All is well in India under the rule of the “Gandhi” family. That’s what Finance Minister Pranab Mukjerjee has been telling us. And that was the message that came through – with some minor qualifications – at UPA-2′s third anniversary meeting on Tuesday.
However, what explains the fall in the rupee? If the exchange rate is the price holders of dollars (or euro or yen) are willing to pay for the rupee, a fall in the rupee’s value by 16-17 percent during UPA-2′s tenure tells its own story of what dollar holders think of us.
The finance minister’s explanation for the rupee’s fall against the dollar is that this is largely a reflection of problems in Greece. And Spain. And Europe. And other parts of the world. On Wednesday morning, the dollar was worth around Rs 55.69, which is a fall of 22-23 percent over the last one year.
The larger view among analysts and experts who track the foreign exchange market is that a dollar will soon be worth Rs 60. And by then there might be problems in some other part of the world and the rupee’s fall might be blamed on the problems there. As a late professor of mine used to say with a wry smile on his face “Since we are all born on this mother earth, there is some sort of symbiosis between us.”
So let’s try and understand why the underlying logic to the rupee’s fall against the dollar is not as simple as it is made out to be.
Dollar is the safe haven
As economic problems have come to the fore in Europe (Read: If PIIGS have to fly they will have to exit the euro), the large institutional investors have moved out of the euro into the dollar. A year back one dollar was worth €0.71, now it’s worth €0.78. So the dollar has gained against the euro, no doubt.
But the argument being made is that this is global trend and that dollar has gained in value against a lot of other major currencies. Is that true? A year back one dollar was worth 0.88 Swiss francs, now it is worth 0.93. So it has gained in value against the Swiss currency.
What about the British pound? A year back the dollar was worth £0.62, now it’s worth £0.63. Hence the dollar has barely moved against the pound. A dollar was worth around 82 Japanese yen around a year back. Now it’s worth around 79.5 yen. It has lost value against the Japanese yen even when the Japanese economy is going nowhere.
The dollar has gained in value against the Brazilian real. It was worth around 1.63 real a year back. It is now worth over 2 real. So yes, the dollar has gained in value against the other currencies but not against all currencies.
What is ironic is that the world at large is considering the dollar to be a safe haven and moving money into it by buying bonds issued by the American government. The debt of the US government is now around $14.6 trillion, which is almost equal to the US gross domestic product of $15 trillion. But since everyone considers it to be a safe haven it has become a safe haven.
But let’s get back to the point at hand. Not all currencies have lost value against the dollar and those that have lost value have lost it in varying degrees. This tells us that there are other individual issues at play as well when it comes to currencies losing value against the dollar.
What is happening in India?
The Indian government has been spending much more money than it has been earning over the last few years. In other words, the fiscal deficit of the government has been on its way up. For the financial year 2007-2008 (i.e. the period between 1 April 2007 and 31 March 2008) the fiscal deficit stood at Rs 1,26,912 crore. This shot up to Rs 5,21,980 crore for the financial year 2011-2012. In a timeframe of five years the fiscal deficit has shot up by more than three time (or 312 percent, to be exact). During the same period the income earned by the government has gone up by only 36 percent to Rs 7,96,740 crore. The fiscal deficit targeted for the current financial year 2012-2013 is a little lower at Rs 5,13,590 crore. The huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertiliser and petroleum.
The tendency to overshoot
Also it is highly likely that the government might overshoot its fiscal deficit target this year like it did last year. In his budget speech last year Pranab Mukherjee had set the fiscal deficit target for the financial year 2011-2012 at 4.6 percent of GDP. He missed his target by a huge margin when the real number came in at 5.9 percent of GDP. The major reason for this was the fact that Mukherjee had underestimated the level of subsidies that the government would have to bear. He had estimated the subsidies at Rs 1,43,750 crore but they ended up costing the government 50.5 percent more at Rs 2,16,297 crore.
Generally, all the three subsidies of food, fertiliser and petroleum are underestimated, but the estimates on the oil subsidies are way off the mark. For the year 2011-2012, oil subsidies were assumed to be at Rs 23,640crore. They came in at Rs 68,481 crore. This has been the case in the past as well. In 2010-2011, he had estimated the oil subsidies to be at Rs 3,108 crore. They finally came in 20 times higher at Rs 62,301 crore. Same was the case in the year 2009-2010. The estimate was Rs 3,109 crore. The real bill came in nearly eight times higher at Rs 25,257 crore (direct subsidies plus oil bonds issued to the oil companies).
The increasing fiscal deficit
The fiscal deficit has gone up over the years primarily because an increase in expenditure has not been matched with an increase in revenue. Revenue for the government means various forms of taxes and other forms of revenue like selling stakes in public sector enterprises.
