Dealing with the Hike in Petroleum Prices

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Dr. Atiq ur Rehman
The petroleum prices in the international market are on a rising trend. This has caused a reduction in the petroleum development Levy and a fall in the government revenue. The government has to shift the effect of international prices to the consumers; therefore, there was a hike in the prices of gasoline and other petroleum products. The public is already witnessing a drastic cut in the purchasing power and this move was certainly very unpleasant for the people. What were the other possible options in such a situation? Assume a central bank having a good working relationship with the government. If so, there could be three options to deal with the situation. First option is to borrow from the Central Bank and to use this money to fill the expected loss of revenue. Second option is to reduce the policy rate which will cause a reduction in the markup payments saving an amount that can cover the loss of revenue. The third option is to pass on the burden of price hike to the public. The third option is inflationary with most direct and immediate effect; the Petroleum Development Levy or the General Sales Tax imposed on petroleum will become the part of price that will cause inflation. The mainstream economic theory says that option 1 and 2 are also inflationary. But the causal mechanisms are indirect, imperfect, and uncertain and involve many steps.Suppose the government borrows from the central bank. This means the government will use the currency printed by the central bank. The new currency will be paid to the public in form of salaries or other payments and will increase the purchasing power of the people. The people will be able to consume more and this rise in consumption will increase aggregate demand leading to a hike in the level of prices. This increase in currency could be inflation free if there was an economic recession and this increase will help to bring the economy to pre-recession level. During the pandemic, many countries borrowed from their central banks very extensively without a significant hike in inflation. Imagine a government like Pakistan having a high proportion of public debt in the form of time bound securities. Suppose the government decides to reduce the interest rate. It will reduce the markup payments on the public debt. The country owes a domestic public debt of about 25 trillion, and a 1% reduction in the policy rate can reduce the markup payments by about 250 billion. This space can be used to fill the expected fall in revenue. The mainstream economic theory suggests that a reduction in interest rate may lead to inflation. There is a long causal channel connecting the fall in interest rate to the hike in price level. Reduction in interest rate will provide incentive to the public to purchase borrow for luxuries, causing a hike in the aggregate demand. The increase in aggregate demand may lead to higher inflation. But there’s a possibility that the fall in interest rate leads to a fall in the price level. The reduction in policy rate will provide incentive to the firms and producers to increase their production and a hike in production will increase aggregate supply leading to lower inflation. In fact the evidence from many countries show that the reduction in interest rate actually led to a reduction in the aggregate inflation, especially during the economic recessions. The causal mechanisms summarized in this post indicate that the two options mentioned above would create an inflationary effect, and it’s also possible that there is no significant inflation emerging from these options. But the third option is very definite, immediate and strong. Any change in tax level or in the levies will be directly counted in the price level and inflation will go up. Suppose the SBP has increased the money supply or has reduced the interest rate, the inflationary effect, if any, would take time. The merchant cannot argue that ‘since the State Bank has printed 100 billion, I will charge a higher price’. But on the other hand, the impact of tax and levies is most immediate and perfect. The government used to choose a certain and immediate source of inflation over the doubtful sources of inflation. The recent hike in petroleum prices in the international market was followed by an increase in the price of petroleum products and certainly, this will put upward pressure on inflation. The State Bank will respond by increasing the policy rate, and as a result the markup payment will go further up, putting further pressure in the budget balance. This is why during recessions, the advanced countries show reluctance to adopt the contractionary measures and adapt the quantitative easing, which means a reduction in interest rate and increase in the central bank borrowing. These actions also help the economy to grow and the businesses to boost. In the countries holding the flag of Central Bank’s Independence, the central banks have very good liaison with the governments and provide full support to the government to come out of recession. Due to huge spending on the covid-19 relief packages, the budget deficit in many countries increased by large proportion during 2020. These deficits were financed by borrowing from central banks which caused a huge increase in debt to GDP ratio. The debt to GDP ratio for the United Kingdom, Canada and Germany increased by 13%, 31% about 10% respectively. There was no inflation due to this huge deficit financing. But the Government and the State Bank of Pakistan are following the path exactly opposite to what the successful nations did during the pandemic. The contractionary policies contributed to lower growth, leading to slower growth of revenue and ultimately more budget deficit. The solution to this situation is to look at the success stories in the world and adapt the same policiesThere are success stories of the countries who adopted the policy of central bank borrowing without any inflation and on the other hand, there are the stories of hyperinflation emerging from the uncontrolled central bank borrowing. Therefore, this post doesn’t mean to say that every shortfall in revenue must be filled by printing money. However, many countries have successfully used monetary expansion to come out of recession without any hike in inflation. If it is possible to generate an amount of resources without putting burden on the public, it must be exploited.