Subsidies = Inflation = Gold problem

ES gold
The government has a certain theory on gold as per which buying gold is harmful for the Indian economy. Allow me to elaborate starting with something that P Chidambaram, the union finance minister, recently said “I…appeal to the people to moderate the demand for gold.”
India produces very little of the gold it consumes and hence imports almost all of it. Gold is bought and sold internationally in dollars. When someone from India buys gold internationally, Indian rupees are sold and dollars are bought. These dollars are then used to buy gold.
So buying gold pushes up demand for dollars. This leads to the dollar appreciating or the rupee depreciating. A depreciating rupee makes India’s other imports, including our biggest import i.e. oil, more expensive.
This pushes up the trade deficit (the difference between exports and imports) as well as our fiscal deficit (the difference between what the government earns and what it spends).
The fiscal deficit goes up because as the rupee depreciates the oil marketing companies(OMCs) pay more for the oil that they buy internationally. This increase is not totally passed onto the Indian consumer. The government in turn compensates the OMCs for selling kerosene, cooking gas and diesel, at a loss. Hence, the expenditure of the government goes up and so does the fiscal deficit. A higher fiscal deficit means greater borrowing by the government, which crowds out private sector borrowing and pushes up interest rates. Higher interest rates in turn slow down the economy.
This is the government’s theory on gold and has been used to in the recent past to hike the import duty on gold to 6%. But what the theory doesn’t tells us is why do Indians buy gold in the first place? The most common answer is that Indians buy gold because we are fascinated by it. But that is really insulting our native wisdom.
World over gold is bought as a hedge against inflation. This is something that the latest economic survey authored under aegis of Raghuram Rajan, the Chief Economic Advisor to the government, recognises. So when inflation is high, the real returns on fixed income investments like fixed deposits and banks is low. As the Economic Survey puts it “High inflation reduces the return on other financial instruments. This is reflected in the negative correlation between rising(gold) imports and falling real rates.”(as can be seen from the accompanying table at the start)
In simple English, people buy gold when inflation is high and the real return from fixed income investments is low. That has precisely what has happened in India over the last few years. “The overarching motive underlying the gold rush is high inflation…High inflation may be causing anxious investors to shun fixed income investments such as deposits and even turn to gold as an inflation hedge,” the Survey points out.
High inflation in India has been the creation of all the subsidies that have been doled out by the UPA government. As the Economic Survey puts it “With the subsidies bill, particularly that of petroleum products, increasing, the danger that fiscal targets would be breached substantially became very real in the current year. The situation warranted urgent steps to reduce government spending so as to contain inflation.”
Inflation thus is a creation of all the subsidies being doled out, says the Economic Survey. And to stop Indians from buying gold, inflation needs to be controlled. “The rising 
demand for gold is only a “symptom” of more fundamental problems in the economy. Curbing inflation, expanding financial inclusion, offering new products such as inflation indexed bonds, and improving saver access to financial products are all of paramount importance,” the Survey points out. So if Indians are buying gold despite its high price and imposition of import duty, they are not be blamed.
A shorter version of this piece appeared in the Daily News and Analysis on February 28, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

