Fiscal Deficit

LIC money: Is it for investors’ benefit, or Rahul's election?


Vivek Kaul

“We’re slowly learning that fact. And we’re very, very pissed off.”
—Lines from the movie Fight Club
The government’s piggybank is in trouble. Well not major trouble. But yes some trouble.
The global credit rating agency Moody’s on Monday downgraded the Life Insurance Corporation (LIC) of India from a Baa2 rating to Baa3 rating. This is the lowest investment grade rating given by Moody’s. The top 10 ratings given by Moody’s fall in the investment grade category.
Moody’s has downgraded LIC due to three reasons: a) for picking up stake in the divestment of stocks like ONGC, when no one else was willing, to help the government reduce its fiscal deficit. b) for picking up stakes in a lot of public sector banks. c) having excessive exposure to bonds issued by the government of India to finance its fiscal deficit.
While the downgrade will have no impact on the way India’s largest insurer operates within India, it does raise a few basic issues which need to be discussed threadbare.
From Africa with Love
The wives of certain African dictators before going on a shopping trip to Europe used to visit the central bank of their country in order to stuff their wallets with dollars. The African dictators and their extended families used the money lying with the central banks of their countries as their personal piggybank. Whenever they required money they used to simply dip into the reserves at the central bank.
While the government of India has not fallen to a similar level there is no doubt that it treats LIC like a piggybank, rushing to it whenever it needs the money.
So why does the government use LIC as its piggybank? The answer is very simple. It spends more than what it earns. The difference between what the government earns and what it spends is referred to as the fiscal deficit.
In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The expenses of the government have risen more than eight and half times faster than its revenues.
What is interesting is that the fiscal deficit numbers would have been much higher had the government not got LIC to buy shares of public sector companies it was selling to bring down the fiscal deficit.
Estimates made by the Business Standard Research Bureau in early March showed that LIC had invested around Rs 12,400 crore out of the total Rs 45,000 crore that the government had collected through the divestment of shares in seven public sector units since 2009. The value of these shares in March was around Rs 9,379 crore. Since early March the BSE Sensex has fallen 7.4%, which means that the LIC investment would have lost further value.
Over and above this the government also forced LIC to pick up 90% of the 5% follow-on offer from the ONGC in early March this year. This after the stock market did not show any interest in buying the shares of the oil major. The money raised through this divestment of shares went towards lowering the fiscal deficit of the government of India.
News reports also suggest that LIC was buying shares of ONGC in the months before the public issue of the insurance major hit the stock market, in an effort to bid up its price. Between December and March before the public offer, the government first got LIC to buy shares of ONGC and bid up the price of the stock from around Rs 260 in late December to Rs 293 by the end of February. After LIC had bid up the price of ONGC, the government then asked it to buy 90% of the shares on sale in the follow on public offer.
This is a unique investment philosophy where institutional investor managing money for the small retail investor, first bid up the price of the stock by buying small chunks of it, and then bought a large chunk at a higher price. Stock market gurus keep repeating the investment philosophy of “buy low-sell high” to make money in the stock market. The government likes LIC to follow precisely the opposite investment philosophy of “buying high”.
Estimates made by Business Standard suggest that LIC in total bought ONGC shares worth Rs 15,000 crore. The stock is since down more than 10%.
The bank bang
LIC again came to the rescue of the cash starved government during the first three months of this year, when it was force to buy shares of several government owned banks which needed more capital. It is now sitting on losses from these investments.
Take the case of Viajya Bank. It issued shares to LIC at a price of Rs 64.27 per share. Since then the price of the stock has fallen nearly 19%.
The same is case with Dena Bank. The stock price is down by almost 10% since allocation of shares to LIC. The share price of Indian Overseas Bank is down by almost 19.7% since it sold shares to LIC to boost its equity capital. While the broader stock market has also fallen during the period it hasn’t fallen as much as the stock prices of these shares have.
