Jain & Patil, 2015; Soni, 2014). The effect on GDP has also been evaluated. It has been observed that a US$1 increase in crude prices decreases GDP by 0.1–1 per cent (Anandan et al., 2013; Jain & Patil, 2015; Soni, 2014).

There have also been many conjectures in the media regarding the possible effects. For instance, a fall of one dollar in the price of oil saves the country about ₹40 billion.⁶ Savings on the fuel subsidy bill is estimated at 0.1 per cent of the GDP (Economic Times, 12 January 2015; Money Control, 16 October 2014).^7,8 Further it has been noted that a 10 per cent decline in oil prices could push up the GDP growth by 0.3 per cent.⁹

There is also a vast literature on the effect of crude oil prices and subsidy removal at the international level using the CGE framework. Major observations are elimination of energy subsidies has a negative effect on GDP (Abouleinein, Heba, & Hanaa, 2009, Fan et al., 2007; McDonald, 2005; Ouyang & Lin, 2014) and comprehensive subsidy reform programmes can result in economic growth of the economy and welfare of society (Yusuf, 2008; Granado, Coady, & Gillingham, 2012; Vagliasindi, 2012). However, we could not find any work on the effect of crude oil prices for India using the CGE framework. This is an important motivation for this work.

The rest of the article proceeds as follows. The second section traces the prices of crude oil and its derivatives. The next section gives the details on construction of the social accounting matrix. The fourth section provides the approach taken for the CGE modelling exercise. The fifth section highlights the results of the research work. Finally, the last section concludes the article.

Prices of Crude Price and its Derivatives

As India imports 85 per cent of her crude from OPEC (Organization of the Petroleum Exporting Countries), we here consider only the OPEC crude oil price.¹⁰ International crude price fluctuations are presented in Figure 1. During the period of study crude oil prices fell from US$69.04 (2007) per barrel to US$52 per barrel (2015), a decrease of 25 per cent (with price increases in between these 2 years). However, there have been great fluctuations (standard deviation is 22). The difference between the peak rate of US$109.45 per barrel (2012) to US$52 per barrel (2015) is a decline of 52 per cent.

Figure 1.

Source: http://www.ft.com/cms/s/0/517b2aa4-0acd-11e5-9df4-00144feabdc0.html#axzz3sCckeV74

Figure 2 shows the net subsidy (which includes subsidy less tax) trend of the petrol, diesel and LPG in India. The net subsidy on petrol reduces from around 11 per cent in 2004 to 0 in 2010 while the net subsidy on diesel reduced from around 32 per cent in 2004 to 0 in 2013. The subsidy on LPG was still relatively higher—around 25 per cent in 2015 having reduced from around 75 per cent in 2004. In fact, until 2010, the central government controlled the prices of LPG, petrol and diesel. In June 2010, the government deregulated the price of petrol and in October 2014, price of diesel was deregulated. This process was made easier for the government as global crude oil prices fell greatly.

Figure 2.

Source: Indian Oil Corporation Ltd.

It should be noted that variations in LPG prices are based on the taxation structure of each state government and freight charges. Freight charges vary based on distance between storage point and bottling plant and local delivery distances. LPG price build-up in Delhi, Kolkata, Mumbai and Chennai (as of 2014) has been illustrated in Table 1. The retail selling price is the lowest in Chennai (₹401 per 14.2 kg cylinder), while the price in Mumbai is the highest (₹451.5 per 14.2 kg cylinder). This is because Mumbai has the highest rates of sales tax and VAT. However, for the sake of analysis in this study, the price of Delhi (₹414 per 14.2 kg cylinder) has been considered.

Table 1.

Price Build-up of LPG (as of 2014–2015) (₹/14.2 kg cylinder)

Price Head	Delhi	Kolkata	Mumbai	Chennai
Current ex-storage point price	340.56	340.56	340.56	340.56
Increase over last year	50	50	50	50
Basic price	340.56	340.56	340.56	340.56
State surcharge	0	0	25.45	0
Freight up to bottling plant	1.42	2.27	0	0
Price adjustment factor(PAF)¹⁴	21.43	22.27	21.88	10.16
Assessable value	363.41	365.10	387.89	350.72
Excise duty	0	0	0	0
Octroi at bottling plant	0	0	0	0
Price at bottling plant	363.41	365.10	387.89	350.72
State subsidy	0	0	0	0
Freight/local delivery charges	10	10	10	10
Octroi/transit tax	0	0.17	0	0
Price including octroi	373.410	375.27	397.89	360.72
Sales tax	0	0	11.94	0
Surcharge on ST	0	0	0	0
Billable rate (or subtotal)	373.41	375.27	409.83	360.72
Price to dealer	373.41	375.27	409.83	360.72
Distributor commission	40.71	40.71	40.71	40.71
Price after distributor commission	414.12	415.98	450.54	401.43
VAT (at applicable rates in respective states)	0	0	1.22	0
Retail selling price (RSP) of 14.2 kg cylinder	414.12	415.98	451.76	401.43
RSP rounded off	414	416	451.5	401

Source: Hindustan Petroleum Corporation Limited.

