The Quagmire State of Indian Economy - A case of Economic Mismanagement and Policy Paralysis

".. During a recent breakfast with an investor visiting Mumbai from a large western fund, the conversation quickly turned to the question of the moment: what ails India?. “On every indicator we look at, there is a red flag,” he said, before adding with a wry smile: “This country is close to becoming the Greece of Asia.”.. " - James Crabtree, The Financial Times, May 15, 2012.

Ever since the Sovereign Debt Crisis in Europe, it has been difficult times for the Indian Economy. Dr. Kaushik Basu, the Chief Economic Advisor to the Government of India, in a recent interview with journalist Karan Thapar admitted that "Its not a pretty picture". A recent article that came in 'The Economist' said "Farewell to Incredible India" (June 9, 2012). The GDP has fallen to 5.3%, the IIP growth rate has slowed down to 0.1%, Inflation rate still lingering around 9%, the Rupee has fallen to 57 per $, the Unemployment is as high as 9.4%, the Net International liability at $244.8 billion (20% hike), Government borrowing as high as Rs. 53000 Crores, burgeoning Fiscal deficits and the declining FIIs to top it up, the picture is clearly not pretty. But are these the inevitable resultants of the Global Financial turmoil or are there any other possible angles to it?

I wish to discuss on three observations I had made on the recent events in our economy.

One, the prices of petrol was hiked overnight by Rs 8, there by crossing the Rs.70 mark, in the name of decreasing Fiscal deficit to the targeted 5.1% viz reducing subsidies. But on the other hand Government gave Customs duty exemptions on gold and diamonds. We have a 967 tonnes of gold imports in this country and  would mean that the Country is set to lose close to Rs 50000 cr from these tax exemptions. Not just that, if the CAG report has to be believed, Rs 80000 cr revenue was forgone from tax exemptions in corporate sector alone, out of the Rs. 1,60,000 cr tax forgone in the recent budget. Why the Government chose not to tax the Gold - Diamond merchants to help in achieving the Fiscal deficit target, but instead taxed the common man of this country taking money out of his already shrunk pocket? It could only be called as an economic paradox!

Two, at a time when the country was strangled with 9% inflation, last season, India harvested a bumper crop of grain, an all time record of 75 million tonnes. But food grains worth hundreds of crores of Rupees went rotting in the FCI godowns in Rajastan. The Supreme Court of India observed that, “In a country where admittedly people are starving, it is a crime to waste even a single grain” to which our Prime Minister had replied that Supreme Court should not interfere itself in the matter of policy decisions. I wonder what would have prevented The government of India from distributing the excess grains through the Public Distribution System (PDS) at BPL prices which would have brought the inflation rate down?

Three, in a country which has 1/3 of world's poor, where millions survive on less than $2 a day, where 41% population live below poverty line, 40 mn living in slums, 3 mn sex workers, 12.6 mn child labors, 72 mn children without primary education, 2nd largest population of mal-nutritioned children with 4 children dying every min prone to illness, 20 cr sleeping hungry every night, 18000 farmers committing suicides an year and 35% of population living without electricity - the Government of India spend $80 million on Chandrayaan 1 for collecting rock samples and to find traces of water on moon surface! Chandrayaan which was supposedly a two year project, had to be called off after a mere 312 days. I wish had the Government concentrated more on building basic infrastructure, like building more storage facility for food grains, building better roads, providing water supply facilities, rather than going to moon and search for the possibility of water traces, would have helped in the country and its poor majority people in these difficult times.

From the above three observations, it gets pretty clear that for the situation India is in now, the policies of the Government of India is equally responsible along with the unfortunate world economic situation. With no major reforms going on and those promised - The Banking,Pension & Insurance(BPI) Reforms Bill, the FDI in Retail, the Goods and Services Tax (GST), the General Tax Code (GTC) - still on hold, the Government is going through a severe policy paralysis. On top of this, the untimely announcement by the Government of India for the retrospective amendment of tax and General Anti - Avoidance Rule (GAAR) to prevent the entry of money through the Mauritius route, has lead to lack of confidence of investors on India and resulted in the flight of capital from India, which in turn has caused the unprecedented downfall of Rupee. If the words of Dr. Kaushik Basu could be believed then there is no scope for any big ticket policy measures from the UPA-II Government till 2014, which means things could go worse. Thus the dirty picture we are seeing of our Economy in the recent times cannot be solely blamed on the turbulance in the World Economy but is also a case of economic mismanagement and still on going policy paralysis of the UPA-II Government. Its time for the Government to wake up and invoke the 'animal spirits' in the Economy, through strong and credible policy decisions otherwise India's wonder story will be over before we even reach 2020.