There are more than a few issues that crop up here. This special allotment of shares to LIC to raise capital has pushed up the ownership of LIC in many banks beyond the 10% mandated by the Insurance Regulatory and Development Authority of India, the insurance regulator. As any investment professional will tell you that having excessive exposure one particular company or sector isn’t a good strategy, especially when managing money for the retail investor, which is what LIC primarily does. What is interesting is that the government is breaking its own laws and thus not setting a great precedent for the private sector.
If LIC hadn’t picked up the shares of these banks, the fiscal deficit of the government would have gone up further. The third issue here is why should the government run so many banks? The government of India runs twenty six banks (20 public sector banks + State Bank of India and its five subsidiaries).
While given that banking is a sensitive sector and some government presence is required, but that doesn’t mean that the government has to run 26 banks. It is time to privatise some of these banks.
Gentlemen prefer bonds
As of December 31, 2011, the ratio of government securities to adjusted shareholders’ equity in LIC was 764%. This is understandable given that the subsidy heavy budget of the Congress led UPA government has seen its fiscal deficit balloon by 312% over the last five years. Again basic investment philosophy tells us that having a large exposure to one investment isn’t really a great idea, even if it’s a government.
The Rahul factor
But the most basic issue here is the fact that the government is using the small savings of the average Indian who buys LIC policies to make loss making investments. This is simply not done.
LIC has turned into the behemoth that it has over the years by offering high commissions to its agents over the years. It sells very little of “term insurance”, the real insurance. What it basically sells are investment policies with very high expenses which are used to pay high commissions to it’s the agents. The high commissions in turn ensure that these agents continue to hard-sell LIC’s extremely high cost investment policies to normal gullible Indians. The premium keeps coming in and the government keeps using LIC as a piggybank.
The high front-loading of commissions is allowed by The Insurance Act, 1938. The commission for the first can be a maximum of 40 per cent of the premium. In years two and three, the caps are 7.5 per cent, and 5 per cent thereafter. These are the maximum caps and serve as a ceiling rather than a floor.
The Committee on Investor Protection and Awareness led by D Swarup, the then Chairman of Pension Fund Regulatory and Development Authority, had proposed in September 2009 to do away with commissions across financial products. “All retail financial products should go no-load by April 2011,” the committee had proposed in its reports.
The National Pension Scheme(NPS) was already on a no commission structure. And so were mutual funds since August 1, 2009. But LIC and the other insurance companies were allowed to pay high commissions to their agents. “Because there are almost three million small agents who will have to adjust to a new way of earning money, it is suggested that immediately the upfront commissions embedded in the premium paid be cut to no more than 15 per cent of the premium. This should fall to 7 per cent in 2010 and become nil by April 2011,” the committee had further proposed.
Not surprisingly the government quietly buried this groundbreaking report.
While insurance commissions have come down on unit linked insurance plans, the traditional insurance policies in which LIC remains a market leader continue to pay high commissions to their agents. These traditional insurance policies typically invest in debt (read government bonds which are issued to finance the fiscal deficit).
This is primarily because the Congress led UPA government needs the premium collected by LIC to run LIC like a piggybank. The piggybank money can and is being used to run subsidies in the hope that the beneficiaries vote for Rahul Gandhi in 2014.
Is the objective of LIC to generate returns and ensure the safety of the hard earned money of crores of it’s investors? Or is it to let the UPA government run it like a piggybank in the hope that Rahul baba becomes the Prime Minister?
The country is waiting for an answer.
(This post originally appeared on Firstpost.com on May 15,2012. http://www.firstpost.com/politics/lic-money-is-it-for-investors-benefit-or-rahul-election-309545.html)
(Vivek Kaul is a writer and can be reached at [email protected])