To illustrate the formation of prices at the regional level the price build-up of petrol and diesel for Delhi has been illustrated in Tables 2 and 3, respectively. In this case also, the VAT rates differ from state to state. In case of diesel, Delhi imposes an additional charge of ₹0.25 per litre as Air Ambience Charges. Note that though we have reported these regional prices in this section for the rest of this study, we only look at the aggregate price for India as reported in 2014–2015. Figure 3 illustrates the average price variation of LPG, petrol and diesel between 2007 and 2015 in India.

Table 2.

Price Build-up of Petrol (as of 2014–2015)

No.	Elements	Unit	Figure
1	Cost and Freight Price of Gasoline (Petrol) BS III equivalent	US$/bbl	61.91
2	Average Exchange Rate	₹/US$	66.08
3	Refinery Transfer Price on landed cost basis for BS-IV Petrol (Price Paid by the Oil Marketing Companies to Refineries)	₹/Litre	26.28
4	Price Charged to Dealers (excluding Excise Duty and VAT)	₹/Litre	29.27
5	Add: Specific Excise Duty @ ₹17.46/Litre	₹/Litre	17.46
6	Add: Dealer Commission	₹/Litre	2.27
7	Add: VAT (including VAT on Dealer Commission) applicable for Delhi @ 25 per cent	₹/Litre	12.25
8	Retail Selling Price at Delhi (Rounded Off)	₹/Litre	61.25

Source: http://www.hpretail.in/documents/pdf/pb/pricebuildup_Petrol.pdf

Table 3.

Price Build-up of Diesel (as of 2014–2015)

No.	Elements	Unit	Figure
1	Cost & Freight Price of Gasoil (Diesel) BS III equivalent	US$/bbl	60.30
2	Average Exchange Rate	₹/US$	66.08
3	Refinery Transfer Price on landed cost basis for BS-IV Diesel (Price Paid by the Oil Marketing Companies to Refineries)	₹/Litre	25.75
4	Price Charged to Dealers (excluding Excise Duty and VAT)	₹/Litre	26.63
5	Add: Specific Excise Duty @ ₹10.26/Litre	₹/Litre	10.26
6	Add: Dealer Commission	₹/Litre	1.43
7	Add: VAT (including VAT on Dealer Commission) applicable for Delhi @ 16.6 per cent and Air Ambience Charges @ ₹0.25/Litre	₹/Litre	6.65
8	Retail Selling Price at Delhi (Rounded Off)	₹/Litre	44.97

Source: http://www.hpretail.in/documents/pdf/pb/pricebuildup_Diesel.pdf

Figure 3.

Source: http://opengovernanceindia.org/bgqtofe/petrol-diesel-lpg-price-in-india-since-2000

Construction of the Social Accounting Matrix

We base our calculations¹¹ on the Social Accounting Matrix (SAM) for India for the year 2007–2008 following Pradhan, Saluja and Sharma (2013).¹² This SAM consists of 78 sectors and nine categories of households which are based on occupation and location (i.e. rural and urban). The gross value added has been divided into three factors of production, that is, labour, capital and land. Further, labour has been divided into three types, that is, unskilled, semi-skilled and skilled.

To construct our Energy SAM (ESAM), relevant sectors from the above SAM were aggregated into primary (agriculture sector consists of all agricultural products, minerals, primary products such as iron ores, crude petroleum and agro process activities), secondary (manufacturing sector comprised mainly of all manufacturing activities such as cotton and textile, plastic, rubber and leather products, cement, different chemical products, etc. without crude oil, LPG, petrol and diesel) and tertiary (service sectors such as education, health care services, public administration, bank and insurance, postal services etc.) sectors. Crude oil has been taken as a separate sector. LPG, petrol and diesel have been proportionately taken out from the sector—petroleum products. Thus, the SAM that we work with has three energy sectors (LPG, petrol and diesel) where subsidies have varied over the years and four non-energy sectors where there is no subsidy. Four types of agents in the economy have been considered, namely (a) household, (b) firm, (c) government and (d) rest of world (ROW). The three types of labour (unskilled, semi-skilled and skilled) were aggregated into one sector–labour. Households have been aggregated into two types–urban and rural household. Table 5 shows the ESAM of India developed for this study.

