Who is Benefitting from Lower Interest Rates?



Over the last one year, bank interest rates have fallen majorly, at least in theory (it will become clear later in the column, why I say this). The question is, who is benefitting from the lower interest rates? The savers, whose fixed deposits have matured, have had to reinvest them at significantly lower interest rates. This includes retirees who have seen interest rates on their deposits, fall from nine per cent to six per cent in a short period of time. In the process, their incomes have crashed by a third. Not surprisingly, they are having a tough time.

People have suggested that senior citizens should invest with the post office where higher interest rates are on offer. Anyone who has actually invested money with the post office for generating a regular income, would never suggest anything like this. Their service levels are abysmally low. They can give a thorough run around to anyone looking to get paid regularly on the investment he has made with the post office.

In fact, I know of several retirees who have reluctantly moved their investments into mutual funds (both equity and debt), given the low after-tax returns on fixed deposits. Even if the returns on mutual funds are the same as bank fixed deposits, the different tax treatment for both these forms of investing, helps generate higher after-tax returns in case of mutual funds.

This investing strategy has worked well for retirees in the last one year, given that the stock market has rallied massively. Nevertheless, is this a sustainable strategy in the long-term for anyone who is looking to generate a regular income out of his accumulated corpus, given the volatility that comes with investing in a mutual fund?

In a country with almost no social security and a health care system which keeps getting expensive by the day, this is a fair question to ask.

Another set of savers who has lost out due to low interest rates are people saving for their future, the wedding and education of their kids, and their own retirement. These people now need to save more in order to meet their long-term investment goals. Of course, these people still have the option of discovering the power of compounding by investing in mutual funds through the systematic investment plan (SIP) route.

But given the abysmal levels of financial literacy that prevail in the country, the chances that they will be mis-sold a unit linked insurance plan(ULIP) by a private insurance company or an endowment or a money-back policy by Life Insurance Corporation of India, remain very high. These forms of investing remain the worst way you can invest your money.

Also, consumption growth and interest rates are closely linked. Conventional economic logic tells us that at lower interest rates people borrow and spend more, and this increases private consumption growth and in turn helps economic growth. QED.

While that may be true for developed countries, it doesn’t quite work like that in India. In India, if interest rates fall, the retirees need to cut down on their regular expenditure because their regular income also falls. People who are saving for the long-term also need to save more in order to meet their investment goals.

Given that most household financial savings get invested in fixed deposits, a fall in interest rates makes people feel less wealthy and this has an impact on their consumption. Due to these reasons people end up cutting down on their expenditure. This is reflected to some extent in Figure 1, which plots the growth in private consumption expenditure over the last few years.

Figure 1: 

As interest rates have fallen through 2017, the growth in private consumption expenditure has collapsed from 11.1 per cent to 6.5 per cent. As of December 2016, private consumption expenditure formed 59 per cent of the Indian gross domestic product. Since then, it has fallen to 54 per cent. So, much for lower interest rates.

There are two sides to interest rates, the saving side which I was talking about up until now, and the borrowing side, which I will talk about in the remaining part of this column.

The total non-food lending carried out by Indian banks has actually contracted during this financial year. But weren’t lower interest rates supposed to help increase lending? Now only if economic theory and reality played out same to same, the world would be such a different place.

Banks are extremely quick to cut interest rates on their fixed deposits, as well as raising interest rates on their loans. Nevertheless, the same cannot be said about a situation where they need to pass on the benefit of lower interest rates to their borrowers.

Let’s take the example of people who have taken on home loans from banks as well as housing finance companies. Over the last one year, the interest rate on a home loan has fallen from 80 to 100 basis points. One basis point is one-hundredth of a percentage.

The trouble is in many cases the banks and the housing finance companies haven’t bothered to inform the borrower, about the lower interest rate. And the borrower has unknowingly continued to pay the higher EMI. This never happens when the banks and the housing finance companies need to raise interest rates on their home loans. In that case, the letter/sms/email arrives right on time.

In fact, I have heard cases where people have pointed this dichotomy out to a leading housing finance company, and they have been told that they are expected to come to the office of the housing finance company and keep checking. So much for market competition which is supposed to lower interest rates. Of course, the stock market rewards such companies with a higher price to earnings ratio, given that they can do these things, get away with it, and make more money in the process.

