Vivek Kaul
Governments spend more money than they earn and finance the difference through borrowing. The government of United States(US) is no different on this front. The trouble is that it cannot borrow beyond a certain limit. This limit, known as the debt ceiling, was set at $16.69 trillion.
This ceiling should have been breached in May 2013, a little earlier this year. Since then, Jack Lew, the American treasury secretary, has taken a number of extraordinary measures like delaying public employee pension fund payments, in order to ensure that the government expenditure remains under control. Lesser expenditure meant lesser borrowing and hence, the government managed to keep its total borrowing below $16.69 trillion.
Today i.e. October 17, 2013, the government would have run out of the extraordinary measures that it has been taking. Given this, the treasury department would have exhausted its borrowing authority.
Hours before this would have happened, the leaders of the Democratic Party and the Republican Party in the American Senate stuck a deal, suspending the debt ceiling. This will allow the US government to borrow beyond $16.69 trillion, till February 7, next year. The will also end the current government shut-down in the US and keep the government running along till January 15, 2014.
This is not the first time that the US government came close to its borrowing limit, given that the debt ceiling has been in place since 1939. Since 1960, the debt ceiling has been raised 78 times by the American Congress. But this time around the Democrats and the Republicans left it too late, each waiting for the other to blink first.
If the ceiling had not been extended the short-term repercussions would have been terrible. The treasury secretary Lew had said in early October that the US government “will be left…with only approximately $30bn” come October 17. This would not be enough to meet the expenditure of the government, which can be as high as $60 billion on some days, Lew had pointed out.
Interest payments of around $6 billion are due on US government bonds before the end of this month. Along with that, bonds worth between $90 to $93 billion need to be repaid between October 24 and October 31 (Source: www.thefinancialist.com) Governments issue bonds to borrow money.
The US government has reached a stage wherein it does not earn enough to repay the money it has already borrowed by issuing bonds. Hence, it has borrow more money by issuing fresh bonds to pay off the older bonds. If the debt ceiling had not been extended, it would have become very difficult for the US government to repay the money it had already borrowed.
More importantly, the US government bonds are deemed to be the safest financial security in the world. If the US government defaulted on paying interest on its bonds or repaying the principal, there would have been mayhem in financial markets, all over the world, including India. It has even been suggested that the crisis that could have unfolded would have been bigger than the crisis that followed the bankruptcy of Lehman Brothers in September 2008. Investors would have sold out of US government bonds driving up global interest rates.
The US government would also have had to prioritise its expenditure. Does it make pension payments? Does it pay its employees and contractors? Does it pay interest on its bonds? Does it repay maturing bonds? These are the questions it would have had to address. Also, there are no legal provisions guiding the government on who to pay first. Hence, any prioritisation of payments could have led to a slew of lawsuits against the US government.
Given the negative repercussions of the debt ceiling not being extended, the markets were positive that a deal reached would be reached. Stock and bond markets around the world have been stable. And gold, looked at as a safe haven, is quoting at levels of around $1280 per ounce (one troy ounce equals 31.1grams).
The trouble is that the US government will cross its debt ceiling level again in February, 2014. What happens then? How long can the American Congress keep increasing the debt ceiling? The basic problem is that the US government has borrowed too much money, and continues to do so, and if it doesn’t default today, it will default in the years to come.
The article originally appeared in the Daily News and Analysis dated October 17, 2013
(Vivek Kaul is the author of Easy Money. He can be reached at [email protected])
Daily News and Analysis
Why Chidu's new plan to revive consumer demand won't work
Vivek Kaul
The finance minister, P Chidambaram is at it again. He wants public sector banks to cut their interest rates so that people borrow and spend more, and consumer demand improves.
The trouble is that the credit deposit ratio of banks is at extremely high levels. Latest data released by the Reserve Bank of India(RBI) shows that as on September 6, 2013, for every Rs 100 that banks borrowed as deposits, they had lent out Rs 78.52.