Table 4.

Schematic Structure of SAM

		Activities	Commodities	Factors	Households	Private Corp.	Public Enter.	Govt.	Ind. Taxes	Capital A/C	ROW	Total
		(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)	(9)	(10)
1	Activities		Gross output									Output
2	Commodities	Purchase of raw material			Household consumption			Govt. consumption		Gross fixed capital formation	Exports	Aggregate demand
3	Factors	Value added									Net factor income	Factor Income
4	Household			Endowment Of HH				Govt. transfer,			Net current transfer	Total household income
5	PVT Corp.			Operating profits				Interest on debt				Income of private corporate
6	Pub. Ent.			Operating surplus								Income of public departmental
7	Govt.			Income from entrepreneurial activity	Income tax by households	Corporate taxes			Total indirect taxes		Net capital transfer	Total govt. earnings
8	Ind. Tax	Taxes on intermediate			Taxes on purchases			Taxes on purchases		Taxes on investment	Tax on exports	Total indirect taxes
9	Capital A/C			Depreciation	Household savings	Corporate savings	Public sector savings	Govt. savings			Foreign savings	Gross savings of economy
10	ROW		Imports									Foreign exchange payments
	Total	Total cost of production	Aggregate supply	Total factor endowments	Total use of HH income	PVT Corp income	Income of PSU	Aggregate govt. exp.	Total indirect. tax	Aggregate investment	Foreign exchange receipt

Source: Lofgren, Harris, & Robinson (2002).

Table 5.

ESAM of India 2007–2008 (in ₹ billion)

Sector	Primary Sector	Secondary Sector	LPG	Petrol	Diesel	Services	Crude Oil	Labour	Capital + Land	Rural Household	Urban Household	Pvt. Corp.	Pub. Enter.	Govt.	Ind. Taxes	Capital a/c	ROW	Row Total
Primary sector	2,388	2,395	0	0	0	1048	0	0	0	4,388	2,077	0	0	100	0	–6	280	12,679
Secondary sector	603	10,991	55	55	645	6,446	83	0	0	3,701	2,739	0	0	483	0	8,418	4,100	38,318
LPG	0	8	0	0	0	32	0	0	0	5	8	0	0	0	0	4	9	77
Petrol	0	8	0	0	0	111	0	0	0	12	17	0	0	2	0	9	21	191
Diesel	120	103	0	0	0	1190	0	0	0	269	380	0	0	51	0	205	461	2,787
Services	1,218	7,115	4	15	161	9,303	12	0	0	0	8,621	0	0	4,378	0	9,654	4,668	50,253
Crude oil	0	2,951	0	0	0	5	0	0	0	0	0	0	0	0	0	–0.4398	42.6262	3,011
Labour	4,720	2,121	0	0	17	15617	98	0	0	0	0	0	0	0	0	0	–25	22,557
Capital+ land	3,749	5,581	8	17	374	13,299	213	0	0	0	0	0	0	0	0	0	–180	23,068
Rural household	0	0	0	0	0	0	0	9989	8033	0	0	0	0	2,189	0	0	378	20,602
Urban household	0	0	0	0	0	0	0	12560	5125	0	0	0	0	1502	0	0	1297	20,497
Pvt. corp.	0	0	0	0	0	0	0	0	2928	0	0	0	0	1921	0	0	0	4,864
Pub. enter.	0	0	0	0	0	0	0	0	1142	0	0	0	0	0	0	0	0	1,158
Govt.	0	0	0	0	0	0	0	0	987	820	982	1921	0	0	4050	0	0	8,772
Ind. taxes	–326	1,045	2	5	112	1113	11	0	0	247	263	0	0	114	0	735	728	4,055
Capital A/C	0	0	0	0	0	0	0	0	4,846	6,045	5,396	2,928	1,142	–1,982	0	0	644	19,029
ROW	198	7,278	6	13	293	2,087	2,550	0	0	0	0	0	0	0	0	0	0	12,435
Column total	12,679	39,603	86	117	1,612	50,256	2,978	22,563	23,071	20,594	20,491	4,863	1,157	8,763	4,065	19,028	12,428

Source: Prepared by the authors.

Assumptions of the Benchmark CGE Model under Perfect Competition

Our benchmark CGE model is based on perfect competition¹³ and constant returns to scale assumption both in commodity market and factor market. The model is based on the following assumptions.