The media which is quick to announce lower EMIs whenever RBI cuts the repo rate, never goes back to check whether EMIs have actually fallen. This is simply because it is easier to take the theoretical way out and announce lower EMIs when RBI cuts the repo rate, whereas actual checking would involve doing some legwork and speaking to banks, housing finance companies and borrowers. And who wants to work hard? It’s worth pointing out here that banks are huge advertisers in the media.

The question is when higher interest rates are passed on immediately, why is the same not true with lower home loan interest rates? What are the Reserve Bank of India (RBI) and the National Housing Bank (the RBI subsidiary which regulates housing finance companies) doing about this? Aren’t the regulators also supposed to take care of the consumers? Or are they just there to bat for those who they regulate? Or is it a case of “regulatory capture” where those who are regulated (i.e. the banks and the housing finance companies) given that they are organised, manage to get their point of view to the regulator, but the borrowers, given that they are not organised, cannot do that.

Whatever it is, it is not fair. And the RBI and the National Housing Bank need to do something about it. Consumer protection is something that should be high on their agenda, even though it may be the most unglamorous of things that they are supposed to do.

The column originally appeared in Equitymaster on December 14, 2017.

Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud

I have been travelling for the past two weeks and a question that has been put to me, everywhere I have gone is: “will fixed deposits be used to rescue banks that are in trouble?

People have been getting WhatsApp forwards essentially saying that the Modi government is planning to use their bank deposits to rescue all the banks that are in trouble. As is usually the case with WhatsApp, this is not true. The truth is a lot more nuanced.

Let’s try and understand this in some detail.

Where did the idea of fixed deposits being used to rescue troubled banks come from?
The government had introduced The Financial Resolution and Deposit Insurance(FRDI) Bill, 2017, in August 2017. This Bill is currently being studied in detail by a Joint Committee of members belonging to the Lok Sabha as well as the Rajya Sabha.

The basic idea behind the FRDI Bill is essentially to set up a resolution corporation which will monitor the health of the financial firms like banks, insurance companies, mutual funds, etc., and in case of failure try and resolve them.

The Clause 52 of the FRDI Bill uses a term called “bail-in”. This clause essentially empowers the Resolution Corporation “in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider.”

What does this mean in simple English? It basically means that financial firms or a bank on the verge of a failure can be rescued through a bail-in. Typically, the word bailout is used more often and refers to a situation where money is brought in from the outside to rescue a bank. In case of a bail-in, the rescue is carried out internally by restructuring the liabilities of the bank.

Given that banks pay an interest on their deposits, a deposit is a liability for any bank.
The Clause 52 of FRDI essentially allows the resolution corporation to cancel a liability owed by a specified service provider or to modify or change the form of a liability owed by a specified service provider.

What does this mean in simple English? Clause 52 allows the resolution corporation to cancel the repayment of various kinds of deposits. It also allows it to convert deposits into long term bonds or equity for that matter. Haircuts can also be imposed on firms to which the bank owes money. A haircut basically refers to a situation where the borrower negotiates a fresh deal and does not payback the entire amount that it owes to the creditor.

But there are conditions to this…
The bail-in will not impact any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance. This basically means that the bail-in will impact only the amount of deposits above the insured amount. As of now, in case of bank deposits, an amount of up to Rs 1 lakh is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). This amount hasn’t been revised since 1993.

Typically, anyone who has deposits in a bank tends to assume that they are 100 per cent guaranteed. But that is clearly not the case. Over the years, the government has prevented the depositors from taking a hit by merging any bank which is in trouble with another bigger bank.

So, to that extent the situation post FRDI Bill is passed, is not very different from the one that prevails currently. It’s just that the government has come to the rescue every time a bank is in trouble and I don’t see any reason for that to change, given the pressure on the government when such a situation arises and the risk of the amount of bad press it would generate, if any government allowed a bank to fail.

Over and above this, Clause 55 of the FRDI Bill essentially states that “no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation.” This basically means that no depositors after the bail-in clause is implemented should get an amount of money which is lesser than what he would have got if the firm were to be liquidated and sold lock, stock and barrel.

While, this sounds very simple in theory, it will not be so straightforward to implement this clause.

So why is the government doing this?
In late 2008 and early 2009, governments and taxpayers all over the world bailed out a whole host of financial institutions which were deemed too big to fail. In the process, they ended up creating a huge moral hazard.

