A series of bold measures (the big bazooka approach) by the government will result in lower CAD, reduced gross fiscal deficit (GFD), a stronger currency and large foreign currency inflows (both equity and NRI deposits). A stronger currency can result in a positive self-fulfilling loop of stronger capital inflows and rupee appreciation. This will help India mitigate the negative impact of potential FII outflows arising from a near-certain tapering of the Feds ongoing bond buy-back programme ($85 billion per month). A reversal in the recent depreciation of the currency and in interest rates eventually will restore the confidence of investors in the prospects of the Indian economy. Thus, the immediate focus of the governments policies and regulations should be on curtailing Indias current account deficit (CAD) to around $50 billion (less than 3% of GDP from 4.8% in FY13), and financing the CAD through more long-term and stable capital flows (FDI and equity). Finally, an effective response to the short-term challenges will give India time to implement longer-term fiscal, governance and investment reforms that can put it back on the path of higher economic growth. Indias long-term potential and fundamental strengths remain intact. Its policymakers can and should use all the means at their disposal to meet its short-term challenges.
India is in a unique position to reduce its CAD without affecting GDP growth meaningfully since imports of gold and related items account for nearly half of Indias CAD. A sharp reduction in CAD usually results in lower GDP growth. However, lower gold consumption (and imports) will have no material impact on Indias GDP. Also, India does not have a problem of large short-term foreign currency borrowings, a common reason for foreign currency crises seen in several emerging markets over the past two decades. Short-term borrowings (excluding trade credit and NRI deposits) were $37 billion on March 31, 2013, and FY13 GDP was $1.8 trillion. Also, Indias current foreign currency reserves of $275 billion can cover seven months of imports. Finally, Indias large and diverse equity market can attract large FII inflows if India can implement measures to stabilise the currency and address the policy and regulatory issues in several large sectors such as energy, mining and telecom.
The government and RBI may want to explore the following options to address Indias immediate problems in the areas of high CAD and large GFD. Without immediate and effective steps, India runs the risk of overshooting its targets for CAD ($70 billion) and GFD (4.8% of GDP) for FY14. April-July GFD is already 63% of the FY14 budget estimate of R5.4 trillion. From a BOP perspective and financing of the CAD, FYTD FII outflows are about $4.5 billion against positive inflows of $17 billion in FY12 and $27 billion in FY13.
First, the government may look at controlling CAD to a more manageable figure of $50 billion ($88 billion in FY13) through measures to control consumption (and hence imports) of gold. India imported gold and other precious items worth $78 billion and exported jewellery worth $43 billion. Gold imports alone were $54 billion and net gold consumption was about $40 billion. Gold is primarily used in India for two purposesas a store of value for households that fear erosion in their wealth by high and persistent inflation, and as a store of unaccounted income or wealth. A domestic transaction tax (same as any value added tax) on gold (and other precious metals and stones) instead of an import duty on gold would bring gold in the tax chain and limit the use of illicit cash for the purchase of gold. A jeweller who buys gold from designated gold importers will pay 3-4% VAT and recover the tax paid from the final customer of gold jewellery as is the case with any other product in India. This will require proper records of all transactions from the initial purchase of gold bullion by the jewellery industry to the final sale of jewellery. However, genuine purchases of gold will not be affected. The government can also increase the disclosure requirements for purchase of gold and related items in cash. It can reduce the requirement of disclosure of the PAN card to R25,000; a poor person who does not have a PAN card is unlikely to buy gold worth R25,000 anyway.
Second, the government should sell its minority stakes in private companies such as Hindustan Zinc (29.5%) and ITC (11.4%). This will raise R400-450 billion for the government, which will help it achieve its divestment target of R558 billion for FY14. Also, divestment in ITC will result in large FII equity inflows since most of the sale would be to FIIs. This will result in significant FII equity inflows ($3-4 billion) and partly finance the CAD. The government can sell its stakes in Axis Bank (20.7%) and L&T (8.2%) at a more opportune time. The government may miss its divestment target without a more innovative approachit has raised only R13 billion so far out of its FY14 target (including the raising of R400 billion from PSU companies). Investment sentiment is weak for PSU stocksmost PSU stocks, post divestment, have not performed well over the past 3-4 years.
Third, the government can ask some of the cash-rich PSU companies to give special dividends. The top-10 cash-rich PSU companies had total net cash of R1.4 trillion at the end of FY13. Some of these PSUs, such as OIL and ONGC, will require cash for overseas acquisitions. However, others can give a special dividend to the government. In particular, Coal India Ltd (CIL) with a net cash balance of R610 billion (on March 31, 2013) can give a dividend of R400 billion and R68 billion of dividend distribution tax (DDT). The government will receive R428 billion (90% of the dividend and 100% of DDT), which can serve as a buffer against likely higher oil subsidies. CIL does not have any requirement of cash and it should return the cash to its shareholders. CILs FY13 operating cash flow alone was twice the capital expenditure incurred by it over the past four years. CIL can very easily fund its future capital expenditure plans from its annual operating cash flows; its FY13 capital expenditure was R24 billion only against operating cash flow of R190 billion.
Fourth, the government should implement a one-time increase in diesel price of R5 per litre and a higher monthly increase of R1 per litre to reduce under-recoveries on diesel. This will help keep oil subsidies at a more manageable level and prevent meaningful fiscal slippage beyond the governments 4.8% target. Diesel under-recoveries have increased to R12.2 per litre currently (based on prices and the exchange rate of the second fortnight of August) from R8.2 per litre at the start of the current fiscal year due to the steep depreciation of the rupee despite several rounds of monthly price increases. A R1 per litre increase in the retail diesel price can reduce under-recoveries by R80 billion on a full-year basis. Most of the benefits of Indias fuel subsidies (R1.65 trillion in FY13) are captured by the high- and middle-income households and not the real poor who outnumber middle-income households. The enhanced scope of Indias food security programme, approved by
Parliament recently, should provide the government sufficient mileage to implement certain unpopular measures that may affect a privileged section of Indias population. The government can mitigate the economic impact of higher diesel prices for certain sections of the population through higher minimum support prices for agriculture product prices (factor in the higher diesel price for irrigation purposes) and higher income tax exemption limit (households with undisclosed incomes do not deserve a subsidy anyway).
The author is co-head and senior executive director, Kotak Institutional Equities