The bad economics of cross-subsidising fuel

The government comes up with a plan to subsidize fuel consumption of two and three-wheelers every few months. This time around they have even included four-wheelers as a sweetener.  The intentions are certainly noble, but there remains a lot to be desired in terms of execution.  The government recently announced that it will be providing petrol to two and three-wheelers, and 800cc automobiles at PKR 75 per liter. A noble task indeed, but the financing plan for the same remains non-existent, and largely depends on increasing fuel prices for all other consumers.

There are more than 25 million two-wheelers and three-wheelers officially plying the country’s roads.  Assuming daily consumption of a conservative 0.5 liters per vehicle, we are looking at subsidizing (or financing) 12.5 million liters. As the fuel would be available for the same at a much lower price, this will incentivize greater consumption hence resulting in increased demand.  As demand for fuel increases, so will potential  imports, thereby further draining precious supply of foreign exchange liquidity.

Annually, such a cross-subsidy amounts to about Pak Rupee 450 billion. To keep things in context, the monthly amount that needs to be financed is roughly equivalent to the capital expenditure required for establishment of Green Line in Karachi. Instead of subsidizing fuel consumption, it just makes more sense to roll out public transit infrastructure across the country to solve the energy conundrum. Subsidizing fuel is the laziest and the most detrimental solution to a complex question.

Instituting two prices for a primary undifferentiated commodity creates more problems than it solves. It creates a parallel market for that commodity, while laying foundations of an informal shadow market. Given availability of such a massive arbitrage, it is entirely possible, and profitable for people to start selling their subsidized fuel quotas in the open market. This will also drive up consumption of fuel at a time when the country can barely scamper enough resources to meet even a fortnight of its import requirements. Such a pricing discrepancy would act as a fiscal stimulus, and increase demand for fuel, thereby resulting in even more pressure on already debilitating foreign currency reserves.

Execution of such an initiative effectively would require instituting quotas for two-wheelers and three-wheelers, that are linked with the identity numbers, which can then be accessed through existing payments infrastructure. Such an infrastructure is already in place, but how it can work seamlessly, and how it cannot be gamed remains a question unaddressed. This can ensure that any financing remains targeted, however, the creation of a parallel market, and a fiscal stimulus that further exerts pressure on the external reserves position will remain an unintended consequence.  

We are at the precipice of a complete financial meltdown. Any more misguided adventures will ensure that we push ourselves over the edge instead of putting in an even half-hearted effort at course correction. Subsidizing fuel consumption at this stage of the global macroeconomic cycle is bad policy, and it will only take a few months till adverse results materialize, similar to what happened in the fuel subsidy that was given in the early part of 2021.  

The scheme is guaranteed to derail the IMF program, and with that any potential bilateral funding, further pushing the country towards the edge. This is a badly thought out plan, and its unintended consequences will lead to creation of a booming informal market (resulting in lower tax collections), and may eventually lead to a complete fiscal disaster, while also derailing the IMF program at the same time.