Sectors and Agents

Following SAM for India for the year 2007–2008 produced by Pradhan et al. (2013), we grouped all sectors of the economy into seven aggregated sectors, namely (i) primary (agriculture sector consists of all agricultural products, minerals, primary products such as iron ores, crude petroleum and agro-process activities); (ii) secondary (manufacturing sector comprised mainly of all manufacturing activities such as cotton and textile, plastic, rubber and leather products, cement, different chemical products, etc. without crude oil, LPG, petrol and diesel); (iii) tertiary (service sectors such as education, health care services, public administration, bank and insurance, postal services etc.); (iv) crude oil; (v) LPG; (vi) petrol and (vii) diesel. We considered four types of agents in the economy, namely (a) household, (b) firm, (c) government and (d) ROW. There are two types of households, namely (a) rural and (b) urban. All other countries and regions are clubbed together into ROW.

Production and Factor Inputs

We have considered two basic factors of production, namely labour and capital, that take part in the production process within which substitution is possible through the Cobb–Douglas production technology. Each production unit requires intermediate inputs following fixed- coefficient-type Liontief technology.

Prices

Product prices are determined from the equality of price and average cost. The average cost is composed of basic factor cost, cost of intermediate inputs that includes cost of energy inputs. Increasing returns to scale is assumed through the presence of fixed cost in the production units.

Household Income and Expenditure

Households are rendering factor services in terms of labour and capital, while in return they are receiving factor payments in the form of wages and rentals. We have considered two types of household, rural and urban. A household spends its income for consumption purposes. We have assumed the linear expenditure-system-type demand function for a household.

Government Income and Expenditure

Sources of income of the government are (a) direct, indirect and corporate taxes; (b) import tariff and (c) income from entrepreneurial activity. In the expenditure front, we assumed government’s expenditure in any sector is exogenously determined, that is, determined in the government’s budget and adjusted to benchmark SAM. The difference between government’s income and expenditure is government’s savings.

Investment and Savings

We considered neo-classical-type closure rule where investment is guided by saving. Total saving is composed of (a) household saving, (b) government saving, (c) corporate saving and (d) foreign savings. Total saving is converted to total investment.

Armington Function and Trade

International trade in our model is guided by Armington function. Total availability of composite commodity in the domestic economy is composed of domestically produced variety of the good demanded by the domestic people and foreign variety of the same good. Both types of the varieties are combined together following a constant elasticity of substitution (CES)-type preference function.

Production of Output and Transformation

Total supply of each domestic good produced using labour, capital and intermediate input is used up by export of that good and to meet up the domestic demand of domestic variety. Both export and domestic demands of the produced good are combined together following the CES-type transformation function.

Factor Prices and Equilibrium

We consider two basic factors of production, namely labour and capital. Total supply of the basic factors is fixed in value terms, and factor prices are flexible. Physical quantity of labour or capital may change in different simulation experiments following demand and supply equilibrium mechanism in the factor market. Demand for a factor is originated from the production of goods and services.

Equilibrium in Commodity Market

In the commodity market, total supply of the composite commodity is constituted by domestic variety as well as imported foreign variety corresponds to each good. Demand for the composite commodity is generated from household consumption, government consumption expenditure, total investment demand and demand for intermediate input. Composite commodity price is determined from the demand and supply of composite commodity.

GDP and Welfare

Under perfect competition GDP has been computed adding all sectoral outputs. Social welfare has been of the Cobb–Douglas type and depends on private household consumption, that is, elasticity of substitution between any two sectors’ product is constant and takes the value unity.

Database and Calibration of Model Parameters

After specifying Energy CGE model, parameters of the model will have to be estimated from the benchmark dataset. The calibration process is outlined in the flowchart in Figure 4. We have used ESAM constructed by segregating the energy sectors. In our ESAM, we have a total of seven sectors. Three of them are conventional sectors (1) primary sector, (2) secondary sector and (3) tertiary service sector, and four energy sectors, that is (4) LPG, (5) petrol, (6) diesel and (7) crude oil sectors. We have constructed SAM of India for the year 2007–2008 based on the SAM constructed by Pradhan et al. (2013).

Figure 4.

Source: Authors’ own.

The ESAM was used for the calibration of the CGE model and considering an open economy and perfect competition. Subsidy rates and variations in international crude oil prices are supplied exogenously. As already noted three sets of simulation experiments have been carried out:

Changing international prices of crude keeping taxes and subsidies on LPG, petrol and diesel remained constant at the 2007–2008 level.

Subsidy removal on LPG, petrol and diesel keeping crude oil prices constant at 2007–2008 level.

Changing both international crude oil prices and taxes and subsidies on LPG, petrol and diesel between 2007 and 2015.

