The National Highway Development Programme (NHDP) was introduced in 1998 and provided a new trajectory for road development in India. In the initial phases of the NHDP, public funding was the default mode, till public-private partnerships (PPPs) took centre stage with the approval of the model concession agreement for PPPs in 2006. So far, the National Highways Authority of India (NHAI) has successfully awarded more than 250 PPP projects covering around 24,000 km of national highways in India.
The NHAI toll policy of 2008 – National Highways Fee (Determination of Rates and Collection) Rules, 2008 – governs tolling on national highways. The policy enables NHAI to collect user fees from different categories of highway users. The toll rates are indexed to the wholesale price index (WPI) inflation to account for changes in wholesale prices. However, such a revision in toll rates is restricted to only a 40 per cent increase in WPI plus a base rate, which is revised annually without compounding. In 2015, the WPI inflation turned negative (-3 per cent) for the first time in the decade 2006-16 and triggered pessimism amongst highway developers owing to declining growth in toll revenues. Negative WPI resulted in declining toll revenue collections for highway developers making it difficult for them to manage project cash flows and debt servicing requirements. There was a growing belief among the developer fraternity that a negative WPI inflation rate is primarily on account of the change in the monetary policy, as initiated by the Reserve Bank of India (RBI) in consultation with the Ministry of Finance in early 2014. Many developers made a representation to the government reflecting that such a case of declining toll revenue (due to negative WPI) is a clear case of “change in law” as per the provisions in the signed concession agreements. Thus, it gives developers the right to claim compensation for losses. However, the logic of such a representation is debatable and needs to be weighed upon appropriate economic principles.
Undoubtedly, WPI indexation has many challenges. It has been acknowledged by several leading economists and the government from time to time both in India and globally. The WPI index results in the underestimation of inflation at the wholesale level mainly due to the non-inclusion of the service sector, where services contribute about 60 per cent to India’s GDP; as against consumer price index (CPI), which constitutes services. The base year for WPI estimation is 2004-05 indicating that a passage of 13 years makes the index non-reflective of changing times and consumption patterns in India. The weightage of certain commodities that form part of the WPI namely, crude oil and primary articles (minerals, metals and agricultural commodities – cotton), which are highly susceptible to external commodity and oil price shocks.
Based on industry norms, the break-up of operation and maintenance (O&M) cost for highways is about 80 per cent material, machine and labour and the balance 20 per cent cost constitutes employee salaries and other administrative expenses. The primary input forming part of the maintenance cost of highways, namely material and machine, gets affected by WPI inflation; however, inputs like labour cost, employee salaries and other administrative costs typically get affected by CPI inflation.
In general, supply-side pressure is better represented through WPI inflation and demand-side pressure through CPI inflation. Global demand fluctuations have an instantaneous bearing on WPI inflation unlike CPI, which tends to remain sticky in the short term (due to stickiness in the revision of any contracts). RBI’s efforts so far have been towards containing WPI inflation, as it was conventionally considered a better indicator. In 2011, with the introduction of the new CPI series, there has been a gradual shift in RBI’s focus from WPI to CPI. The new CPI series is more representative of the consumption basket.
Post the global financial meltdown of 2008, WPI inflation declined drastically from 9 per cent to 2 per cent in 2009; however, in the same period, retail CPI inflation remained sticky at higher levels from 8 per cent to 11 per cent. Gradually, in 2011, the lagged impact of the global financial meltdown affected retail prices as well, declining from 12 per cent in 2010 to 8 per cent in 2011. This period also witnessed a gradual correction in wholesale prices making it the only year in the decade 2006-16, when wholesale prices were higher than retail prices.
After 2011, WPI inflation witnessed a consistent decline from 9 per cent to negative 3 per cent in 2015, whereas CPI inflation declined from 8 per cent to 5 per cent during the same period, thus increasing the divergence between the CPI and the WPI. Also, during this period, the CPI base year was altered twice with modifications in CPI composition. On the other hand, barring basic changes, WPI inflation did not witness such drastic changes in composition during the period.
WPI and CPI inflation indices are correlated, albeit with a lagged effect on each other. The RBI-appointed Urjit Patel Committee’s report highlighted (pp. 14 and 74, Annexure 1, Urjit Patel Committee Report, 2014) the circular impact of components of the WPI and CPI on each other. Certain categories (like food and fuel) in the WPI and CPI have commonalities and to that extent affect each other. The food basket constitutes a 26 per cent weightage in the WPI as compared to 46 per cent in the CPI and the fuel basket constitutes 16 per cent in the WPI as compared to 7 per cent in the CPI, highlighting that the 42 per cent weightage in the WPI and 53 per cent in the CPI will have a bearing on each other. Non-food and non-fuel components in both the indices have been empirically found to have the least impact on each other. However, despite the correlation between the WPI and the CPI, there are a multitude of factors that have an instantaneous bearing on the WPI, making it rather vulnerable and may have a lagged and diffused effect on the CPI.
Although the WPI and CPI are correlated, several factors have a greater impact on one index as compared to the other. Some emanate from the domestic market while others are a result of global trade conditions. A number of these factors led to declining WPI inflation in 2015.