As Mohamed A El-Erian writes in The Only Game in Town“[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.”

If governments and taxpayers keep rescuing banks what is the signal they are sending out to bank managers and borrowers? That it is okay to lend money irresponsibly given that governments and taxpayers will inevitably come to their rescue.

In order to correct for this moral hazard, in November 2008, the G20, of which India is a member, expanded the Financial Stability Forum and created the Financial Stability Board. The Board came up with a proposal titled “Key Attributes of Effective Resolution Regimes for Financial Institutions”. This proposal suggests to “carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions”. India has endorsed this proposal. Hence, unlike what WhatsApp forwards have been claiming this proposal has been in the works for a while now.

But does this really prevent moral hazard?
A bulk of the banking sector in India is controlled by the government owned public sector banks. As of September 30, 2017, these banks had a bad loans rate of 12.6 per cent (for private banks it is at 4.3 per cent).  Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more. The bad loans rate when it comes to lending to industry is even higher. In case of some banks it is close to 40 per cent.

This is primarily because banks over the years, under pressure from politicians and bureaucrats, lent a lot of money to crony capitalists, who either siphoned off this money or overborrowed and are now not in a position to repay. This is a risk that remains unless until the banking sector continues to primarily remain government owned in India.

Also, the rate of recovery of bad loans of banks in 2015-2016, stood at 10.3 per cent.  This does not inspire much confidence. In this scenario, having a clause which allows the resolution corporation to get depositors to pay for the losses that banks incur, is really not fair. The moral hazard does not really go away. The bankers, politicians and crony capitalists, can now look at bank deposits to rescue banks. As of now, the government and the taxpayers have kept rescuing public sector banks, by infusing more and more capital into them. Now the depositors can take over, if FRDI Bill becomes an Act.

It is worth pointing out here that the other G20 countries which have supported this proposal have some sort of a social security system in place, which India lacks. Given this, deposits are the major form of savings and earnings for India’s senior citizens and clearly, they don’t deserve to be a part of any such risk.

While, any government will think twice before using depositor money to rescue a bank, this is not an option that should be made available to governments or bureaucrats in India. It is a bad idea. It needs to be nipped in the bud.

These are my initial thoughts on the issue. Depending on how the situation evolves, I will continue to write on it.

The column originally appeared on Equitymaster on December 11, 2017.

Modi-Rajan Bhai-Bhai, Financial Savings of Households at a Five Year High

The Reserve Bank of India released its annual report earlier this week. The report had some important data points which I shall discuss in this piece.

Financial Savings Of the Household Sector

Take a look at the above table. The household financial savings of the country in 2015-2016 were the highest in five years. They stood at 7.7 per cent of the gross national disposable income. And what is gross national disposable income(GNDI)? Clara Capelli and Gianni Vaggi define the term in the research paper titled A better indicator for standard of living: The Gross National Disposable Income: “The GNDI…measures the income that residents can actually use for either consumption or saving, thus accounting for their purchasing power and, consequently, for their living standards.”

Let’s try and understand GNDI in a little more detail. It is essentially the sum of the gross domestic product (a measure of national income) plus remittances (money transfer carried out by migrant workers to their home country) plus money/food received as a part of an international assistance programme plus the net primary income. Net primary income is essentially the “difference between the primary income receivable from non-residents and the primary income payable to non-residents”.

As per the paper, India’s GNDI is around 1.03 times its gross domestic product.

The household financial savings comprise of currency, deposits, shares and debentures, insurance funds, pension and provident funds and something referred to as claims on government. The claims on government largely reflects of investments made in post office small savings schemes.

The household financial savings have gone up to 7.7 per cent of GNDI in 2015-2016. This is a five-year high.

Why has this happened? The simple reason for this lies in the fact that the rate of inflation has been lower in 2015-2016 than it was in the earlier years.
Inflation as measured by the consumer price indexs

As the chart shows, the rate of inflation as measured by the consumer price index has shown a downward trend between December 2013 and September 2015. Since then the rate of inflation has gone up a little.

The point is that when the rate of inflation goes down (i.e. there is disinflation) people have a chance of saving a greater portion of their income and that is what seems to have happened. Lower rates of inflation have led to higher household financial savings. The inflation as measured by the consumer price index peaked at 11.5 per cent in November 2013. It collapsed to 4.3 per cent in December 2014 and it averaged under 5 per cent through 2015.