The base year of this study has been taken as 2007–2008. The mathematic structure of the Benchmark CGE model has been explained in Appendix 1 while the calibrated values of the different parameters have been listed in Appendix 2.

Results

Four simulations have been carried out as detailed in the following. The impacts on different parameters between 2007 and 2015 have been tabulated in Table 6. The year-on-year impacts of crude oil price reduction and subsidy reduction have been analysed for GDP and exchange rate. These impacts have been tabulated in Tables 7 and 8 respectively. Results of the three simulations are discussed as below.

Table 6.

Simulation Experiment Results (% change for 2015 over 2007)

ECONOMIC VARIABLES	EXP–1	EXP–2	EXP–3
Macro Indicators
GDP	1.5	–0.6	0.9
External Account
Exchange rate	3.4	0.8	4
HH Income
Rural income	–0.08	1	0.92
Urban income	–0.5	0.7	0.2
Government Account
Government savings (fiscal deficit)	3.2	–2.4	0.8
Energy subsidy	–3	–95	–98

Source: Prepared by the Authors based on the modelled results.

Notes: Table showing percentage change over 2007–2015.

(i) EXP 1: the impact of the fall in international prices of crude had taxes and subsidies on LPG, petrol and diesel remained constant at the 2007–2008 level.

(ii) EXP 2: the net impact of the changes in taxes and subsidies on LPG, petrol and diesel on the Indian economy had crude oil prices remained constant at 2007–2008 level.

(iii) EXP 3: the net impact of change in international crude oil prices and changes in taxes and subsidies on LPG, petrol and diesel between 2007 and 2015.

Table 7.

Comparison of Modelling Results with Real World Data (GDP)

Year	Real World Change (%) in Real GDP at Constant Prices¹	Modelled Result Changes (%) in Case of Change in Crude Price + Subsidy	Modelled Result Changes (%) in Case of Change in Crude Price Only	Modelled Result Changes (%) in Case of Change in Subsidy Only
2007	9.3	0.3	0.6	–0.3
2008	6.7	–1.7	–1.7	–0.03
2009	8.5	1.2	1.2	–0.01
2010	8.9	–1.1	–0.6	–0.5
2011	6.6	–1.1	–1.1	–0.001
2012	4.4%	–0.1	–0.1	–0.01
2013	4.7	2.0	2.1	–0.02
2014	4	2.2	2.3	–0.001
2015	3.5	1.5	1.6	–0.001

Source: Prepared by the Authors based on the modelled results.

Note: http://planningcommission.nic.in/data/datatable/data_2312/DatabookDec2014%2012.pdf

Simulation 1: Impact of International Crude Oil Price Variation Only

Impact between 2007 and 2015

Impact on Exchange Rate: Import of crude oil decreases by about 3 per cent if international crude oil price increases by 25 per cent (all other factors remaining same). The product of crude oil price and crude oil import quantity increases as the price effect overrides the quantity effect. Thus an increase in crude oil price leads to depreciation of home currency by 3 per cent due to higher foreign currency demand. Between 2007 and 2015, crude oil price falls by 25 per cent. Import of crude oil increases by 10 per cent. However, price effect overrides the quantity effect. Hence exchange rate appreciates to the tune of 3.4 per cent between 2007 and 2015.

Impact on GDP: With reduction in international crude oil prices, domestic consumption of energy goods increases. Due to higher consumption of goods, there is an increase in GDP (defined as sum of supply of each good) by 1.5 per cent.

Impact on Government Savings (fiscal deficit): With energy subsidy remaining same and crude oil price decreasing, government transfers to households decrease, causing an increase in government savings by 3.2 per cent.

Impact on Household Income: With energy subsidy remaining same and crude oil price decreasing, government transfers to households decrease, causing a decrease in rural and urban household income levels by 0.08 and 0.5 per cent, respectively.

Impact on Energy Subsidy Amount: With reduction in international crude oil prices there is reduction in energy subsidy outflow and there is reduction of energy subsidy by 3 per cent.

Year-on-year Impact on GDP

Year-on-year Impact on Exchange Rate

In the case where international crude oil price fluctuation has only been considered, it is seen that in all the years that crude oil price had increased over the last year’s price, exchange rate has depreciated. For the years 2009, 2013, 2014 and 2015, where international crude oil price decreased over previous year, exchange rate also appreciated by 6, 0.7, 1.5 and 1.1 per cent, respectively. This is in line with the previous explanation that import of crude oil increases if international crude oil price drops; however, price effect overrides the quantity effect and this leads to appreciation of home currency due to lower foreign currency demand. For the other years, there is increase in crude oil price over the previous year and hence there is depreciation in exchange rate in 2008, 2010, 2011 and 2012 by 4.8, 3.3, 2.2 and 0.3 per cent, respectively.