It is Sonia who needs to read Rajan’s Economic Survey


Vivek Kaul 
Raghuram Govind Rajan, the chief economic advisor to the government of India, likes to talk straight and call a spade a spade. He was the first economist of some standing to take on Alan Greenspan’s economic policies at a public forum. In a conference in 2005, Rajan said “The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis.”
This was during the time when the United States of America was in the middle of a real estate bubble. Everyone was having a good time. And no one wanted to spoil the party.
Alan Greenspan hadn’t achieved the ignominy that he now has, and was revered as god, at least in economic circles. Hence, any criticism of the American economy was seen as criticism of Greenspan himself. Given this, Rajan came in for heavy criticism for what he said. But we all know who turned out to be right in the end.
Recalling the occasion Rajan later wrote in his book 
Fault Lines “I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticised by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.”
What this tells us is that Rajan doesn’t hesitate in pointing out what is going on before his eyes, even though it might be politically incorrect to do so. This clearly comes out in the Economic Survey for the year 2012-2013. A part of the summary to the first chapter State of the Economy and Prospects reads “With the subsidies bill, particularly that of petroleum products, increasing, the danger 
that fiscal targets would be breached substantially became very real in the current year. The situation warranted urgent steps to reduce government spending so as to contain inflation.”
The last sentence of the above paragraph makes for a very interesting reading. This is probably the first occasion where a government functionary has conceded that it is the increased government spending during the second term of the UPA that has led to a high inflationary scenario. This is not surprising given that Rajan holds a full time job teaching at the University of Chicago.
Rajan’s thinking is in line with what the late Milton Friedman, a doyen of the University of Chicago, had been talking about since the early 1960s. As Friedman writes 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…Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”
And that is what has happened in India with the government spending more and more money over the last five years. This money has chased the same number of goods and services and thus led to higher prices i.e. inflation.
Rajan has never been a great fan of subsidies and he looks at them as a short term necessity. In an interview I did with him after the release of his book 
Fault Lines, for the Daily News and Analysis(DNA), I had asked him whether India could afford to be a welfare state, to which he had replied “Not at the level that politicians want it to.”
In another interview that I had done with him in late 2008, for the same newspaper, he had said “There is a real concern in India that government in India is not doing enough of what it should be doing…I don’t agree that we should overspend and run large deficits but I think we should bite the bullet and cut back on subsidies where we can for the larger good of the public investment into agriculture, roads etc.”
This kind of thinking that Rajan is known for clearly comes out in the Economic Survey. The subsidy bill (oil, food and fertilizer primarily) for the current financial year 2012-2013 (i.e. the period between April 1, 2012 and March 31, 2013) is estimated to be at Rs 1,90,015 crore. This has to come down. As the Economic Survey points out “Controlling the expenditure on subsidies will be crucial. Domestic prices of petroleum products, particularly diesel and liquefied petroleum gas (LPG) need to be raised in line with the prices prevailing in international markets. A beginning has already been made with the decision in September 2012 to raise the price of diesel and again in January 2013 to allow oil marketing companies to increase prices in small increments at regular intervals.”
The question is that will this be enough. The amount budgeted for oil subsidies during the course of this financial year was Rs 43,580 crore. These subsidies are given to oil marketing companies because they sell diesel, cooking gas and kerosene at a loss.
The amount budgeted against oil subsidies will not be enough to meet the actual losses. As the Chapter 3 of the 
Economic Survey points out “The Indian basket crude oil was $107.52 per bbl (April-December) in 2012 and even with the pass through effected in the course of the year, under-recoveries of OMCs surged and were estimated at Rs1,24,854 crore during April-December 2012-13.”
So for the first nine months of the year the oil subsidy bill was more than Rs 81,000 crore off the target. By the end of the financial year this might well touch Rs 1,00,000 crore. This of course will need some clever accounting to hide. Chances are that the finance minister P Chidambaram might move this payment that will have to be made to the oil marketing companies to the next financial year.
Hence it becomes even more important to cut these subsidies in the years to come. As Rajan writes “
The crucial lesson that emerges from the fiscal outcome in 2011-12 and 2012-13 is that in times of heightened uncertainties, there is need for continued risk assessment through close monitoring and for taking appropriate measures for achieving better fiscal marksmanship. Openended commitments such as uncapped subsidies are particularly problematic for fiscal credibility because they expose fiscal marksmanship to the vagaries of prices.”
The phrase to mark over here is that 
‘open ended commitments such as uncapped subsidies are particularly problematic‘. This is something that Sonia Gandhi, president of the Congress party, and Chairman of UPA wouldn’t want to hear. This specially during a time when Lok Sabha elections are due in a little over a year’s time and this budget is the last occasion which the government can use to continue bribing the Indian public through subsidies.
It will be interesting to see whether the finance minister P Chidambaram takes any of the suggestions put forward by Rajan and his team, when he presents the annual budget tomorrow. Or will this Economic Survey, like many before it, be also confined to the dustbins of history?
The piece originally appeared on www.firstpost.com on February 27, 2013

 (Vivek Kaul is a writer. He tweets at @kaul_vivek ) 

 

