RBI, by keeping real interest rates very high in 2017, attracted hot money into the debt market, causing problems in financing the CAD.
Except for the US, most economies of the world are in crisis mode. Policymakers will be judged by how they responded to essentially, for each country, an externally induced crisis. Today, I will try and analyse how Indian authorities have responded to the oil price explosion, and the dollar strength.
We live in a highly globalised and instantaneous transmission world. We live in a world where politics and economics intermingle and each component accuses the other of causing a mishap, or a crisis. Today the crisis in question is a rupee current-account deficit (CAD) crisis.
The current account deficit is the difference between exports and imports. An improvement in CAD can either occur through an improvement in exports, or a reduction in imports. Exports is money coming in, and that is “good”. Imports is money going out, and that is “bad”. Economic growth increases capital inflows and therefore helps the current account; it also increases imports, and so hurts the current account. Exchange rate is a price—a cheaper rupee helps exports, and hurts imports. A cheaper currency, especially a fast depreciating one, hurts confidence, sentiment, and investment flows (both domestic and international) and is not much of a good.
This is all basic macro, and well known. Good policy is the art of balancing the various currents to achieve a harmonious balance. There isn’t a greater truism then ‘that is easier said than done’. Nevertheless, as analysts, we need to detach ourselves from the fire, and decipher the underlying “truth”.
Just like 2013, this year is also an election year. Economists, and analysts, are also human. They make genuine and honest mistakes. As humans, they also possess ideologies and are prisoners of their “political” outlook. This is true at all times, and I have often emphasised that objective observers have to make out for themselves whether a policy-wonk is stating the truth as she sees it, or is recommending something because of her ideology or her politics or both.
With that very important caveat, let us begin to examine some recent policy measures (mistakes?) in India.
First a few facts. Emerging economies, and especially fast-growing economies like India, need capital inflows to finance their investments. The CAD is also equal to the gap in savings and investment. The “high” GDP growth over the years helps pay for the borrowing of savings from abroad. Borrowing can be “good”, but obviously contrary to Shakespeare, who said “never a borrower be”—though he also added that one should not be a lender either!
We will look at policy measures from the angles of good (money in) and bad (money out).
This list of economic mishaps, for the year 2018, starts with the imposition of a 20% long-term capital gains tax announced in the 2018/19 budget. This large increase was a reversal of a long-standing 14 year policy, and I have commented on it, at length, in my piece (bit.ly/2ya2yUn). The simple point made there was that capital taxation revenue was essentially a morality “good”, but a revenue bad. As is obvious, if you do not have capital gains, you will not obtain capital gains tax revenue. For the present fiscal year, capital gains have been zilch; the much-touted long term capital gains tax will yield zilch.
In late August, the ministry of finance (MoF) announced measures to arrest import growth. The 19 items for which import duties were hiked included items such as air conditioners, refrigerators and washing machines and the total value of these imports in 2017/18 was about Rs 86,000 crore. The recent additional policy was calibrated on high value imports, and was an extension to the imposition of import duties contained in budget 2018 which covered a much broader category of goods totalling about a quarter of total imports in 2017/18.
The international price of oil declined from $110 a barrel in May 2014 to an average of $50 to $60 in each of the last three fiscal years. In late 2014, the Modi government decontrolled the price of oil (a very good reform). Despite large international price fluctuations, the government kept the domestic oil price broadly constant. On a base of 100 in 2012, the CPI for petrol averaged the following in the last four years: 108 in 2014/15, and 99, 103, 108, and 119 in the present fiscal year (April through September 2018). So, at the time of the election in May 2014, CPI for petrol was 115. The CPI for petrol is estimated to have averaged 126 in September 2018 or a mere 10 % above the 2014 election price.
On September 4, the government announced an excise tax reduction of Rs 1.5 per litre. An additional Rs 1/litre reduction in the price of oil is to be contributed via price control—i.e., oil companies will “volunteer” a reduction in their price (and profits) by Rs 1/litre. This loss to the oil companies is expected to yield Rs 9,000 crore. In less than 24 hours since the policy was announced, the market cap of oil companies reduced by Rs 1.26 trillion. What an idea, Sirji. Or as Twitter would say, LOL.
It is sound fiscal fundamentals to keep the domestic oil price relatively constant amidst international turbulence. In that regard, the sacrifice of a little bit of fiscal by reducing central taxes (and getting states to reduce their oil taxes) is economically, and tactically, brilliant. Forcing oil companies to volunteer a contribution is very bad economics.
In a parallel fashion, I believe there have been missteps regarding capital flight and the consequent weakening of the rupee. The original sin was likely committed by RBI in keeping real interest rates very high in 2017. This attracted hot money into the debt market, and the reversal of these capital flows maybe one of the major explanations for the present problems in financing the current account. Most analysts have the current account weakening by about 1 to 1.5 percentage points in 2018/19 i.e., from a -2 % level in 2017/18 to around 3 to 3.5 % in 2018/19. GDP is estimated to be $2,900 billion in 2018. Each additional 1% of CAD is $29 billion. Where will this money come from?
Foreign inflows into the domestic debt market was $20 billion in 2017; this year the flow is a negative $7 billion. Do the math. RBI/MPC appears to have just begun to do this math; they want to liberalise foreign debt inflows via “voluntary commitments to retain minimum investments in debt”. This, the MPC believes, will increase debt inflows. Oil companies and other investors want predictable, reality-based policies, not inducements to volunteerism.
The expert talk about our current account (and rupee) problems centre around the presumption that the rupee is overvalued, hence the current account is in trouble, and exchange rate depreciation will bring us back to the holy good land of a 2% CAD. If only the “experts” were right about their facts—and unwittingly, such experts are on the same side of illogical interpretations as those recommending a tax on oil companies (price control) to finance a small reduction in the fisc.
The authoritative Swiss-based Bank of International Settlements (BIS), publishes, for more than 60 countries, a monthly estimate of the real exchange rate (REER). In India, REER averaged around 92 in crisis year 2013 and exports (manufacturing and services) increased at a 6% rate. In 2018 (to date) the REER has averaged 103 and exports have increased at a near 20% rate. Further, the BIS REER averaged 103 in Q1 of 2018 (before the exchange rate depreciation) and averaged 103 in Q3 of 2018.
Two simple facts emerge from these “simple” data. REER levels (at least as measured by the BIS or RBI) do not seem to be associated with either exports or the desirability of exchange rate change. Of course, a legitimate complaint is that this is a very partial and incomplete analysis of exports and exchange rate. True, but tune in again in the next couple of weeks for a more complete analysis!
-The author is Contributing Editor, Indian Express, and part-time member of the PM’s economic advisory council. Surjit tweets @surjitbhalla