Both the Narendra Modi government and the Reserve Bank of India governor Raghuram Rajan deserve credit for this. The Modi government for managing food inflation by not increasing the minimum support price on rice and wheat at the same rapid rate as it had been raised in the past (although this had started during the last year of the Manmohan Singh government) and Rajan for managing inflationary expectations (or the expectations that consumers have of what future inflation is likely to be).

In fact, things get interesting if one looks at the breakup of the household financial savings. In 2011-2012, deposits formed the bulk of the savings. They stood at 6 per cent of the GNDI. By 2015-2016, this had fallen to 4.7 per cent of the GNDI. What is happening here?

This clearly shows that most people who invest in deposits (of banks or otherwise) are victims of money illusion.  In 2011-2012 and 2012-2013, the nominal interest rates on bank deposits where close to 9-10 per cent and so was the inflation as measured by the consumer price index. This clearly meant that people were losing purchasing power on the money invested in deposits.

The inflation since then has fallen to around 5-6 per cent. The interest rates on bank deposits has fallen to around 7-7.5 per cent. Nevertheless, depositors are now making a real rate of return on their deposits because the rate of interest on deposits is greater than the rate of inflation. This clearly wasn’t the case earlier, and the depositors were essentially losing purchasing power by staying invested in deposits.

As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

This explains why people have moved away from deposits. The falling nominal rates have led to them shifting their investment to other avenues even though the nominal return on deposits is now in positive territory. Take a look at the claims on government. This has jumped from almost nothing to 0.4 per cent of GNDI. This basically means that the smarter lot has moved their money to small saving schemes where the nominal rate of interest as of now is higher than the interest on offer on fixed deposits.

Investments in shares and debentures has also jumped up from 0.4 per cent to 0.7 per cent of GNDI. This should make the finance minister Arun Jaitley happy. He complained some time back that people invest so much money in fixed deposits while ignoring other forms of investing like shares, debentures and mutual funds.

Currency holdings have also jumped from 1.1 per cent of GNDI to 1.4 per cent of GNDI. I really do not have an explanation for this. Why would people want to hold money in a form where they don’t get paid any interest?

The other interesting thing that comes out of the chart is that the gross household financial savings have risen to 10.8 per cent of GNDI in 2015-2016, from 10 per cent in 2014-2015. This has translated into the net household financial savings going up to 7.7 per cent of GDP in 2015-2016 from 7.5 per cent in 2014-2015.

Why is there such a substantial difference between the jump in gross household financial savings and the jump in net household financial savings? The net household financial savings figure is obtained by subtracting financial liabilities from the gross household financial savings.

The financial liabilities in 2015-2016 have jumped to 3 per cent of GNDI, in comparison to 2.5 per cent in 2014-2015. This basically means that people borrowed more in 2015-2016 than was the case in the past. In fact, at 3 per cent of GNDI, the financial liabilities are not significantly different from the 3.2 per cent figure of 2011-2012 and 2012-2013.

This basically tells us that households borrowing is alive and kicking. These numbers are again an answer to those who keep demanding that the RBI cut the repo rate at a much faster rate than it has. The trouble is clearly with corporate borrowing which continues to remain in a mess, and there is not much (and it shouldn’t) that the RBI can do about ensuring that banks lend to corporates.

The column originally appeared in Vivek Kaul’s Diary on September 1, 2016

Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman

Nirmala Sitharaman Spokesperson 11, Ashoka Road, New Delhi - 110001.

BA Kiya Hai, MA Kiya,
Lagta Hai Wo Bhi Aiwen Kiya.
– Gulzar in Mere Apne

The commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India(RBI) to cut the repo rate by 200 basis points.

Yes, you read that right!

200 basis points!

The repo rate is the rate at which banks borrow from the RBI on an overnight basis. One basis point is one hundredth of a percentage. The repo rate currently stands at 6.5 per cent.

I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports… are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend,” Sitharam told the press yesterday in New Delhi.

What Sitharaman was basically saying is that India’s micro and small and medium enterprises(MSMEs) are not approaching banks for loans because interest rates are too high. Given this, the RBI should cut the repo rate by 200 basis points and in the process usher in lower interest rates for MSMEs.