Banks need to maintain a cash reserve ratio of Rs 4 for every Rs 100 that they borrow as a deposit. This money is deposited with the RBI. They need to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 for every Rs 100 they borrow as a deposit in government bonds.
This means that Rs 27 out of Rs 100 that is borrowed as a deposit goes out of the equation straight away. Only the remaining Rs 73 can be lent out. But banks are lending Rs 78.52 for every Rs 100 that they raise as a deposit. This means that they are borrowing from other sources in the market to lend money.
This is happening primarily because banks have been unable to raise enough money as deposits. The deposit growth in one year(between September 7, 2012 and September 6, 2013) was at 13.5%. In comparison the loan growth has been at 18.2%.
Given that loan growth has been happening at a much faster rate than deposit growth, banks cannot cut interest rates. To cut interest rates on loans, banks will have to first cut interest rates on deposits. And if they do that they will find it even more difficult to raise deposits.
But Chidambaram seems to have found a way to get around this problem. A finance ministry press release pointed out yesterday that “It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently.
The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates in order to stimulate demand.”
There are multiple problems with this plan. Where will the government get the money for the extra capital it is planning to offer to banks? It will borrow money by selling bonds, which will be bought by banks and other financial institutions. And where will the banks get this extra money to lend to the government? By trying to raise more deposits. And how will they do that? By offering higher interest rates.
The second and the bigger problem with the argument is that the size of loans for two wheelers, consumer durables etc is too small, for a fall in interest rates to make any difference. Lets assume an individual takes a two year two wheeler loan of Rs 50,000 from SBI at 18.05% per annum. The EMI for this comes to Rs 2497.4. If the interest rate falls to 17.05% per annum, the EMI will fall by around Rs 24 to Rs 2473.3. If the interest rate falls to 16.05% per annum, the EMI will fall by around Rs 48 to Rs 2449.35.
Of course no one is going to go ahead and buy a two wheeler because his EMIs have come down by Rs 24-48. When it comes to these kind of purchases interest rates don’t really matter. What matters is how people feel about their economic future. Questions like whether they will get a raise this year or even whether they will keep their job in the time to come are more important.
Given the bleak economic scenario that prevails, Chidambaram’s plan won’t work.
The article originally appeared in the Daily News and Analysis dated October 5, 2013 with a different headline
(Vivek Kaul is the author of soon to be published Easy Money. He tweets @kaul_vivek)
Nailed: Chidu's lie on the fiscal deficit
Vivek Kaul
On September 30, the Controller General of Accounts (CGA), a part of the ministry of finance, announced the fiscal deficit for the first five months of the financial year (April to August 2013). Fiscal deficit is the difference between what a government earns and what it spends.
The fiscal deficit during April-August 2013 stood at Rs 404,651 crore. The annual target for the fiscal deficit is Rs 542,499 crore, or 4.8% of the gross domestic product (GDP). This means that the government has already reached 74.6% of the annual fiscal deficit target during April-August 2013.
This is clearly something to be worried about as chances of the government not meeting its fiscal deficit target and hence, India facing a sovereign downgrade to “junk” status, are very high. But finance minister P Chidambaram dismissed any worries. “The 74.6% number is irrelevant. We deliberately front-loaded our planned expenditure,” he told reporters on Tuesday evening.
Hence, what Chidambaram was saying was that the government is spending more in the first half of the year than the second half and this had bloated the fiscal deficit. The only trouble with this argument is that numbers released by CGA tell a completely different story.
Lets look at planned expenditure first. Planned expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. Chidambaram wants us to believe that the government has front loaded the planned expenditure and hence, the fiscal deficit for the first five months is at 74.6% of the annual target.
The total planned expenditure for the first five months stood at Rs 1,83,091 crore or around 33% of the Rs 5,55,322 crore to be spent during the course of the year.
If the government divides the annual targeted expenditure to be spent equally every month, then it is likely to spend 8.33% (100/12) of the total annual target every month. Over five months this would mean spending 41.65% (8.33 x 5) of the total annual expenditure.