KFA and Sahara: How they have damaged capitalism

saving capitalism
Vivek Kaul
Capitalism is a bad word these days.
And who made it a bad word? The communists? The trade unionists? Those fired from their jobs? Those who fear they might be fired from their jobs? The politicians? Or simply put you and I?
Well, actually none of the above.
Capitalism has been given a bad name by those who practise it i.e. the capitalists. And the capitalists in this have been helped by the politicians and the other insiders.
In India this role has been played to the hilt by Vijay Mallya of Kingfisher and Subrata Roy of Sahara.
As Raghuram Rajan and Luigi Zingales write in
Saving Capitalism from the Capitalists “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”
Lets look at this statement first in the context of Kingfisher and then Sahara. The Kingfisher crisis has been on for sometime now and the firm has not been allowed to fail. In fact last year there was a lot of talk of even the government of India stepping in to rescue the airline. But thankfully, the government which continues to blow up the taxpayer’s hard earned money on Air India, chose not to do so with Kingfisher.
Before that as per an announcement made in April 2011, the banks which had loaned a lot of money to Kingfisher agreed to convert Rs 1400 crore of it into equity at a premium of more than 60%.
Of course with the benefit of hindsight one can clearly say that what were they thinking? At the time of conversion of debt into equity Kingfisher shares were priced at Rs 39.9 and the debt was converted into equity at a price of Rs 64.48. As I write this the share price of the former airline is at Rs 9.56 on the Bombay Stock Exchange (BSE). Interestingly, there are sellers willing to sell the share at this price but there are no buyers in the market. So this price doesn’t really have any meaning. A stock market like any other market needs sellers and buyers to function.
If there are no buyers there is no market. As of December 31, 2012, the State Bank of India, IDBI Bank, ICICI Bank and Bank of India owned 8.78% of the shares of the company. This was down from the 18.78% that these banks along with Punjab National Bank and UCO Bank held as on March 31, 2011, after the banks had converted their debt into equity. So these banks have managed to whittle down their holding in the airline but even with that they may have been left holding onto a stake which is worth next to nothing now. Since the latest numbers as on March 31, 2013 are not available it can’t be said with clarity what stake banks have still left in the airline.
Also, this is only the part that was converted into equity. Over and above this there is Rs 7,723 crore of debt that Kingfisher Airlines still owes the banks. The banks have a collateral worth Rs 5,237 core against the outstanding loans of Kingfisher. Experts remain sceptical on how much collateral, which includes Mallya’s bungalow at Candolim in Goa among other things, the banks will be able to sell to recover their loans.
The basic question that remains is that why would banks convert debt into equity at a premium of more than 60%, for an airline that even then had never made money? The answer probably lies in the fact that most of the banks that had given loans to Kingfisher, with the possible exception of ICICI Bank, were public sector banks. It can be safely said that political pressure was at play. The fact that Mallya is a member of the Rajya Sabha must have helped.
Hence those who Rajan and Zingales call the incumbents i.e. the promoter, his financiers and the politicians kept Kingfisher going, when it clearly was in no position to continue. And we have now ended up with a situation which is clearly messier.
No one in their right mind will now buy the airline given that it would be cheaper and easier to start a fresh airline than clear up the mess inside Kingfisher and re-launch it.
The moral of the story is that while capitalism creates, it is very important to let it destroy as well, otherwise there are costs for the society to bear.
In the aftermath of Kingfisher going bust the Ministry of Civil Aviation does not seem to be in the mood to issue fresh licenses, such is the fear of another airline going bust. Also, when Spice Jet recently cut ticket prices, the Ministry went out of its way to ensure that other players did not match that price. The logic being that if tickets are sold at a lower price there would be more losses, more airlines getting in trouble (read Air India) and so on.
In the process the prospective consumer i.e. you and me, lose out on cheaper tickets and perhaps better service, which would be the case with more airlines in the fray.
And more than anything the employees of the airline who had gone back to work on the assurances of the top management, continue to remain largely unpaid.
If the process of trying to rescue the airline had not been prolonged for so long, things would have been better for everyone concerned, except perhaps the promoter.
Now lets come to Sahara. Sahara is an even more blatant example of why you need to save capitalism from the capitalists. Here is a firm, which has been directed by no less than the Supreme Court of India to hand over more than Rs 24,000 crore to the Securities Exchange Board of India (SEBI) to repay its investors and is not doing so. In fact as an earlier column pointed out Sahara is probably even going against the decision of the Supreme Court. This cannot happen without political support.
In fact till date, politicians who jump at every opportunity to be seen as messiahs of the masses, haven’t spoken a word against Sahara. This is probably also linked to the fact that most politicians run cricket in India by controlling the state boards and the district cricket associations and Sahara remains the biggest sponsor of what was once called the gentleman’s game. As the old saying goes, you don’t bite the hand that feeds you.
Meanwhile the unsuspecting poor of the country continue to handover their hard earned money to Sahara. It is safe to say that Sahara has inspired a whole host of other firms to raise money from the unsuspecting public in India, knowing fully well that even if they do not follow the law of the land, things would just be fine. It also explains to a large extent why pyramid and Ponzi schemes continue to flourish in India. Nobody ever gets punished.
Rajan and Zingales point out that “Those in power – the incumbents – prefer to stay in power.” And in order to do that they tend to go any extent possible. In the process things get messier.
Hence, it is important for firms which are no longer viable to be allowed to fail, and if they are not in the mood to do it themselves, then they the law of the land should ensure that they do fail. As a certain Frank Borman once said “I’ve long said that capitalism without bankruptcy is like Christianity without hell.”
The article originally appeared on www.firstpost.com on February 16, 2013