How the bastardisation of Keynes is still haunting us


Vivek Kaul

“So how does it feel to be an educated unemployed?” she asked.
“Shikshit berozgar sounds much better,” I retorted. “Plus you are making a pot load of money anyway.”
“Ah. Where has the male ego gone?”
“Well, as long as you keep the money coming, ego can take a backseat.”
“On the subject of money I was reading somewhere about some Western economists recommending negative interest rates,” she said.
“ The idea is to charge people who let their money lying idle in a bank account,” I explained.
“Charge?”
“Yes. Say if you keep $1000 in your bank account and the negative interest rate is 2%, then at the end of the year your account will have $980 ($1000 – 2% of $1000).”
“Oh. But why?”
“So that instead of letting the money lay idle in the bank account people take it out and spend it.”
“And how will that help?”
“Well when people spend the money the demand for goods and services will go up. This in turn will mean more profits for businesses, which in turn may recruit more people and decrease unemployment.”
“Interesting. Where does this idea come from?”
“It comes from the concept of paradox of thrift which was first explained by John Maynard Keynes, an economist whose thinking had the most influence on economists and politicians of the twentieth century.”
“But why call it a paradox? Isn’t being thrifty or saving money a good thing?”
“Keynes thought that when it comes to saving what makes sense for an individual may not work for the economy. If an individual saves more he cuts down on his expenditure. If one person does this, it makes sense for him because he saves more money. But more people doing it creates a problem.”
“What problem?”
“What is expenditure for one person is income for someone else. When you buy your fancy makeup, a lot of people earn money. The shop you buy it from. The company that makes the brand you buy and so on. When you don’t the entire chain earns lesser.”
“Ah. Never thought about it that way.”
“So as everybody spends less, businesses see a fall in revenue. To stay competitive they start firing people, which leads to a further cut in spending. The unemployed obviously spend less. But so do others in the fear that they might be fired as well.”
“And all this is not good for the economy,” she said. “But how is it linked to negative interest rates?”
“Since the financial crisis started in 2008, people in Europe, America and even Japan, are not spending money. Hence the idea of negative interest rates has been put forward. People would rather spend the money than see its value go down.”
“But is that what Keynes suggested?”
“No. What Keynes had said was that consumers and firms would be unwilling to spend money in an environment where jobs are falling and demand is falling or is flat or growing at a very slow rate. So the government should become the “spender of the last resort” by coming up with a stimulus package.”
“Hmmm.”
“Keynes also said during recessions the government should not be trying to balance its budget i.e. match its income with expenditure. The logic being that taxes collected would anyway fall during a recession, if the government tried to match this with a cut in expenditure, it would squeeze the economy even more.”
“So Keynes advocated that governments run fiscal deficits,” she concluded.
“Not at all. Keynes believed that on an average the government budget should be balanced. This meant that during years of prosperity the governments should run budget surpluses i.e. earn more than what they spend. But when the economy wasn’t doing well governments should spend more than what they earn and hence run a fiscal deficit.”
“Okay. So the money saved during the good time could be spent during the bad times.”
“Yes. Keynes came up with this theory in his book The General Theory of Employment, Interest and Money in 1936. This book had ideas based on the study of the Great Depression. During those days it was not fashionable for governments to run fiscal deficits as it is today. As Franklin Roosevelt, the then President of America put it “Any government, like any family, can, for a year, spend a little more than it earns. But you know and I know that a continuation of that habit means the poorhouse.” But then attitudes changed.”
“How was that?”
“As governments around the world got ready to fight the Second World War they spent a lot of money in getting ready for it, which meant they ended with fiscal deficits. Economies around the world which were still in the doldrums because of the Great Depression, suddenly started rebounding,” I explained.
“And so the star of Keynes shone?”
“Yes. But the politicians over the decades just took one part of Keynes’ advice and ran with it. The belief in running deficits in bad times became permanently etched in their minds. In the meanwhile they forgot that Keynes had also wanted them to be running surpluses during good times. So they ran deficits in good times and bigger deficits in bad times. This meant more and more borrowing. And this how the Western world has ended up with all the debt which has brought the whole world to the brink of a huge economic disaster.”
“But what about negative interest rates?” she asked. “Will they help?”
“Not really.”
“Why?”
“See the thing is other than government debts increasing in the Western world, the debt of individuals has also gone up over the years. So right now they by not spending they are saving money so that they can repay their debts.”
“Hmmm. But do you see negative interest rates coming in?”
“On the face of it I don’t think that will happen,” I replied. “But then you never know. Politicians have bastardised Keynes in the past. They can do it again.”
“How sure are you of this?” she asked.
“Let me answer your question with a couplet written by Javed Akhtar “main khud bhi sochta hoon ye kya mera haal hai, jiska jawab chahiye wo kya sawal hai.”
(The interview was originally published on May 14,2012, in the Daily News and Analysis (DNA). http://www.dnaindia.com/analysis/column_how-the-bastardisation-of-keynes-is-still-haunting-us_1688370).
(Vivek Kaul is a writer and can be reached at [email protected])