This, according to Sitharaman, was important because MSMEs create a lot of jobs and contribute to exports, and hence, should be able to borrow at a lower interest rates, than they currently are. As per the National Manufacturing Policy of 2011, the small and medium enterprises contribute 45 per cent of the manufacturing output and 40 per cent of total exports.

Hence, Sitharaman was batting for the MSMEs. But is it as easy as that?

That politicians don’t understand economics, or at least pretend not to understand it, is a given. But Sitharaman is a post graduate in economics from the Jawaharlal Nehru University in Delhi. (You can check it out here). For her, to make such an illogical remark, is rather surprising.

Not that the RBI is going to oblige her, but for a moment let’s assume that it does, and cuts the repo rate by 200 basis points, in the next monetary policy statement, which is scheduled for October 4, 2016, or over the next few statements.

What is going to happen next? Will banks cut their lending rates by 200 basis points? Only, when the banks cut their lending rates by 200 basis points, is the MSME sector going to benefit.

Banks only borrow a small portion of money from the RBI on an overnight basis and pay the repo rate as interest. A major portion of the money that they lend is borrowed in the form of fixed deposits. Hence, lending rates cannot fall by 200 basis points, unless fixed deposit interest rates fall by at least 200 basis points. (I use the word at least because banks tend to cut deposit rates faster than lending rates).

Wil the banks cut deposit rates by 200 basis points? Let’s assume that they do. If the deposit rates are cut by such a huge amount at one go, people will not save money in fixed deposits. Money will move into post office savings schemes, which offer a significantly higher rate of interest in comparison to fixed deposits (which they do even now, but with a cut the difference will be substantial).

Over a longer period of time, money will also move into real estate and gold, as people start looking for a better rate of return, higher than the prevailing inflation. This will lead to the financial savings of the nation as a whole falling. And banks in order to ensure that deposits keep coming in, will have to reverse the 200 basis points cut and start raising interest rates.

This is precisely how things played out between 2009 and 2013, when household financial savings fell from 12 per cent of the GDP to a little over 7 per cent of the GDP. Meanwhile, the interest rates went up, in order to attract financial savings.

This is Economics 101, which a post graduate in economics from a premier university in the country, should be able to understand.

Another important issue that our politicians seem to forget, over and over again, is the importance of fixed deposits, as a mode of saving, in an average Indian’s life. In 2013-2014, the latest year for which data is available, 69.23 per cent of total household financial savings, were in deposits.

Of this nearly 62.02 per cent was with scheduled commercial banks and 4.19 per cent with cooperative banks and societies. Nearly 2.61 per cent was invested in deposits of non-banking companies.

What does this tell us? It tells us that for the average Indian, the fixed deposit is an important form of saving. For the retirees it is an important form of regular income. Now what happens if fixed deposit interest rates are cut by 200 basis points? The regular income from the fresh money that retirees invest, will come down dramatically. Also, when their old fixed deposits mature, they will have to be invested at a significantly lower rate of interest.

This means that they will have to limit their consumption in order to ensure that they meet their needs from the lower monthly income that their fixed deposits are generating.

What about those who use fixed deposits as a form of saving? (I know that fixed deposits are a terribly inefficient way of saving, but that is really not the point here). Those who are using fixed deposits to save money, for their retirement, for the education and wedding of their children, will now have to save more money, in order to ensure that they are able to create the corpus that they are aiming at. This will also mean lower consumption.

Ultimately lower consumption will impact MSMEs as well, because there won’t be enough buyers for what they produce, as people consume less.

Those individuals who are not in a position to save the extra amount in order to make up for lower interest rates, will end up with a lower corpus in the years to come.

The point being that MSMEs do not operate in isolation. And the level of interest rates impacts the entire economy and not just the MSMEs, as Sitharaman would like us to believe.

Further, even if fixed deposit rates fall by 200 basis points, banks may still not be able to offer low interest rates to MSMEs, simply because they need to charge a credit risk premium i.e. factor in the riskiness of the loan that they are maing.

In case of the State Bank of India, the gross non-performing assets of SMEs stands at 7.82 per cent, as on March 31, 2016. This means that for every Rs 100 that the bank has lent to an SME, close to Rs 8 has been defaulted on. This risk of default needs to incorporated in the interest rate that is being charged.