(Vivek Kaul is a writer. He can be reached at [email protected])



Raghuram Rajan’s advice isn’t what UPA may want to hear


Vivek Kaul

Every year the Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organizes a symposium at Jackson Hole in the state of Wyoming. The conference of 2005 was to be the last conference attended by Alan Greenspan, the then Chairman of the Federal Reserve of United States, the American central bank.
Hence, the theme for the conference was the legacy of the Greenspan era. One of the economists who had been invited to present a paper at the symposium was the 40 year old Raghuram Govind Rajan, the man who is likely to be the government’s next Chief Economic Advisor.
Rajan is an alumnus of IIT Delhi, IIM Ahmedabad and the Massachusetts Institute of Technology (MIT). After doing his PhD at MIT, he had joined the Graduate School of Business at the University of Chicago (now known as the Booth School of Business). At that point of time Rajan was on leave from the business school and was working as the Chief Economist at the International Monetary Fund.
The United States had seen an era of unmatched economic prosperity under Greenspan. Even, the dotcom bust in 2000-2001 hadn’t held America back. Greenspan had managed to get the economy back on track by cutting the Federal Funds Rate to as low as 1% by mid 2003. The low interest rate scenario along with a lot of financial innovation had created a financial system which was slush with money. American banks were falling over one another to lend money. And borrowers were borrowing as much as they could to buy homes, property and real estate. The dotcom bubble of the late 1990s had given away to the real estate bubble.
In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. Such was the belief in the bubble.
And the belief was not limited to only the people of United States. Banks were equally optimistic that real estate prices will continue to go up. Between 2004 and 2006, banks and other financial institutions playing in the subprime home loan space gave out loans worth $1.7trillion in total. Of this a massive $625billion was lent in 2005, the year Rajan was invited to speak at Jackson Hole.
In its strictest sense a subprime loan was defined as a loan given to an individual with a credit score below 620, who had no assets and was thus unlikely to qualify for a traditional home loan. A credit score is a number calculated on the basis of the borrower’s past record at paying bills and loans of all kinds, the length of his credit history, the kind of loans taken etc. On the basis of the number the lender can get some sort of an idea of what sort of a risk he is taking on by lending to the borrower.
That was the purported idea behind the credit score. In the normal scheme of things, a borrower categorized as “sub-prime” should not have been touched with a bargepole. But those were days when everybody and anybody got a loan.
It was an era of optimism which had been fueled by easy money that was going around in the financial system. The conventional wisdom of the day was that the bull run in property prices would continue forever. The American economy would continue to prosper.
In this environment Raghuram Rajan presented a paper titled “Has Financial Development Made the World Riskier?” In his speech Rajan harped on the fact that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to.
He said:
The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis
He also suggested in his speech that the incentives of the financial sector were skewed and employees were reaping in rich rewards for making money but were only penalized lightly for losses. In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.
Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear. Also in a way Rajan was questioning the credentials of Alan Greenspan who would soon retire spending nearly 18 years as the Chairman of the Federal Reserve of United States. He was essentially saying that the Greenspan era was hardly what it was being made out to be.
Given this, Rajan came in for heavy criticism. As he recounts in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy:
Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.
The criticism notwithstanding Rajan turned out right in the end. And what was interesting that he called it as he saw it. He called spade a spade despite the aura of Alan Greenspan that prevailed.