The pain in Spain will get us too; so forget market rallies


Vivek Kaul

If you are the kind who reads the pink papers religiously, you would have come to conclusion by now that good times are back again for the stock market investors in India, now that the finance minister has deferred the implementation of GAAR to next year. But before you open that champagne bottle and say cheers, here are some reasons why the stock market will remain flat or fall in the days to come.
Pain in Spain:
The gross domestic product (GDP) of Spain grew at the rate of 8% every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle. As Jonathan Carman points out in a presentation titled The Pain in Spain “Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade.”
So far so good. The trouble was Spain ended up building way too many homes than it could sell. Even though Spain forms only 12% of the GDP of the European Union (EU) it has built nearly 30% of all the homes in the EU since 2000. As John Mauldin and Jonathan Tepper point out in Endgame – The End of the Debt Supercycle and How It Changes Everything “Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the United States, even though the United States is six times bigger”.
All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP.
What makes the situation more precarious is the fact that the housing prices are still falling. Carman expects prices still need to fall by 35% from their current levels if they are to reach normal levels. This will mean more home loan defaults and more trouble for Spain. The Spanish stock market is already taking this into account and IBEX-35, the premier stock market index of the country is down a little more than 10% in the last one month. Banking stocks have fallen much more.
While countries like Greece may be in more trouble, they are not economically big enough to cause a lot of trouble worldwide. But if Spanish banks go bust, there will be a lot of trouble in the days to come. Spain has now emerged the basket case of Europe, but other countries in the European Union are not doing well either and this means trouble for China.
China’s After Party:
If things are not well in Europe, it has an impact on China because Europe is China’s biggest trading partner. The Chinese exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. Falling exports are not the best news for China.
There are other things which aren’t looking good either. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles “In the last decade the main driver of China’s boom was a surge in the investment share of the GDP from 35% to almost 50%, a level that is unprecedented in any major nation…The investment effort focused on building the roads, bridges, and ports needed to turn China into the world’s largest exporter, doubling its global export market share to 10% in the last decade.”
This spending spree which was responsible for its fast growth is now slowing down. New road construction is down from 5000miles in 2007 to 2500 miles. Railway spending is down by 10%.
The other major factor likely to pull down growth is wage inflation i.e. salaries are rising at a very fast rate. In 2011, the average wage was rising at a rate of 15%, in a scenario where the consumer price inflation was around 5%. As Sharma points out “In fact hourly wages are now rising twice as fast productivity, or hourly output per worker, which is forcing companies to raise prices just to cover the cost of higher wages.” This has led to manufacturers moving to cheaper destinations like Bangladesh and Indonesia.
Given these reasons it is highly unlikely that China will continue to grow at the rates that it has been. Since 1998, China’s economic growth has averaged around 10% and it has never fallen below 8%. As Sharma points out “China’s looming shadow is about to retreat to realistic dimensions.” Sharma expects Chinese growth to slowdown by 3-4% percentage points in comparison to its current growth rate over the next decade.