In comparison the government has spent only 33% of the total targeted planned expenditure during the first five months. So how is this expenditure front loaded? For the expenditure to have been front loaded, it should have been greater than 41.65% of the total targeted expenditure. But that is clearly not the case.
What this means is that Chidambaram was not telling us the truth. To give Chidambaram the benefit of doubt, lets also look at non-plan expenditure and see if that has been front loaded. Non- plan expenditure is an outcome of planned expenditure. For example, the government constructs a highway using money categorised as a planned expenditure. But the money that goes towards the maintenance of that highway is non-planned expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.
The total non-planned expenditure for the first five months stood at Rs 4,79,845 crore or around 43.2% of the Rs 1,109,975 crore to be spent during the course of the year. Hence, the non planned expenditure is a little higher than the cut off 41.65% arrived at earlier. But the difference is not so significant to call it front-loaded.
So what is happening here? What Chidambaram forgot to tell the reporters is that the government has not been able to collect enough taxes till date. The total tax collected by the government in the first five months was at Rs 1,83,686 crore. This is nearly 20.8% of the annual target. What is worrying is that taxes collected have grown by only 4.9% during the first five months in comparison to the same period last year. As Sonal Varma of Nomura points out in a note dated September 30, 2013, “Fiscal year to date (FYTD), net tax revenue growth was muted at 4.9% year on year (versus the budget target of 19.3% year on year) due to weak indirect tax collections (excise, services, customs), while government expenditure rose 17.3% year on year FYTD, within the budget target of 18.2% year on year.”
Indirect tax collections have slowed down primarily on account of a slowdown in economic growth. In fact, when one looks at past data, the fiscal deficit number should have Chidambaram very worried.
For a period of 16 years since 1998-1999 (for which the data is publicly available on the CGA website), the average fiscal deficit for the first five months of the financial year stands at 54.2% of the annual target. In the period the Congress led UPA government has been in power (i.e. since 2004-2005), the average fiscal deficit for the first five months of the financial year has been 60.4% of the annual target. Last year it was 65.7% of the annual target.
Hence, 74.6% is not a small number, despite the spin Chidambaram tried to give it. What this means is that the government will have to start cutting its expenditure big time if it has to get anywhere near the targeted fiscal deficit of 4.8% of the GDP. In short, there is trouble ahead.
A slightly different version of the article appeared in the Daily News and Analysis (DNA) dated October 4, 2013
(Vivek Kaul is the author of the soon to be published Easy Money. He tweets @kaul_vivek)
Will Rajan fight inflation, leave rupee to market?
Vivek Kaul
Milton Friedman was the most famous economist of the second half of the twentieth century. He believed that inflation is a monetary phenomenon. As he wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation.”
This line of thinking has influenced many economists over the years ‘particularly’ those who work and teach at the University of Chicago, where Friedman was based for 31 years between 1946 and 1977.
Raghuram Rajan, who teaches at the University of Chicago and is scheduled to takeover as the next governor of the Reserve Bank of India (RBI), is one such economist. In fact Rajan has clearly pointed out in his earlier writings that RBI should simply concentrate on managing inflation.
As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”
The trouble is that the RBI has moved on from a single minded focus on inflation, since the days of Bimal Jalan and tends to follow what experts refer to as the ‘multiple indicator approach’. The central bank now looks at a range of indicators from inflation to capital flows and even the exchange rate. Though at times the objectives the RBI is trying to achieve, are at odds.
This is what is happening currently. The RBI is trying to control inflation, accelerate economic growth and stabilise the value of the rupee, all at the same time. Something which is not possible. Rajan understands this well enough. “The RBI’s objective could be restated as low inflation, and growth consistent with the economy’s potential. They amount to essentially the same thing! But it would let the RBI off the hook for targeting the exchange rate. And that is the key point,” Rajan wrote in the 2008 article cited earlier.
