The government raised the price of heavily subsidised diesel on Thursday to rein in its fiscal deficit and counter the threat of becoming the first of the big emerging economies to be downgraded to junk.
The long-awaited decision follows intense pressure on Prime Minister Manmohan Singh to plug one of the biggest drains on the treasury. It was greeted with elation by investors and raised expectations of more reforms to reverse an investment slump and revive a sluggish economy.
But the fuel price increase caused an instant political backlash. Trinamool Congress, a partner in the ruling coalition, announced a protest march at the weekend and the Bharatiya Janata Party (BJP) called the move "financial terror".
Protests earlier this year over petrol price and railway fare hikes prompted Singh to partially roll them back.
"Nobody wants to put pressure on people but the subsidy bill had risen so high that this became inevitable," Pawan Kumar Bansal, minister for parliamentary affairs, told Reuters. "This is an essential step to revive the economy and the investors' confidence."
A cabinet committee increased diesel prices by 5 rupees per litre from Friday. That translates as a 14 percent rise, including taxes. The hike is the first in 15 months.The committee also decided to limit the number of subsidised cooking gas cylinders per household to six per year, a move seen as hitting the poor hard. Any LPG cylinders bought over this ceiling will be at market rates, which could almost double the price.
Ratings agencies Standard & Poor's and Fitch said earlier this year that a widening deficit had put India on the brink of losing the investment grade status enjoyed by fellow "BRICS" Brazil, Russia, China and South Africa.
The government hopes the move will help avert a sovereign credit downgrade, the prime minister's chief economic advisor, C. Rangarajan, said. "The government has shown it can take hard decisions, very difficult decisions."
Diesel is one of the main contributors to a subsidy bill that economists warn could push the country's fiscal deficit above a target of 5.1 percent of gross domestic product.
"It is the first credible step towards fiscal consolidation that the government has taken, something for which the market has been waiting for long. It also gives some hope for a rate cut by the Reserve Bank of India," said Manish Wadhawan, managing director and head of rates, HSBC, Mumbai.
The central bank holds a monetary policy meeting on Monday to look at interest rates, some of the highest among large economies.
Higher diesel prices means higher inflation in the short term, but the central bank has been clear it wants the government to slash the fiscal deficit, a structural inflation driver, before it will tackle rates.
After months of policy drift that critics derided as dithering, Singh's government suddenly shifted gear this week, by looking afresh at a number of policies stalled by a lack of consensus within the Congress party and among its allies.
The cabinet's economic panel is due to meet on Friday to discuss a plan to invite foreign airlines to invest in domestic carriers and a proposal to sell shares of large state-run firms.
With the first in a series of state elections due within weeks, Singh is seen as having a narrow window of opportunity to act on the economy before electoral politics takes over.
Singh's biggest coalition ally, Mamata Banerjee, who last year forced the government to roll back a policy to allow foreign supermarket investment in India, said her party was not consulted and vowed to lead a protest in Kolkata on Saturday.
The BJP, which is likely to exploit the price hike ahead of elections, also condemned the move.
"This is financial terror unleashed on the common man by the government," Rajiv Pratap Rudy, a leader of the main opposition Bharatiya Janata Party (BJP) leader, told Reuters. "The economy has collapsed and the government is passing on that burden to the people."
Diesel accounts for more than 40 percent of India's refined fuel consumption. It is subsidised mainly to benefit farmers but the wide gap with petrol prices has caused the 'dieselisation' of the economy, with car companies launching diesel versions of popular models aimed at price-conscious middle class consumers.
Even after the price hike diesel is considerably cheaper than petrol, meaning demand is unlikely to drop off.
"This (price rise) will not allow gasoline demand to pick up in India. You will see stagnant growth in passenger vehicles and solid growth in diesel-based utility vehicles continue in India," said Praveen Kumar, analyst with FACTS Global Energy.
Three state-run fuel retailers -- Indian Oil Corp, Bharat Petroleum Corp and Hindustan Petroleum Corp -- have together racked up losses of 405.4 billion rupees in their first fiscal quarter, four times the loss from a year ago.