What this story clearly tells us is that Rajan is not an “on-the-other-hand” economist. There are too many “on-the-other-hand” economists going around, who do not like to take a stand on an issue. As Harry Truman, an American President once famously said “All my economists say, ‘on the one hand… and on the other hand…Someone give me a one-handed economist!
If news-reports in the media are to be believed the government is in the process of appointing Rajan as the Chief Economic Advisor to replace Kaushik Basu. As far as academic credentials and experience go they don’t come much better than Rajan. Other than having been the Chief Economist of the IMF between September 2003 and January 2007, he is also currently an honorary economic adviser to the Prime Minister Manmohan Singh.
The question though is will the plain-speaking Rajan who seems to like to call a spade a space, fit into a government which believes in the idea of a welfare state? In an interview I did for the Daily News and Analysis (DNA) after the release of his book Fault Lines I had asked him “whether India can afford a welfare state?” “Not at the level that politicians want it to. For example, the National Rural Employment Guarantee Scheme (NREGS), if appropriately done it is a short term insurance fix and reduces some of the pressure on the system, which is not a bad thing. But if it comes in the way of the creation of long term capabilities, and if we think NREGS is the answer to the problem of rural stagnation, we have a problem. It’s a short term necessity in some areas. But the longer term fix has to be to open up the rural areas, connect them, education, capacity building, that is the key,” Rajan had replied.
This is a view that is not held by many in the present United Progressive Alliance (UPA) government. They politicians who run this country have great faith in the NREGS.
Rajan had also written in Fault Lines that “the license permit raj has given away to the raj of the land mafia.” I had asked him to explain this in detail and he had said:
Earlier…you had to navigate the government for permissions and this was license permit. You needed permission to produce. Now you have to navigate the government for land because in many situations land titles are murky, acquiring the land is difficult, and even after you acquire protecting that land is difficult. So there are entrepreneurs who have access to the power of the government, who basically can do it. And then there are others who can’t. So you have made it a test of who can acquire the land in certain kind of functions than who is the best developer than who is the best manufacturer. Put differently what used to surround the license permit has moved to corruption surrounding land. The central source of wealth today in the whole economy is land and we need to make the land acquisition process transparent.
In answer to another question Rajan had said:
The predominant of the sources of mega wealth in India today are not the software billionaires who have made money the hard way by being competitive in a global economy. It is the guys who have access to natural resources or to land or to particular infrastructure permits or licenses. In other words proximity to the government seems to be a big source of wealth. And that is worrisome because it means that those who can access the government who can manage it are in a sense far more powerful than ordinary businessmen. In the long run this leads to decay in the image of businessmen and the whole free enterprise system. It doesn’t show us in good light if we become a country of oligopolies and oligarchs and eventually this could even impinge on democratic right.”
What these answers tell us is that Rajan has clear views on issues that plague India and he is not afraid of putting them forward. But these are things that the current government would not like to hear. Given this, it remains to be seen how effective Rajan’s tenure in the government will turn out to be. The trouble is if he calls a spade a spade, it won’t take much time for the government to marginalize him. If he does not, he won’t be effective anyway.
(The interview originally appeared on www.firstpost.com on August 8,2012. http://www.firstpost.com/economy/raghuram-rajans-advice-isnt-what-upa-may-want-to-hear-410694.html/)
(Vivek Kaul is a writer and can be reached at [email protected] )