India's government on Thursday allowed state-run fuel retailers to raise prices of heavily subsidised diesel, distancing itself from an unpopular policy ahead of general elections while trying to revive an economy growing at its slowest pace in a decade.
Fuel subsidies are a major drain on India's budget, which is already running a deficit that the government is struggling to bring within a target of 5.3 percent of GDP for the financial year ending March.
India imports 80 percent of the crude oil it refines into diesel, and benchmark Brent crude prices were at their highest annual average on record last year at around $111 a barrel, significantly raising its energy bill.
Diesel accounts for about 40 percent of India's fuel consumption, and the government currently loses 9.6 rupees for every litre of diesel sold.
"Oil marketing companies have been allowed to raise diesel prices in small quantities over a period of time," senior oil ministry official G. C. Chaturvedi told reporters.
Finance Minister P Chidambaram said he did not know when, or by how much, diesel prices will be increased.
The government liberalised petrol prices in June 2010, but has often prevented costs from being raised to reflect rising oil prices on global markets.
Prime Minister Manmohan Singh's government, which must hold general elections by early next year, is trying to revive Asia's third largest economy, which is set to grow at 5.7-5.9 percent this fiscal year, its weakest rate since 2002/03.
Ratings agencies had threatened to strip India of its investment-grade credit rating if the government did not take steps to rein-in the widening fiscal deficit. Chidambaram has repeatedly vowed that the deficit will not exceed 5.3 percent of GDP this financial year.
Fuel subsidies comprised more than 5 percent of the government's budget spending in previous 2011/12 budget. Asked if raising diesel prices would affect this year's subsidy bill, Chidambaram said the effect was so far unclear.
"I am proceeding on the basis that the subsidy bill remains the same. When they will make the small corrections, how much, I cannot say," he told reporters.
Fuel consumption in India rose 5 percent in the last fiscal year, its fastest since 2007/08, and analysts said any price increase was unlikely to dampen demand.
"The prevailing thought is there is certainly a sense of inevitability considering the huge subsidy burden and the need to maintain the fiscal deficit to GDP ratio at 5.3 percent," said Shubhada Rao, chief economist at Mumbai's Yes Bank.
"In that context, there is inevitability of upward price adjustment in petroleum prices. The magnitude and the timing will be worked out between the government and the retailers."
Shares in oil marketing companies rose while bond yields fell after the announcement.
Hindustan Petroleum Corp shares surged 5.2 percent while Oil and Natural Gas Corp gained 4.3 percent.
The 10-year yield fell as much 3 basis points to 7.85 percent.
The rupee rose to 54.47/4950 to the dollar from around 54.63/64 previously.