Rating agency Crisil has warned that artificially capping the prices of commodities through price controls could lead to shortages, a resurgence of black marketing and deceleration of investment, saying that while inflation needed to be tamed, the use of price controls to moderate it should be avoided.

Instead it has mooted measures that improve competitiveness or reduce costs of production such as labour legislation and infrastructure development, which the rating agency says "will go a long a way towards supporting capacity expansion and easing pressure on prices in the medium term".

On petroleum pricing, it says, "In the unreformed petroleum sector, price controls are creating a situation where oil companies' finances are increasingly stretched, while the consumer receives no signal to cut down or rationalise oil consumption," adding that though global prices have more than doubled, the rise inm petrol and diesel prices has been only 4 per cent.

The sudden spike in inflation from below 5 per cent to 8 per cent in two months has prompted the centre and the Reserve Bank of India to respond through a variety of monetary, fiscal, and trade-related measures that includean increase in banks' cash reserve requirements, duty cuts on imports, and curbs on exports.

The government has also intervened in specific product pricing. Prices of key petroleum products like petrol, diesel, kerosene, and LPG have been regulated to rise much slower than global crude prices: although global crude prices have doubled over the past year, kerosene and LPG prices in India have not increased, while petrol and diesel inflation is only around 4 per cent.

The government has also moved to control prices of commodities like steel and cement by persuading manufacturers of to reduce prices. Says Roopa Kudva, managing director and CEO, CRISIL, "The imperative underlying these attempts is to bring immediate relief from rising prices, but the measures could have several detrimental consequences and prove counter-productive in the long run, besides creating several short-term problems."

In the long term, price controls are clearly damaging as they distort resource allocation and create shortages. Artificially capping the prices of steel and cement, for example, could force manufacturers to put their expansion plans on hold. This can have an adverse long-term impact, as the resulting shortages push prices up further when controls are lifted. It can also potentially decelerate the investment momentum that is driving overall GDP growth in India.

In the unreformed petroleum sector, price controls are creating a situation where oil companies' finances are increasingly stretched, while the consumer receives no signal to cut down or rationalise oil consumption. In Europe and North America, price signals have already led to oil demand moderation and intensified conservation efforts; in India, on the other hand, since consumers have not felt the pinch of increased oil prices, there is no meaningful effort at conservation.

Further, the containment of domestic petroleum prices in India is fast leading to a situation where the government will be unable to bear the burden of subsidies. Other Asian countries have already taken measures to correct the anomaly: Indonesia recently raised petroleum product prices by about 30 per cent, and Sri Lanka by 24-37 per cent. Other countries where price increases are proposed include Bangladesh (37-80 per cent) and Malaysia (20 per cent).  

Price controls create distortions in the short run too.  "Past experience shows us that companies and traders can counter price ceilings by lowering the quality of goods,: says D K Joshi, principal economist, CRISIL. "Price controls also encourage hoarding and black marketeering, and lead to loss of valuable time and energy in queues when supply is rationed. Moreover, additional official machinery would need to be pressed into service to ensure quality standards and check hoarding. The mixed signals and uncertainties created by price controls can also undermine market and investor confidence." '

CRISIL believes that though inflation needs to be tamed, the use of price controls to moderate it should be avoided. Unreformed sectors hurt the most during testing times, with the petroleum sector being a prime example. A complete overhaul of the petroleum pricing regime would be a superior policy alternative to capping prices. It is also critical to transmit the signal of high global crude prices to the end consumer, however unpopular the message might be, to rationalise usage.

Measures that improve competitiveness or reduce costs of production, such as labour legislation and infrastructure development, will go a long a way towards supporting capacity expansion and easing pressure on prices in the medium term. The present crisis should also be used as an opportunity to address fundamental issues related to the supply situation in agriculture. Measures that could be taken include increasing investments, revamping rural infrastructure, and correcting price distortions in agriculture.