A Chinese slowdown will mean disaster for nations which have been thriving by exporting commodities to China. In 1998, when China was a $1trillion economy, to grow by 10% meant it had to expand its economy by $100billion. This could have been done by consuming 10% of the world’s industrial commodities, raw materials like oil, steel and copper. In 2011, China is a $6trillion economy. If this economy needs to grow by 10% or $600billion, more than 30% of the world’s commodity production would be needed. With growth slowing down, China’s commodity requirements will come down as well. As Sharma puts it “It’s my conviction that China – commodity connection will fall apart soon”.
China’s stock markets remain largely closed to international investors. But the Hang Seng index listed in Hong Kong has a lot of Chinese companies. This index has gone up 0.9% over the last one month.
The Kangaroo Won’t Jump:
In fact the Aussies are already feeling the heat with a slowdown in Chinese exports. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2010, or around 26% of total exports. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion. The S&P ASX/200 one of the premier stock market indices in Australia, has been flat for the last one month.
Brazil – God’s Own Country:
The rise of China has led to huge demand for Brazilian commodities. As Gary Dorsch an investment newsletter writer points out in a recent column “Brazil has been enjoying an economic boom based on soaring prices for its natural resources including crude oil, agricultural products, such as soybeans, corn, and cattle, and metals such as iron ore and bauxite-aluminum.”
The rise of Brazil was captured very well by Glenn Stevens, governor of the Reserve Bank of Australia. Stevens pointed out that in 2006, money received from shipload of iron ore could buy 2,200 flat screen TVs. In 2011, the same shipload could buy 22,000 flat screen TVs.
Since the start of the financial crisis a lot of money printed by Western governments to revive their economies has flowed into Brazil. This has driven up the value of the real, the currency of Brazil, and made Brazil one of the most expensive countries in the world. As Sharma points out “Restaurants in Sao Paulo are more expensive than those in Paris. Hotel rooms cost more in Rio than French Riviera”.
An expensive currency has meant that imports rising faster than exports. This situation is expected to get worse as China’s slowdown and the demand for Brazilian commodities falls. In fact the impact is already being felt. As Dorsch points out “Brazil’s economy stalled out in the past two quarters, showing near zero growth in Q’3 of 2011 and Q’4 of 2012. Factory output in February was -3.9% lower than a year ago.” The premier stock market index Bovespa is down 4.5% over the last one month.
On a totally different note the most popular television serial in Brazil is a soap opera called “A Passage to India” shot in Agra and Jodhpur and which has Brazilian actors playing Indian roles and as Sharma puts it, they could “pass easily for North Indians”.
India- Done and Dusted:
The economic problems of India deserve a separate article. But let me list a few. In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The targeted fiscal deficit for 2012-2013 is Rs 5,13,590 crore. This is likely to go up given the fact that the rupee is depreciating against the dollar and thus our oil bill is likely to go up, pushing up our fiscal deficit. This would mean that higher interest rates will continue to prevail.
The stock market obviously realizes this and hence has fallen by 1.8% over the last one month, yesterday’s brief rally notwithstanding.
Over the last few years stock prices all across the world have moved in a synchronized fashion because the international investors like to move in a herd. Whenever there has been trouble in the United States or Europe it has led to emerging markets all across the world falling. Now we are in a situation where the emerging markets themselves are in a lot of trouble. So it is a no brainer to say there will be no rally in the stock market in the near future. Unless of course a certain Mr Ben Bernanke decides to open up the money tap again and go in for Quantitative Easing Round Three or to put it in simple English, print some more dollars. If that happens, then investors can get ready to have some fun.
(This article was originally published on May 8, 2012 at http://www.firstpost.com/economy/the-pain-in-spain-will-get-us-too-so-forget-market-rallies-302278.html. Vivek Kaul is a writer and can be reached at [email protected])