Rajan’s writing suggests that he believes in letting the currency finding its right value. This puts him at odds with the current RBI policy of defending the rupee at around 60-61 to a dollar. If he allows the rupee to fall and find its right value against the dollar, it would make him terribly unpopular with the political class. Also, do nothing might be a good theoretical strategy, but an RBI governor needs to be seen doing something to defend the rupee.
A weaker rupee would mean higher oil prices for one. These higher prices would have to be passed onto the consumers in the form of higher price of petrol, diesel, cooking gas etc. With the Lok Sabha elections due in mid 2014, this would be politically disastrous for the Congress led UPA.
Also it is worth remembering that there is not much a central bank governor can do about high consumer price inflation in India, given that most of it has come about from increased government expenditure, which more than doubled(gone up by 133%) to Rs 16,65,297 crore between 2007-2008 and 2013-2014. In fact, inflation might only go up once the food security scheme is on full swing.
In short, a tough test lies ahead for Raghuram Rajan. But given his impeccable credentials he might just be the best man for the job. As Turkish-American economist Dani Rodrik put it“In Rajan, India gets a superb economist as its central bank governor.”
Rajan himself realises the challenges he has to face and the fact that there are no “magic wands” to cure India’s economic problems. He also realises the limited power of a central banker. As he wrote in an October 2012 column for Project Syndicate “Central bankers nowadays enjoy the popularity of rock stars, and deservedly so…But they must be able to admit when they are out of bullets. After all, the transformation from hero to zero can be swift.”
The article originally appeared in the Daily News and Analysis on August 8,2013
(Vivek Kaul is a writer. He can be reached at [email protected])
RBI is behaving like a football goalkeeper
Vivek Kaul
A former well respected governor of the Reserve Bank of India (RBI) once told me that in a “moment of crisis the central bank can’t be seen to be doing nothing” even if “do nothing” might be the best strategy to follow.
This might well be the spur behind the RBI’s recent defence of the rupee. It started its defence when the currency first closed in on the 60 per dollar mark, by selling dollars.
But selling dollars couldn’t go on indefinitely. India’s foreign exchange reserves are around $280 billion – equal to around six-and-a-half months’ imports. Such low levels of forex reserves haven’t been seen since the 1990s.
Then the central bank tried to squeeze out rupee liquidity by severely limiting the amount of money that banks could borrow from it at the repo rate, or the rate at which the RBI lends to banks, now at 7.25%.
Banks are now allowed to borrow only up to 0.5% of their deposits at the repo rate. Beyond that, they need to borrow at the marginal standing facility rate, which is at 10.25%. That’s 300 basis points (one basis point equals one hundredth of a percentage) higher than the repo rate.
This has started to push up interest rates in general.
Banks are also supposed to maintain an average cash reserve ratio of 99% with the RBI on a daily basis, against the earlier requirement of 70%.
The RBI had hoped that all these moves would squeeze rupee liquidity out of the market and help it gain value against the dollar.
But nothing of that sort happened. On Tuesday, the rupee lost further value to hit an all-time low of 61.80 to the dollar intraday, before recovering to close at 60.81, again, with RBI intervention.
Several economists have now come around to the view that the rupee will continue to lose value against the dollar. Rajeev Malik of CLSA, for one, sees the rupee hitting 65-70 to the dollar by next year.
Given this, the RBI’s intervention might at best postpone the inevitable.
But the central bank can’t stop trying, can it?
Albert Edwards of Societe Generale has a very interesting analogy explaining this. As he pointed out in a report earlier this year. “When there are problems, our instinct is not just to stand there but to do something… When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But they rarely do that. “Because it is more embarrassing to stand there and watch the ball hit the back of the net than to do something (such as dive to the right) and watch the ball hit the back of the net,” wrote Edwards.
The RBI is like a football goalkeeper right now. It can’t just stand pat.
The article originally appeared in the Daily News and Analysis dated August 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)