The Genesis of European Economic Crisis and its Impacts on India

The fear of an economic crisis arising from the burgeoning sovereign debts in some of the European countries developed during the late half of 2009 and this fear turned to a reality in the early half of 2010 that took the shape of what we know today as the European Sovereign Debt Crisis. Sovereign debt crisis means that the sovereign government’s borrowing from the domestic and external markets is in excess of its capacity to repay, resulting in loan defaults. In such situation the countries under trouble will require bailout packages from other countries or institutions such as IMF.

The countries caught up in this crisis were Portugal, Italy, Greece and Spain (known as PIGS). The economic activities of these countries came under the intense scrutiny from the international investment community, in the early 2010, with the threat of Sovereign default lurking around the corner. The crisis occurred as an aftermath of the Global Recession. The European governments had to introduce various financial stimulus packages to confront the recession. The Government expenditure on public job creation, pensions, social benefits etc in these countries took gargantuan proportions to support these packages. Governments were forced to borrow heavily to support these financial stimulus packages, generating high fiscal deficits. The government of PIGS nations, in the panic of recession, thus mopped up huge debt.

The Genesis of the Crisis

Greece was the epicenter of the crisis. The shambolic state of affairs in Greece, which was known to ‘live beyond its means’, was the major reason behind the crisis. The successive Governments in Greece till 2008 resorted to high Government spending which led to the situation of high budget and current account deficits. But the Governments concealed the real situation by manipulating with its deficit figures. From 2001 to 2008, the reported budget deficit of Greece averaged 5% per year and the current account deficit averaged at 9% per year. Several international rating agencies mislead the international community by high rating the Greek bonds. 

But soon the world came to know about the real condition of the Greek economy. The new socialist government in Greece, led by Prime Minister George Papandreou released the revised estimates of the Government Budget Deficit during late 2009. The revised estimates showed the budget deficit to be a whopping 12.7% of the GDP, when the previous estimate was only 6.7% of GDP. Greece held external debt to the tune of $236 billion and was unable to continue making their interest payments. Subsequently three major credit rating agencies downgraded the Greek  bonds and investors lost their confidence on Greek economy. A $1 trillion rescue package from the EU and the IMF was agreed upon in Brussels in May 2010.

Greece was not alone in this quagmire. The situations of other European economies like Italy, Portugal and Spain also surfaced. All these countries faced a roll-over risk. That is they had debts mainly comprising of short term maturity, and hence the amount to be rolled over was large, that aggravated the crisis.

Consequences

The crisis considerably affected the growth of the PIGS countries. The GDP of all the PIGS countries showed a steady decline from 2009 to 2011.

The GDP (in $ bn) of the PIGS countries from 2005-2011

Being the common currency for the entire European Union, the debt crisis had immediate impact on the Euro. The value of Euro fell drastically since 2009. Most of the Currency traders feared that some Exchange Rate countries with large budget deficits might be tempted to leave Euro. If it happens, that is if a country leaves the European Union, it could allow its currency to fall in value and there by improve their monetary situation. But it would cause huge ruptures in the financial markets as the investors would fear other nations might follow this and it could potentially lead to the breakup of the European Union itself.

U.S. / Euro Foreign Exchange Rate

The steady fall in the Euro and the weakening dollar due to the Global recession and the fear of a possible double-dip recession in U.S. all directly affected the gold prices. Investors saw Gold as a safer investment in this difficult economic situation and hence started to invest on gold. The high demand for gold resulted in a hike in the Gold price. The average gold price went up steadily since 2008 and this hike got accelerated since 2009 when the crisis in Europe was revealed.

The Greek crisis has also affected the Global banking system, as many of the Global major banks had invested in the Debt instruments issued by the Greece government. This ultimately affected the ordinary investors or the people who own their shares through pension funds. It also affected the common tax payers of the other Euro zone countries, as they have agreed to help the countries in crisis and hence the tax payers of these countries have to pay more taxes in order to share a part of Greece’s burden.

Impact of the Crisis on India

India has out-performed other economies during this period of crisis. The major reason for this is that the Indian economy is not much exposed to the European economy as it is to the U.S. economy. Indian economy is far less dependent on its trade with Europe. Indian IT companies have lower exposure to European clients and hence were not majorly affected by the crisis. The software receipts were $11.3 billion in Apr-Jun 2008 which came down only to $10.6 billion which is very less as compared with the impact crisis had on IT in other economies To understand the real impact of the European debt crisis on the Indian Economy, we need to check the major Macro Economic indicators of India and see if there were any significant impacts on it during the period of the crisis.

