In 2004 Sri Lanka’s government, abandoned automatic fuel price adjustments and printed money to the equivalent of 3 percent of GDP, to subsidize a range of imported commodities including oil and fertilizer under a new home-grown economic policy framework, which was aimed at insulating the country from world market prices.
The use of excessive Central Bank credit promptly pushed year-on-year consumer inflation up to 18 percent and plunged the country into a balance of payments crisis.
The World Bank has found that in many South Asian countries, more than 30 percent of the subsidy is going to high income earners.
Mel Gunasekera spoke to Shantayan Devarajan, a World Bank economist specializing in South Asia, to find out more about the problem.
Given below are some of the excerpts of the interview, which was telecast on ETV’s Money Report program.
Q: Who usually gets subsidies?
A: Many countries in the South Asian region subsidize oil products like diesel petrol, kerosene, Liquefied Petroleum Gas and so on. The point is that in general the benefits of these subsidies accrue to the richer people of the population and the reason is very simple; if you subsidize the price of something then anybody who buys it can benefit from it. And since the rich buy more of these goods, they benefit more than the poor.
Q: What about gas?
A: Well, Liquefied Petroleum Gas (LPG) is consumed by the very richest parts of the population. We’ve done some studies in India, Pakistan and Bangladesh that show that 92% of the consumption of LPG is by the richest 40% of the population. Even diesel, which is a little bit more broadly used, since it is used for transportation, tends to be consumed more by wealthier people than poorer people. In the poll we found that 57% of the diesel subsidy goes to the richest 40% of the population.
Q: Why are subsidies really bad especially when there is a deficit?
A: When there is an increase in the world price of oil, then the size of the subsidy increases, which contributes to the fiscal deficit: which means even more spending by the government. But even if there were no fiscal deficit to start with, subsidies can be harmful because they give bad price signals to producers and consumers. Say the price of oil domestically, or even electricity, is subsidized. That gives consumers the incentive to consume more of it, which means that we have a much more energy intensive economy.
Q: So what are the options of raising money to pay for subsidies?
A: It is not a question of raising money to pay for subsidies but a question that if the purpose of the subsidy is to protect the poor, then there are other ways in which you can protect poor people at much lower cost. So you can actually save money. For instance take the kerosene subsidy; say you eliminate the kerosene subsidy, take the money you save from that and give it as a cash grand just like a transfer payment to people. Even if there is a leakage of 40% of that cash grant, which is a lot, you still will be helping the poor more than you would with the kerosene subsidy.
Q: Could you explain the negative effects of financing a subsidy?
A: Well the negative effects of financing a subsidy are no different from the negative effects of financing any fiscal deficit. Basically there are three or four different ways to finance a fiscal deficit; one is by increasing taxes, the other is by borrowing both domestically and abroad, and the third is essentially by borrowing from the Central Bank which is equivalent to printing money. Now all of these have negative effects. If you raise taxes of course the people who pay the taxes are unable to spend that money on other things which may crowd out private spending. If you borrow it, you have to pay back the loans and that at high interest rates so it can create debt problems.
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If you borrow it domestically from the Central Bank that can create inflation and inflation can actually hurt the poor. It’s a very difficult choice and countries always have to balance among these three. But we have to always look at which of these are the least damaging to poor people, particularly in a country with so many poor people such as Sri Lanka.
Q: How are automatic price adjustments least damaging to poor people?
A: Well it’s what we were talking about earlier, which is that the subsidy is not benefiting the poor people. When there is an automatic price adjustment, that means that when the world price of oil goes up, it automatically gets transmitted as a price adjustment to the domestic price which means that the subsidy does not increase. In fact it decreases, so that actually helps the poor because you reduce the subsidy that they are not getting anyway. You also reduce the need to finance the fiscal deficit by a little bit which means that you might have lower inflation or lower taxes or less borrowing.
Q: What are the long term effects of having subsidies in your system?
A: The long term effects are that subsidies provide bad price signals, less incentive for conserving energy as well as seeking out alternate energy sources. So because the price of oil is so low, countries like Sri Lanka and India have actually invested in technologies that use more oil than they need to. You compare it to countries in East Asia or in Western Europe where the domestic price of oil is so high that they have invested in energy conservation and alternate sources of energy.
Q: Are there countries that have made use of some of these theories. Have you seen less leakages and some of the benefits been passed on?
A: Well absolutely. I think three East Asian countries; the Philippines, Thailand and Indonesia have all adjusted their domestic prices of oil products to international price levels. Indonesia was the last to do it. They suffered badly by continuing to subsidize. Indonesia used to be an oil exporter but they subsidized so much that they became a net oil importer. Because they consumed so much oil that when the price of oil went up they suffered a huge deficit that was unsustainable so they quickly adjusted the domestic prices to world price levels. Philippines and Thailand now have automotive adjustments so that whenever the price of oil goes up in the world it goes up domestically as well.
Q: If as you say this information is available why don’t most governments take these things seriously?
A: I think the reason is that it’s politically very difficult. Even if the subsidies are not benefiting the poor, they are likely to elect that government back into office. Let me give you India as an example. In India some states have a policy of giving free power to farmers. Some of these subsidies are of the order of 1% of state GDP. And these are not poor farmers who are benefiting from it, it is usually rich farmers benefiting because they use more water and more of the electricity than the poor farmers. Yet whenever a government tries to reform that policy by increasing the price of farmers from zero to some positive amount they get thrown out of office. Recently in Undra Pradesh a reformist government raised prices and then the opposition ran on a campaign that if elected they would restore free power to farmers and they won the election.
Q: Do you think there is education going down to users and the general public of the cause-and-effects of what is happening, or do they prefer to believe that free and cheap power is the way to go?
A: Well this information needs to be made more broadly available and accessible to the people. But I think that we also have to understand what are the incentives facing politicians. If doesn’t help for us to tell them ‘you should reform this policy’ if they are going to lose the election when they do so. I think by getting this information out and more importantly by having a public debate about it, so that people are actually discussing it in public, based on information, we might increase the chances of pro-poor reforms.
Q: Do you have any comparable data on expenditure on oil compared with social spending, like health?
A: The size of oil subsidies in countries like Sri Lanka, India, Bangladesh and Pakistan is of the order of 1% GDP. In India it is of 1.2% of GDP which is more than their entire spending on health, the public spending on health. Closer to home in Sri Lanka, the size of the power subsidy, or the losses of the Ceylon Electricity Board, which is just one part of the subsidy system, is Rs. 50 million a day. That’s the cost of one rural hospital a day. So if you didn’t have that subsidy you could build 365 hospitals in a year.
Q: What is actually the win-win situation for governments like these? Is there some way of helping to bring about an equitable solution?
A: This is a government that was elected on a platform that it was there to help the poor. I think the election platform of this government is wonderful because Sri Lanka has too many poor people and we should help them come out of poverty. I think this is an opportunity with this new government that if it is seriously concerned about helping the poor of Sri Lanka that we should be discussing and having a public debate about these reforms like the reform of the Ceylon Electricity Board or the reform of oil subsidies, which if we can design them properly, can actually end up helping the poor.
...in Sri Lanka, the size of the power subsidy, or the losses of the Ceylon Electricity Board, which is just one part of the subsidy system, is Rs. 50 million a day. That’s the cost of one rural hospital a day. So if you didn’t have that subsidy you could build 365 hospitals in a year.
Chief Economist — South Asia, World Bank
Devaranjan: Pro-poor governments should help the poor.