Simulation 2: Impact of Energy Subsidy Reduction Only

Impact between 2007 and 2015

Impact on Exchange Rate: With removal of subsidies, prices of energy goods (LPG, petrol and diesel) increases. Accordingly, the domestic demand of these energy goods decreases which effects import of these goods. Import decreases although the impact is negligible. This leads to appreciation of home currency by 0.8 per cent due to lower foreign currency demand.

Impact on GDP: With reduction in energy subsidies, prices of energy goods increase and consumption of goods decrease. Due to lower consumption of goods, there is a dampening effect of 0.6 per cent on GDP.

Impact on Government Savings (fiscal deficit): With energy subsidy decrease only, the government transfers more money to the households under other welfare schemes and hence government savings decreases by 2.4 per cent.

Impact on Household Income: Household incomes (both rural and urban) depend on government transfers to households. With reduction in energy subsidies, household income increases since government transfers under other welfare schemes increase. Rural income increases by 1 per cent while urban income increases by 0.7 per cent.

Impact on Energy Subsidy Amount: Due to reduction in energy subsidy over the years, there is reduction in energy subsidy outflow by 95 per cent.

Year-on-year Impact on GDP

In the case where subsidy reduction has been considered only, it is seen that there is a decrease in GDP over the years as subsidy decreases year-on-year. This is in line with the discussion above that with reduction in energy subsidies, prices of energy goods increase and consumption of goods decrease, leading to a decrease in GDP.

Year-on-year Impact on Exchange Rate

In the case where subsidy reduction has been considered only, it is seen that exchange rate appreciates in all the years. This is in line with the discussion above that with removal of subsidies, prices of energy goods increases leading to decrease in their domestic demand. Imports decrease (although negligibly) due to decreased domestic demand. This leads to appreciation of home currency due to lower foreign currency demand.

Simulation 3: Net Impact of International Crude Oil Price Variation and Energy Subsidy Reduction

Impact between 2007 and 2015

Impact on Exchange Rate: On the net level with decrease in crude oil price and reduction of energy subsidies, exchange rate appreciates by 2.4 per cent (Table 8).

Impact on GDP: On the net level with decrease in crude oil price and reduction of energy subsidies, GDP increases by 0.9 per cent. The effect of net reduction of crude oil price outweighs the effect of reduction of subsidy causing GDP to increase.

Impact on Government Savings (fiscal deficit): On the net level with decrease in crude oil price and reduction of energy subsidies, government savings increases by 0.8 per cent.

Impact on Household Income: On the net level with decrease in crude oil price and reduction of energy subsidies, rural and urban household incomes increase by 0.92 and 0.2 per cent, respectively.

Impact on Energy Subsidy Amount: In case of net impact of international crude price fluctuation and energy subsidy removal, energy subsidy outflow decreases significantly to the tune of 98 per cent.

Table 8.

Comparison of Modelling Results with Real World Data (Exchange Rate)

Year	Real World Change in Exchange Rate (%)	Modelled Result Changes (%) in Case of Change in Crude Price + Subsidy	Modelled Result Changes (%) in Case of Change in Crude Price Only	Modelled Result Changes (%) in Case of Change in Subsidy Only
2007	2	–0.8	–1.2	0.3
2008	10	–4	–4.8	0.0001
2009	–22	6.1	6	0.1
2010	4	–2.5	–3.3	0.7
2011	0.1	–2.2	–2.2	0.001
2012	14	–0.3	–0.3	0.001
2013	9	0.7	0.7	0.002
2014	6	1.5	1.5	0.001
2015	2	1.1	1.1	0.001

Source: Prepared by the Authors based on the modelled results.

Year-on-year Impact on GDP

On the net level with decrease in crude oil price and reduction of energy subsidies, the GDP increases or decreases depending on the crude oil price variation of that year. If crude price had increased, GDP decreases and if crude price had decreased, GDP increase relative to the previous year.

Year-on-year Impact on Exchange Rate

On the net level with decrease in crude oil price and reduction of energy subsidies, the exchange rate increases or decreases depending mostly on the crude oil price variation of that year. If crude price had increased, exchange rate depreciates and if crude price had decreased, exchange rate appreciates relative to the previous year.

Simulation 4: Impact of Reduction of Subsidy on LPG and Introduction of Direct Cash Transfer Scheme

In the case where the nature of subsidy of LPG is changed from direct subsidy to cash transfer, it is seen that neither the different macroeconomic parameters, discussed in Table 6, nor the consumption of LPG changes. The consumption of LPG does not change in spite of the fact that the price of LPG increases (as subsidy is removed and given as direct cash transfer). This shows that LPG is an essential commodity and substitution effect is negligible in this case.