Impact on growth

The Sovereign debt crisis in Europe did not have much impact on the growth rate of India. The Indian economy continued to grow even during the crisis period. The indicators of growth, the Index of Industrial Production (IIP) and the Gross Domestic Product (GDP) did not show any decline during the period of the crisis, i.e. from 2009 onwards.

Impact on Trade

The European Union accounts for nearly 21% of India’s total export and out of that the exports to Greece, Spain, Portugal and Italy constitute only 4%. Since the Indian exports to PIGS are very low, the crisis did not have any impact on it. India’s major exports to EU are textiles, pharmacy products, gems which were not much affected by the crisis. Hence neither the Exports nor the imports show any decline during the crisis period from 2009, showing no impact of the crisis on India’s Trade.

Impact on Foreign Investments

The international investors lost their trust on the European economy owing to the crisis and hence majority of the FII and other individual investors chose Indian market to invest as it showed stability in the economy even at the adverse time of the crisis. The Foreign Direct and Portfolio investments showed a steady rise since 2008-09 and continued its rise in 2009-10. Though there was a dip in the Portfolio investments in India at the time of the Global recession but it is notable that the Direct Investments was stable throughout the period.

Impact on the Forex Reserves

India is sitting comfortably on a high Forex reserve that could absorb any shock from outside on the Indian economy. It could be seen that there was a dip in the Forex reserves of India at the time of the Global recession. But during the period of the European Crisis, the Forex reserves were steady and showed an upward trend.

Conclusion

The European economic crisis was a Government driven crisis than a market failure. It occurred due to the shambolic state of affairs that existed in European countries, the extravagant Government spending and abysmal management of funds. The Governments were found to be in a quandary at the time when the crisis emerged. Hence the Governments tried to manipulate with the numbers to hide the reality. This took long time for the world to understand the real situation. This highly condemnable act of the Governments to hide the reality about their true economic situation has raised serious questions about ethics in economics.

The investment agencies also played a part in misleading the investors into investing in the government bonds of Greece. Greece and Europe was majorly hit because good part of the Government debt was held by foreign institutions. On top of that, all these countries faced a roll-over risk as they had debts mainly comprising of short term maturity, and hence the amount to be rolled over was large.

Though the crisis had a major impact on the world economy, it could not cause much an impact on the Indian economy. The major reasons Indian economy has not had a direct impact of the crisis are the fewer linkages it has with European economy and the highly cautious approach that the Indian monetary authorities have shown in managing the economy right from the time of the Global Recession. Hence the economic growth, the foreign trade, the foreign investments and the Forex reserves of India did not show any signs of decline during the crisis period. The better performance of the Indian economy has increased the belief of the investors on the stability of the Indian economy, which was evident in the steady rise in the Investment inflows into the country at the time of the European economic crisis. Hence the crisis has only provided an opportunity to India in proving its economic stability and credibility.

The lessons learned from the European Debt Crisis are the following:

• Governments should not go in pursuit of Economic development at the cost of high fiscal deficit.
• Governments should not manipulate with the numbers and try to hide the reality about the economic condition that exists in their country.
• Governments should not be too much dependent on foreign institution in raising their funds.
• Governments should not hold debts which are mainly of short term maturity, since it can cause roll-over risk, leading to fiscal crisis
• The investment agencies should not try to mislead the investors in making their investment decisions.
• The failure of the Credit rating agencies in discovering the correct fiscal positions of countries may prove highly costly to all entities associated with them. Hence the credit rating agencies should be highly cautious in making their ratings and should ensure their credibility.

Thus Governments, Investment agencies, Credit rating agencies all have to maintain economic prudence otherwise the price for any mismanagement from them have to be paid by the common man.

References

1. Bajpai, Nirupam. 2011. “Global Financial Crisis, its Impacts on India and the Policy Response”, Working Paper No.5, Working Paper Series, Columbia Global Centers.

2. European Commission. 2009. “Economic Crisis in Europe: Cause, Consequences and Responses”. European Commission Report.

3. Reddy, T. Koti. 2011. “Greek Crisis and its Impact on the World Economy”, IBS, Hyderabad.

4. Zandstra, Deborah. 2011. “The European Sovereign Debt Crisis and its Evolving Resolution”, Capital Markets Law Journal, Vol.6, No.3. pp. 285-316.

Oil Price Hike June 2010 – The Facts and Myths

June 25, 2010 saw the first “big-bang” reform policy by the Congress-led UPA government, which was re-elected last year with a strong mandate and with increased hopes of taking firm steps towards economic development of India. The Government took the first step towards decontrolling petroleum and petroleum products prices by completely freeing petrol and partially freeing diesel and reducing the subsidies on other products and subjecting its prices to be determined by market forces. With surprise to none, the strong and bold step was taken by a Government headed by Dr. Manmohan Singh, the person who was the mastermind behind the Indian Economic Reform of 1991.