And finally, the interest rates on fixed deposits of greater than one year are currently in the region of 7 to 7.5 per cent. This is when the rate of inflation has already crossed 6 per cent. In July 2016, the rate of inflation as measured by the consumer price index was at 6.07 per cent.

If fixed deposit rates are cut by 200 basis points, the interest rates will fall to around 5 to 5.5 per cent. This when the rate of inflation is greater than 6 per cent. This would mean that the real rate of interest (the difference between the nominal rate and the rate of inflation) would be in a negative territory. This is precisely how things had played out between 2009 and 2013 and look at the mess it ended up creating for the Indian economy.

Given these reasons, it is best to say that Sitharaman’s prescription would be disastrous for the Indian economy.

The column originally appeared in Vivek Kaul’s Diary on August 25, 2016

Petrol bomb is a dud: If only Dr Singh had listened…

Vivek Kaul
The Congress led United Progressive Alliance (UPA) government finally acted hoping to halt the fall of the falling rupee, by raising petrol prices by Rs 6.28 per litre, before taxes. Let us try and understand what will be the implications of this move.
Some relief for oil companies:
The oil companies like Indian Oil Company (IOC), Bharat Petroleum (BP) and Hindustan Petroleum(HP) had been selling oil at a loss of Rs 6.28 per litre since the last hike in December. That loss will now be eliminated with this increase in prices. The oil companies have lost $830million on selling petrol at below its cost since the prices were last hiked in December last year. If the increase in price stays and is not withdrawn the oil companies will not face any further losses on selling petrol, unless the price of oil goes up and the increase is not passed on to the consumers.
No impact on fiscal deficit:
The government compensates the oil marketing companies like Indian Oil, BP and HP, for selling diesel, LPG gas and kerosene at a loss. Petrol losses are not reimbursed by the government. Hence the move will have no impact on the projected fiscal deficit of Rs 5,13,590 crore. The losses on selling diesel, LPG and kerosene at below cost are much higher at Rs 512 crore a day. For this the companies are compensated for by the government. The companies had lost Rs 138,541 crore during the last financial year i.e.2011-2012 (Between April 1,2011 and March 31,2012).
Of this the government had borne around Rs 83,000 crore and the remaining Rs 55,000 crore came from government owned oil and gas producing companies like ONGC, Oil India Ltd and GAIL.
When the finance minister Pranab Mukherjee presented the budget in March, the oil subsidies for the year 2011-2012 had been expected to be at Rs Rs 68,481 crore. The final bill has turned out to be at around Rs 83,000 crore, this after the oil producing companies owned by the government, were forced to pick up around 40% of the bill.
For the current year the expected losses of the oil companies on selling kerosene, LPG and diesel at below cost is expected to be around Rs 190,000 crore. In the budget, the oil subsidy for the year 2012-2013, has been assumed to be at Rs 43,580 crore. If the government picks up 60% of this bill like it did in the last financial year, it works out to around Rs 114,000 crore. This is around Rs 70,000 crore more than the oil subsidy that the government has budgeted for.
Interest rates will continue to remain high
The difference between what the government earns and what it spends is referred to as the fiscal deficit. The government finances this difference by borrowing. As stated above, the fiscal deficit for the year 2012-2013 is expected to be at Rs 5,13,590 crore. This, when we assume Rs 43,580crore as oil subsidy. But the way things currently are, the government might end up paying Rs 70,000 crore more for oil subsidy, unless the oil prices crash. The amount of Rs 70,000 crore will have to be borrowed from financial markets. This extra borrowing will “crowd-out” the private borrowers in the market even further leading to higher interest rates. At the retail level, this means two things. One EMIs will keep going up. And two, with interest rates being high, investors will prefer to invest in fixed income instruments like fixed deposits, corporate bonds and fixed maturity plans from mutual funds. This in other terms will mean that the money will stay away from the stock market.
The trade deficit
One dollar is worth around Rs 56 now, the reason being that India imports more than it exports. When the difference between exports and imports is negative, the situation is referred to as a trade deficit. This trade deficit is largely on two accounts. We import 80% of our oil requirements and at the same time we have a great fascination for gold. During the last financial year India imported $150billion worth of oil and $60billion worth of gold. This meant that India ran up a huge trade deficit of $185billion during the course of the last financial year. The trend has continued in this financial year. The imports for the month of April 2012 were at $37.9billion, nearly 54.7% more than the exports which stood at $24.5billion.