Concluding Comments

The effect of international crude oil price fluctuation is more pronounced on both GDP and exchange rate as compared to the effect of energy subsidy reduction. However, energy subsidy removal has greater effect on household incomes and energy subsidy outflow of government. Effect on other economic parameters like government savings (or fiscal deficit) is around 2–3 per cent. Overall, net impact of crude oil price variation and energy subsidy removal is not large in magnitude in case of GDP; however, the impact on exchange rate is large and significant for most of the years. Therefore, comparing the scenario in reality and the results from the simulation model, it can be concluded that the directions of change are same in both cases for most of the years although the magnitude of change is not the same. This is due to the fact that there are so many imperfections in the economy like political barriers etc. that everything cannot be incorporated in the model.

Footnotes

Mathematical Structure of the Benchmark CGE Model

Production Block:

(1)

Y_{j} = b_{j} \cdot [\prod_{h} F_{h, j}^{β_{j, h}}]

(2)

X_{i, j} = a x_{i, j} \cdot Z_{j}

(3)

Y_{j} = a y_{j} \cdot Z_{j}

(4)

F_{h, j} = \frac{β_{h, j} \cdot p y_{j} \cdot Y_{j}}{p f_{h}}

(5)

p z_{j} = a y_{j} \cdot p y_{j} + \sum_{i} a x_{i, j} \cdot p q_{i} + \frac{F C_{j}}{Z_{j}}

Government Behaviour:

(6)

\begin{matrix} G I N C = T d + T d c + T I n d + N C A T + E N T + \\ T A R R - T s \end{matrix}

(7)

T d = \sum_{b} t a u d_{b} \cdot [\sum_{h} p f_{h} \cdot F F_{h} \cdot r_{h, b} + G T_{b} + N C U T_{b}]

(8)

T d c = t c o r p \cdot (O P R + I N D)

(9)

O P R = s o p \cdot [\sum_{h} p f_{h} \cdot F F_{h} + N F_{1} + N F_{2}]

(10)

T I n d = \sum_{b} t a u z_{j} \cdot p z_{j} \cdot Z_{j}

(11)

T A R R = \sum_{i} t a u m_{i} \cdot p m_{i} \cdot M_{i}

(12)

T s = t a u s \cdot \sum_{i} p e_{i} \cdot E_{i}

(13)

X g_{i} = \frac{m u \times G D P}{p q_{i}}

(14)

G T_{b} = g t_{b} \cdot G I N C

(15)

G E X P = \sum_{i} X g_{i} + \sum_{b} G T_{b} + T s

(16)

S_{G} = G I N C - G E X P

Investment Behaviours:

(17)

X v_{i} = λ_{i} \cdot \frac{[D e p + \sum_{b} S p_{b} + S g + S c + S f \cdot ε]}{p q_{i}}

Savings:

(18)

\begin{matrix} H H I N_{b} = \sum_{h} [\sum_{h} F F_{h} \cdot p f_{h} + N F_{1} + N F_{2}] \cdot r_{h}^{}_{b}^{} + \\ N C U T_{b} + G T_{b} \end{matrix}

(18.a)

\begin{matrix} H H I N_{b} = [\sum_{h} F F_{h} \cdot p f_{h} + N F_{1} + N F_{2}] \cdot r_{b} + \\ N C U T_{b} + G T_{b} \end{matrix}

Where $r_{b} = \sum_{h} r_{h, b}$

(19)

S p_{b} = s s p_{b} \cdot H H I N_{b}

(20)

S c = s s c \cdot (O P R + I N D)

Household Consumption:

(21)

X p_{i, b} = a l p h a_{i, b} \cdot \frac{[H H I N_{b} - T d_{b} - S p_{b}]}{p q_{i}}

International Trade:

(22)

p m_{i} = ε * p W m_{i} * (1 + t a u m_{i})

(23)

p e_{i} = ε * p W e_{i} * (1 + t a u s)

(24)

\begin{matrix} \sum_{i} p W e_{i} * E_{i} + S f + \sum_{b} N C U T_{b} + N F_{1} + N F_{2} + \\ N C A T + T s = \sum_{i} p W m_{i} * M_{i} \end{matrix}

Armington Function:

(25)

Q_{i} = γ_{i} {[δ m_{i} \cdot M_{i}^{η_{I}} + δ d_{i} \cdot D_{i}^{η_{i}}]}_{}^{\frac{1}{η}}_{i}^{}