The freeing up of petroleum prices resulted in the hike of petroleum products and it led to a wide spread protests against the Government move from all opposition parties. To this raging opposition, the Prime Minister Dr. Manmohan Singh reacted sharply by stating, “The fact that petrol prices have been set free, and the same is going to be done to diesel prices, are much-needed reforms. Any increase in prices does hurt some people, but we have to take a long-term view. It is high time to end excessive populism, for the cause of the economic development of the country.”  In this scenario, I decided to probe into the economics behind the issue, to analyze the reasons behind the Government’s decision and the facts behind the allegations raised by the opposition.

It all began on August 26, 2009 when a five member committee headed by Dr. Kirit S.Parikh was constituted by the Government of India, to advice the government on the most viable and sustainable system of pricing the petroleum products. The other committee members were Isher Ahluwalia (Chairperson, Indian Council for Research on International Economic Relations), Suman Bery (Director General, National Council of Applied Economic Research) and the secretaries of finance and petroleum. The Kirit Parikh Committee submitted its report to the Petroleum Ministry on February 03, 2010. The committee has recommended that prices of petrol and diesel to be market-determined, both at the refinery gate and retail levels, whereas the prices of kerosene and domestic LPG can be partially raised by Rs.6 per liter and Rs.100 per cylinder respectively. The panel also recommended for linking the prices of cooking fuels- LPG and Kerosene with the increase in the per-capita GDP of Urban and rural population. The committee has accepted the subsidy formula proposed by Oil and Natural Gas Corporation (ONGC) aimed at reducing burden of oil companies. The formula suggests an incremental rate of taxes on higher crude oil price realization from the nomination blocks of ONGC and Oil India Ltd (OIL).  Thus in the light of the Kirit Parikh Report, the Government of India freed the price of Petrol and partially freed the price of Diesel, from the Government control. The decontrolling resulted in the hike of price of petrol by Rs.3.50, that of diesel by Rs.2, kerosene by Rs.3 and LPG by Rs.35. But even after this hike, though prices of petrol has been completely decontrolled, Diesel is still under priced at Rs.1.50, Kerosene at Rs.15.07 per liter and  LPG at Rs.226.90. Government has declared that the complete decontrol of diesel prices will be undertaken slowly.

 The opposition parties in India have responded strongly against this fuel price hike. The fact is that in India the changes in petrol and diesel prices are treated more as a political matter than as an economic matter.

Prices are controlled forever in a communist system, but the burden such an absolute control infests on a Government is mammoth and it can push the economy into the abyss of public debt and ever increasing fiscal deficit. Price controls can provide short-term relief to consumers, but act as longer-term disincentives to production and efficiency. It was the cumulative impact of all these which led to the collapse of USSR. Countries without price controls have far outperformed those with controls, in terms of poverty removal and GDP growth.

The Opposition claimed that the inflation rate will rise and common man will be pushed into poverty and privation by the price hike, while farmers and agriculture will be ruined. However, the fact is that despite price controls, India has 10% wholesale price inflation and 14% consumer price inflation. In contrast, the inflation is just 2 to 3 percent in countries like US, Europe, Japan and other countries where there exists no price control. When the crude oil prices had doubled last year from $40 to $80 per barrel, the consumers of these places had to bear it full. It is fiscal, monetary and trade policy that control inflation in these places and not fuel price control. India Government did not exercise fuel price control as late as 1980s. In the 1970s, during the first oil shock, when the oil prices had increased from $1.20 a barrel to $3.65 a barrel, and in 1980s during the second oil shock, when the price increased from $10 a barrel to $30 a barrel, the then Prime Minister Mrs.Indira Gandhi had passed on almost all of the burden to the consumers. The consumers adjusted and the economy stood without collapse. It is also worth mentioning here that the Government has not completely decontrolled the prices of diesel considering the cascading effect it can have on Food article inflation.

In India, the state owned Indian Oil Corp., Hindustan Petroleum and Bharat Petroleum have been losing over Rs.200 Crore per day on selling fuel below the import cost. They sell petrol at a loss of Rs.3.35 a litre, while that for diesel is Rs.3.49, Rs.18.82 for Kerosene and Rs.261.90 for every 14.2 kg LPG Cylinder. If the oil prices were kept unchanged, these oil companies estimated loss could have touched Rs.90000 Crores for 2010. How will oil companies buy oil without money? India would be in deep trouble if the oil companies were not to survive.