These imports have to be paid for in dollars. When payments are to be made importers buy dollars and sell rupees. When this happens, the foreign exchange market has an excess supply of rupees and a short fall of dollars. This leads to the rupee losing value against the dollar. In case our exports matched our imports, then exporters who brought in dollars would be converting them into rupees, and thus there would be a balance in the market. Importers would be buying dollars and selling rupees. And exporters would be selling dollars and buying rupees. But that isn’t happening in a balanced way.
What has also not helped is the fact that foreign institutional investors(FIIs) have been selling out of the stock as well as the bond market. Since April 1, the FIIs have sold around $758 million worth of stocks and bonds. When the FIIs repatriate this money they sell rupees and buy dollars, this puts further pressure on the rupee. The impact from this is marginal because $758 million over a period of more than 50 days is not a huge amount.
When it comes to foreign investors, a falling rupee feeds on itself. Lets us try and understand this through an example. When the dollar was worth Rs 50, a foreign investor wanting to repatriate Rs 50 crore would have got $10million. If he wants to repatriate the same amount now he would get only $8.33million. So the fear of the rupee falling further gets foreign investors to sell out, which in turn pushes the rupee down even further.
What could have helped is dollars coming into India through the foreign direct investment route, where multinational companies bring money into India to establish businesses here. But for that the government will have to open up sectors like retail, print media and insurance (from the current 26% cap) more. That hasn’t happened and the way the government is operating currently, it is unlikely to happen.
The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupee to ensure that there is adequate supply of dollars in the market and the excess supply of rupee is sucked out. But the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
What about the trade deficit?
The trade deficit might come down a little if the increase in price of petrol leads to people consuming less petrol. This in turn would mean lesser import of oil and hence a slightly lower trade deficit. A lower trade deficit would mean lesser pressure on the rupee. But the fact of the matter is that even if the consumption of petrol comes down, its overall impact on the import of oil would not be that much. For the trade deficit to come down the government has to increase prices of kerosene, LPG and diesel. That would have a major impact on the oil imports and thus would push down the demand for the dollar. It would also mean a lower fiscal deficit, which in turn will lead to lower interest rates. Lower interest rates might lead to businesses looking to expand and people borrowing and spending that money, leading to a better economic growth rate. It might also motivate Multi National Companies (MNCs) to increase their investments in India, bringing in more dollars and thus lightening the pressure on the rupee. In the short run an increase in the prices of diesel particularly will lead higher inflation because transportation costs will increase.
Freeing the price
The government had last increased the price of petrol in December before this. For nearly five months it did not do anything and now has gone ahead and increased the price by Rs 6.28 per litre, which after taxes works out to around Rs 7.54 per litre. It need not be said that such a stupendous increase at one go makes it very difficult for the consumers to handle. If a normal market (like it is with vegetables where prices change everyday) was allowed to operate, the price of oil would have risen gradually from December to May and the consumers would have adjusted their consumption of petrol at the same pace. By raising the price suddenly the last person on the mind of the government is the aam aadmi, a term which the UPAwallahs do not stop using time and again.
The other option of course is to continue subsidize diesel, LPG and kerosene. As a known stock bull said on television show a couple of months back, even Saudi Arabia doesn’t sell kerosene at the price at which we do. And that is why a lot of kerosene gets smuggled into neighbouring countries and is used to adulterate diesel and petrol.
If the subsidies continue it is likely that the consumption of the various oil products will not fall. And that in turn would mean oil imports would remain at their current level, meaning that the trade deficit will continue to remain high. It will also mean a higher fiscal deficit and hence high interest rates. The economic growth will remain stagnant, keeping foreign businesses looking to invest in India away.
Manmohan Singh as the finance minister started India’s reform process. On July 24, 1991, he backed his “then” revolutionary proposals of opening up India’s economy by paraphrasing Victor Hugo: “No power on Earth can stop an idea whose time has come.
Good economics is also good politics. That is an idea whose time has come. Now only if Mr Singh were listening. Or should we say be allowed to listen..
(The article originally appeared at www.firstpost.com on May 24,2012. http://www.firstpost.com/economy/petrol-bomb-is-a-dud-if-only-dr-singh-had-listened-319594.html)
(Vivek Kaul is a writer and can be reached at [email protected])