(26)

\frac{M_{i}}{Q_{i}} = {[γ_{i}^{η_{i}} \cdot δ m_{i \cdot} \cdot \frac{p q_{i}}{p m_{i}}]}^{\frac{1}{1 - η_{i}}}

(27)

\frac{D_{i}}{Q_{i}} = {[γ_{i}^{η_{i}} \cdot δ d_{i \cdot} \cdot \frac{p q_{i}}{p d_{i}}]}^{\frac{1}{1 - η_{i}}}

Transformation Function:

(28)

Z_{i} = ϕ_{i} \cdot {[x i e_{i} \cdot E_{i}^{ρ_{i}} + x i d_{i} \cdot D_{i}^{ρ_{i}}]}^{\frac{1}{ρ_{i}}}

(29)

\frac{E_{i}}{Z_{i}} = {[ϕ_{i}^{ρ_{i}} \cdot x i e_{i} \cdot (1 + t i n d) \frac{p z_{i}}{\cdot p e_{i}}]}^{\frac{1}{1 - ρ_{i}}}

(30)

\frac{D_{i}}{Z_{i}} = {[ϕ_{i}^{ρ_{i}} \cdot x i d_{i} \cdot (1 + t i n d) \cdot \frac{p z_{i}}{p d_{i}}]}^{\frac{1}{1 - ρ_{i}}}

Market Clearing Condition:

(31)

Q_{i} = \sum_{b} X p_{i, b} + X g_{i} + X v_{i} + \sum_{j} X_{i, j}

(32)

F F_{h} = \sum_{j} F_{h, j}

Fictitious Objective Function:

(33)

U U = \sum_{b} \prod_{i} X p_{i, b}^{α_{i, b}}

List of Endogenous Variables

List of Exogenous Variables

List of Equations Changed in the Standard Mathematical Structure of the Benchmark CGE Model for Simulation 1

where ‘x’ is the percentage change in international crude oil price every year.

List of Equations Changed in the Standard Mathematical Structure of the Benchmark CGE Model for Simulation 2

Government behaviour: Introduction of energy subsidy (Ts1) in various equations

\begin{matrix} G I N C = T d + T d c + T I n d + N C A T + E N T + \\ T A R R - T s - T s 1 \end{matrix}

Household consumption (for energy good):

X p_{i, b} = α_{i, b} \cdot [H H I N_{b} - T d_{b} - S p_{b}] / p q_{i} (1 - s_{i})

Calibrated Values of the Parameters

Parameter	Description	Primary	Secondary	Tertiary	LPG	Petrol	Diesel	Crude oil
β_i (Labour)	Share parameter in production function	0.583	0.297	0.566	0.047	0.047	0.047	0.338
β_i (Capital)	Share parameter in production function	0.417	0.703	0.434	0.953	0.953	0.953	0.662
b_j	Production function shift parameter	1.972	1.837	1.983	1.21	1.21	1.21	1.896
ay_i	Composite factor requirement	0.651	0.233	0.603	0.099	0.176	0.303	0.744
mu_i	Government consumption share	0.001	0.005	0.048	1.13E-5	2.56E-5	5.63E-4	1.104E-5
taum_i	Import tariff rate	0.3	0.3	0.3	0.3	0.3	0.3	0.3
tind_i	Indirect tax rate	–0.004	0.005	0.003	0.005	0.008	0.014	0.004
γ_i	Scale parameter in Armington function	1.262	1.829	1.504	1.436	3.389	4.377	1.688
δm_i	Share parameter of imported good	0.113	0.343	0.184	0.235	0.302	0.39	0.73
δd_i	Share parameter of domestic good	0.887	0.657	0.816	0.765	0.698	0.61	0.27
η_i	Elasticity of substitution in Armington	0.5	0.5	0.5	0.5	0.5	0.5	0.5
ϕ_i	Scale parameter in transformation function	131.282	382.886	468.581	6.686	8.872	52.652	19.863
xie_i	Share parameter of export.	6.7E-4	1.4E-4	1.04E-4	0.149	0.043	0.003	0.012
xid_i	Share param. of domestic good (Trans)	6.7E-4	1.4E-4	1.04E-4	0.062	0.043	0.003	0.012
ρ_i	Substitution elasticity in transformation	1.5	1.5	1.5	1.5	1.5	1.5	1.5
Parameter	Description	Rural		Urban
taud_b	Direct tax rate	0.041		0.051
gt_b	Parameter for govt. transfer	0.328		0.225
ssp_b	Propensity to save for households	0.299		0.281

Source: Prepared by the authors.

Notes

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