What the UPA government can learn from B.E.S.T

Vivek Kaul
“Ek bandra station,” I told the conductor of the B.E.S.T (BrihanMumbai Electric Supply and Transport) bus number 83, handing over a ten rupee note.
“Do rupiya aur,” he replied.
“12 rupiya ka ticket hai?” I asked him.
“Ji sir,” he replied.
I was travelling from Century Bazar in Worli to Bandra. The ticket till very recently used to cost eight rupees. It has now been increased to Rs 12, a rather steep 50% increase. The prices of tickets of lower denominations haven’t been increased so much. A four rupee ticket is now five rupees. But at the same time a ten rupee ticket now costs fifteen rupees and a twelve rupee ticket costs eighteen rupees.
This got me thinking. Why had the B.E.S.T increased prices? Well for the simple reason that they had to match their income with their expenditure, which is the most basic thing that needs to be done for successfully operating any institution. The fact that it is not allowed to raise prices as often as it probably wants to has led to this very high increase.
While the B.E.S.T believes in at least trying to ensure that its income meets its expenditure, the United Progressive AllianceUPA) which runs the government of India, doesn’t. And this is neither good for the UPA nor for you and me, the citizens of India.
In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore.
Things cannot be quite right when your expenditure is expanding nine times as fast as your income. As Franklin Roosevelt, who was the President of America for a record four times, between 1933 and 1945 famously said “Any government, like any family, can, for a year, spend a little more than it earns. But you know and I know that a continuation of that habit means the poorhouse.”
So why is the UPA led Indian government headed to the poorhouse? For that we have to dig a little deep and look into this document known as the annual financial statement of the government of India. In this document the government gives out numbers for the amount it had assumed initially as the oil subsidy for the year, and the final oil subsidy it gave.
The data for the last three years has been very interesting. The subsidy assumed at the time of the finance minister presenting the budget has always been much lower than the final subsidy bill. Take the case for the year 2009-2010(i.e. between April 1, 2009 and March 31,2010) the oil subsidy assumed was Rs 3109 crore. The final bill came to Rs 25,257 crore (direct subsidies + oil bonds issued to the oil companies), around eight times more.
The next year (i.e. between April 1, 2010 and March 31, 2011) the oil subsidy assumed was Rs 3108 crore. The actual bill was nearly 20 times more at Rs 62,301 crore. For the year 2011-2012(i.e. between April 1,2011 and March 31,2012) the subsidy assumed was Rs 23,640 crore. The actual subsidy bill came to Rs 68,481 crore.
So in each of the last three years the oil subsidy bill has come out to be greater than what was assumed. For the current financial year (i.e. April 1, 2012 to March 31,2013) the oil subsidy bill has been assumed to be at Rs 43,580 crore. While this is greater than the assumption made over the last three years, it is highly likely that the oil subsidy bill will come to amount greater than this.
There are two reasons for the same. The first reason is that the rupee has been rapidly depreciating against the dollar and since oil is sold in dollars that means that the Indian companies are paying up more in rupees to buy the same volume of oil. Currently oil is priced at around $115 per barrel (around 159litres) of oil. This means that Indian companies pay around Rs 6141 per barrel of oil.
If the rupee falls further and one dollar equals Rs 60 (as has been written about on this website), the Indian companies will be paying Rs 6900 or 12.4% more per barrel of oil. In the normal scheme of things this cost would have been passed onto the customer and everybody would have lived happily ever after.
But that is not the case. Various products coming out of oil like kerosene, diesel etc, are heavily subsidized in India. Hence even with higher prices of oil internationally the Indian oil companies will have to keep selling their products at lower prices and suffer losses. These companies are then compensated for the losses they face by the government of India.
The second reason is that the price of oil is unlikely to go down in dollar terms as well. As governments and central banks around the world run close to zero interest rates and print more and more money (and are likely to continue to do so) in order to revive economic growth in their respective countries, oil has become a favourite commodity to buy among the speculators.
While central banks and governments can print all the money they want, they can’t dictate where it goes. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles “When money is loose, investors borrow to buy hard assets, which is why the prices of oil, copper, and other commodities have become disconnected from actual demand.”
This means that oil will either continue at its current price level or even go up for that matter. And with the rupee likely to depreciate further this means that India’s oil import bill is likely go up even further.
It is highly unlikely that this increase in price will be passed onto the end customer. This means that the government will have to bear the losses incurred by the oil companies, pushing up the oil subsidy, which has been assumed to be at Rs 43,580 crore.
A higher oil subsidy bill means the government expenditure going up and this in turn means a higher fiscal deficit. Typically, the government finances this deficit by borrowing money. With the government needing to borrow more money it would have to offer a higher rate of interest. At the same time a higher government borrowing will crowd out private borrowing, meaning that the private borrowers like banks and other finance companies will have to offer a higher rate of interest on their deposits because there would be lesser amount of money to borrow. A higher rate of interest on deposits would obviously mean charging a higher rate of interest on loans.
All this can be avoided if the government follows what B.E.S.T did recently i.e. allow oil companies to raise prices of its products. Why can’t a free market operate when it comes to oil products? If the price of oil products changes on a daily basis depending on its international price, like the price of vegetables, people will gradually get used to the idea of a changing price for products like diesel and kerosene.
And of course chances are that with the government borrowing coming down, interest rates might also fall. In 2007, when the government fiscal deficit was low, a 20 year home loan could be got at an interest rate of 8%. A loan of Rs 25 lakh would mean an EMI(equated monthly installment) of around Rs 25,093. A lot of banks are now charging their existing consumers around 13% on their home loans. This means an EMI of around Rs 35,147 or almost 40% more.
The huge subsidy on oil prices has had a role to play in this increasing EMI. Bad economics does not always mean good politics. Its time UPA woke up to that.
(The article was originally published on May 9, 2012,at http://www.rediff.com/business/slide-show/slide-show-1-special-what-the-upa-govt-can-learn-from-best/20120509.htm. Vivek Kaul is a writer and can be reached at [email protected])