WPI constitutes primary inputs like crude oil, heavily traded commodities like agricultural commodities (like wheat, cotton) and mineral-based products (like copper) and manufactured products using these inputs. Global price movements in these commodities can send a price shock to wholesale price inflation immediately. The softening of global crude oil prices, mineral prices (like copper), agricultural commodity prices (like that of cotton) from 2014 onwards has had an impact of decreasing the price of primary articles and manufactured products, thereby resulting in WPI disinflation till 2016. (Disinflation is declining inflation, which is still positive. Deflation is negative inflation.)
Other factors such as global merchandise trade flows (both import and export) reflect the demand conditions in trading countries like the US, the UK, the UAE, China and Canada. Softening trade flows get reflected in declining demand witnessed in all these countries between 2013 and 2015 exerting negative pressure on the global prices of tradable goods, thereby impacting the WPI and CPI. These countries witnessed a rapidly declining WPI as against the CPI. On the other hand, inflationary expectations of consumers have a significant contribution towards keeping CPI inflation sticky unlike their impact on the WPI, which is rather weak. It has been observed that in 2015 the three-month-ahead mean CPI inflationary expectations have remained sticky at elevated levels at a time when the WPI declined drastically, eventually becoming negative. Factors like positive growth in the reserve money supply and declining call rate trends have shown a similar trend in CPI inflation, however, WPI inflation has declined drastically indicating that several other factors have a bearing on the WPI as compared to the CPI.
RBI’s nominal anchor
Typically, RBI uses tools like open market operations, foreign exchange sterilisation and policy rates to control inflation. The WPI inflation rate has conventionally been the reference inflation rate for any indicative targeting by RBI, mainly because the frequency of WPI inflation data as compared to the CPI was higher whereas CPI data had greater lag in its release, thus losing relevance. Also, the WPI was more representative of the entire population as compared to the CPI in the pre-2011 phase.
In 2014, a report was submitted by the Urjit Patel Committee to revise and strengthen the monetary policy framework. The report indicated a move from a multiple indicator approach to a single nominal anchor giving credibility to RBI’s monetary policy with a focus on price stability. It suggested that inflation targeting be adopted formally and retail inflation be selected as the nominal anchor. Inflation targeting reduces inflation volatility and the impact of shocks and anchors inflation expectations. Emerging economies face the challenge of vulnerability to high inflation threatening output and employment. Hence, the price stability target makes it imperative to make inflation targeting the goal of monetary policy so as to anchor inflation expectations.
Along with the 2011 CPI modifications and the Urjit Patel Committee recommendations, the CPI-combined (CPI-C) series (a series of CPI that factors in both urban and rural components) is the preferred choice, reflective of the latest consumer expenditure survey (2004-05 National Sample Survey Organisation) and the cost of living and influences inflation expectations. The committee suggested the adoption of the CPI-C target at 4 per cent with a band of +/- 2 per cent considering the vulnerability of the Indian economy to external shocks and large weight of food in the CPI and to avoid a deflation bias. Considering the current elevated CPI inflation, hardened inflation expectations, supply constraints and weak output performance, the transition path to the target was calibrated to bring down inflation to 8 per cent by 2015 and 6 per cent by 2016 before formally adopting the target of 4 per cent.
Comparable emerging market experience
World development indicator (WDI) data revealed that in the year 2015, globally, there had been a general softening of WPIs across most emerging and developed economies. This is mainly owing to the declining global tradable commodity and oil prices post 2012 and muted global demand conditions.
In light of the factors affecting the WPI and the typical operations and maintenance cost break-up for a highway developer, it can be ascertained that a mere claim of a change in the monetary policy may not be a sufficient reason to demand compensation for negative WPI inflation. There are several factors which have a bearing on the WPI and alienating any probable impact of the adoption of the nominal anchor and the impact because of the correlation between the WPI and CPI may be challenging. Also, the operations and maintenance cost structure reflects components which are affected both by the WPI and CPI, hence, the need to move towards a more composite toll indexation method from the current one.
It is understood that as toll revenues generate cash flows primarily to meet highway operations and maintenance costs and debt servicing costs, a hybrid formulation for the toll inflation index is better suited to factor in retail price changes that get affected by CPI inflation. This is mainly because the cost of living is factored into the CPI and hence if components like labour, employee and administrative costs getting affected by CPI inflation are not accounted for suitably, it will result in the underestimation of the toll growth rate in comparison with growth in operations and maintenance expenses. The toll indexation should also factor in the variability index to account for fluctuations in market interest rates that will impact debt servicing costs.
Emerging market experience with toll indexation
According to a World Bank report, toll rate indexation is usually carried out with the CPI with adjustments done once or twice a year. In some of the emerging market economies like Indonesia, highway tolls are indexed to retail prices with a toll rate growth price regulation cap of 25 per cent. On the other hand, in the Philippines, in order to make investments in highways attractive for investors, the Presidential Decree 1894 mandates a formula taking into account local and foreign interest rates, the CPI, currency values, and a construction materials price index.
BY Indranil Bose, Transport Sector Consultant, IFIs and EY
and Shreyoshi Saha, Senior Consultant, EY
(The article does not reflect the views of any organisation, only those of the authors.)