India imports nearly 70 percent of its crude oil requirement. In June 2008, when the crude oil prices went upto $130 per barrel, the Government were giving a subsidy of Rs.25 per litre of diesel and Rs. 15 to 17 per litre of petrol. This induced great burden on the government’s Fiscal deficit. Due to the Global recession the International Crude Oil price has eased out from a 2010 high of around $85 a barrel to around $70 a barrel, which has given the government some room to bring domestic oil prices in parity with international crude oil price. Even with the complete decontrol of petrol prices, the petrol prices increased by only Rs.3.50, thanks to the low fuel price in international market, which is very much affordable by the people. In turn the complete deregulation of petrol and reduction in the subsidies of the other petroleum products would help the government in reducing fiscal deficit of the Government and thus curtail its borrowing.

The consumption of crude oil in India has been increasing in the past few years.  Consumption in crude oil has increased from 127.42 million tones in 2004-’05 to 160.77 million tones by 2008-’09. According to an International Energy Agency(IEA) forecast in 2006 the demand for oil in India would increase by 2.9% per year, reaching 5.6 million barrels a day in 2030. This expected level of consumption would make India the world's third largest oil consumer. The increase in the fuel prices could halt this uncontrolled increase in the oil consumption. While speaking to the National Italian American Foundation, Washington D.C. on October 15, 2004, the then US Federal Reserve Board Chairman Mr.Alan Greenspan had said, “The higher prices of the 1970s brought to an abrupt end the extra ordinary period of growth in U.S. oil consumption and the increased intensity of its use that was so evident in the decades immediately following World War II”. Between 1945 and 1973, consumption of petroleum products rose at startling  4.5% average annual rate, well in excess of growth of real gross domestic product. However, between 1973 and 2003, oil consumption grew on an average only at 0.50 % per year, far short of the rise in real GDP.

Thus on one hand, the decontrolling of fuel prices will decrease the Government’s fiscal deficit, reduce the loss of the petroleum companies, reduce the unwanted usage of a scarce and fast depleting resource like petroleum and make people aware of the importance of saving oil, all at time when the international fuel price is low, which will give only minimum burden on the shoulders of the people in the form of a price hike. 

 But still on the other hand it has to be said that if the tax levied on the oil is cut, it could still serve the purpose without hurting the life of common man.The reduction in the fiscal deficit may not be as big in such a case, as a cut in  tax will have its impact on the revenue side. In addition, the tax relief on oil means that other non-oil consuming sectors will be taxed at a higher rate to make up for the shortfall in revenues from oil consumers. Those not consuming oil will be taxed to subsidize those who consume more oil. This will encourage greater consumption of expensive oil.

Still, going by the welfare objectives of public finance, the government cannot be all non-populistic. In Gujarat, VAT on diesel is 29.13 per cent and on petrol it is 29.88 per cent. VAT on diesel is 20.62 per cent and on petrol is 27.66 per cent in West Bengal; in Andhra Pradesh, VAT is 33 per cent on petrol; and in Punjab, VAT is around 30 per cent on petrol. The West Bengal government has kept 4 per cent tax on kerosene and 4 per cent on LPG gas bottles.  If the States decrease this tax a little, it could well compensate for poor people, the price hike resulting from decontrol. However, the truth is that the State governments do not want to decrease their VAT at all!

My Self...

Hii everyone.. before I start my blogging let me first introduce myself to all. My name is Vineeth Mohandas, son of Mr.Mohanadas M.N. and Mrs.Sulochana Mohanadas. I was born in the 'City of Letters' Kottayam in Kerala- "The God's Own Country".. I am currently a Research Scholar in Economics registered at Pondicherry Central University, under the guidance of Dr.M.Ramadass, Head of the Department of Economics and the Ex-M.P of Puducherry. My area of interest is Monetary Economics especially Inflation dynamics. With this blog what I intend to do is to share with all of you the bit of knowledge that I might gain and the new discoveries that I might make along the way of my journey in Economics and my research in the subject, so that I can over come the uncertainties of life and its essential risk of mortality. I dedicate this blog to my teachers at Baselius College Kottayam, Mr.P.J.Mathew, Mr.C.V.Scariakutty, Mrs.Omana Mathew and Mr.M.J.Shaju, and to Prof. M. Ramachandran, Dept. of Economics, Pondicherry University, who introduced me to this wonder called Economics. I sincerely thank my guide Prof. M. Ramadass for constantly encouraging my research aptitude and for igniting the fire in me for more and more inquiries into world of Economics. I will keep updating the blog as my work progress and I hope it will be useful to at least some if not for all students of Economics..