The fact of the matter is that Indians do not like to pay income tax or any other kind of tax. This is a throwback from the days of the high income tax rate in the 1960s, 1970s and the 1980s, when a series of finance ministers (from CD Deshmukh to Yashwantrao Chavan and bureaucrats like Manmohan Singh) implemented high income tax rates in the hope that taxing the “rich” would solve all of India’s problems.
In the early 1970s the highest marginal rate of tax was 97 percent. The story goes that JRD Tata sold some property every year to pay taxes (income tax plus wealth tax) which worked out to be more than his yearly income. Of course, not everybody would like to be a JRD, and because of the high tax rates implemented by various Congress governments over the years, a major part of the Indian economy became black. Dealings were carried out in cash. Transactions were made but they were never recorded, because if they were recorded tax would have to be paid on them.
A series of exemptions were granted to corporate India as well, and companies like Reliance Industries did not pay any income tax for years. As a result of this India and Indians did not and do not like paying tax.
Various lobbies have also emerged which have ensured that their segment is not taxed. As Professor Amartya Sen wrote in a column in The Hindu earlier this year: “It is worth asking why there is hardly any media discussion about other revenue-involving problems, such as the exemption of diamond and gold from customs duty, which, according to the ministry of finance, involves a loss of a much larger amount of revenue (Rs 50,000 crore per year)”.
As he further points out, “The total “revenue forgone” under different headings, presented in the ministry document, an annual publication, is placed at the staggering figure of Rs 5,11,000 crore per year. This is, of course, a big overestimation of revenue that can be actually obtained (or saved), since many of the revenues allegedly forgone would be difficult to capture — and so I am not accepting that rosy evaluation.”
But even with the overestimation the fact of the matter is that a lot of tax that can be collected from those who can pay is not being collected, and that of course means a higher fiscal deficit.
The twin deficit hypothesis
The hypothesis basically states that as the fiscal deficit of the country goes up its trade deficit (i.e. the difference between its exports and imports) also goes up. Hence when a government of a country spends more than what it earns, the country also ends up importing more than exporting.
But why is that? The fiscal deficit goes up because the increase in expenditure is not matched by an increase in taxes. This leaves people with a greater amount of money in their hands. Some portion of this money is used towards buying goods and services, which might be imported from abroad. This leads to greater imports and thus a higher trade deficit.
The situation in India is similar. The government of India has been spending more than it has been earning without matching the increase in income with higher taxes, which in turn has led to increasing incomes and that, to some extent, has been responsible for an increase in Indian imports. But that could have hardly been responsible for the trade deficit of $185 billion that India ran in 2011-2012. The imports for the month of April 2012 were at $37.9 billion, nearly 54.7 percent more than exports, which stood at $24.5 billion. So the trend has continued even in this financial year.
The golden oil shock
India imports a major part of its oil needs. On top of that it is obsessed with gold. Last year we imported 1,000 tonnes of it. Very little of both these commodities, priced in dollars, is dug up in India. So we have to import them.
This pushes up our imports and makes them greater than our exports. 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 shortfall 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.
This, to some extent, explains the current rupee-dollar rate of $1 = Rs 55.69. The Reserve Bank of India does intervene at times to stem the fall of the rupee. This it does by selling dollars and buying rupees. But the RBI does not have an unlimited supply of dollars and hence cannot keep intervening indefinitely.
As mentioned earlier, the major part of the trade deficit is because of the fact that we need to import oil. Oil prices have been high for the last few years, though recently they have fallen. Oil is sold in dollars. Hence, when India needs to buy oil it needs to pay dollars. But with the rupee constantly losing value against the dollar, it means that Indian companies have to pay more per barrel of oil in rupees.
The government of India does not pass on a major part of the increase in the price of oil to the end consumer and hence subsidises the prices of diesel, LPG, kerosene, etc. This means that the oil companies have to sell these products at a loss to the consumer. The government in turn compensates these companies for the loss. This leads to the expenditure of the government going up and hence it incurs a higher fiscal deficit.
No passing the buck
If the government had not subsidised prices of oil products and passed them on to the end consumer, their consumption would have come down. With prices of oil products not rising as much as they should people have not adjusted their consumption accordingly. An increase in price typically leads to a fall in demand. If the increased price of oil had been passed onto the end-consumer, the demand for oil would have come down. This would have meant that a fewer number of dollars would have been required to pay for the oil being imported, in turn leading to a lower trade deficit and hence lesser pressure on the rupee-dollar rate.
So let me summarise the argument I am making. The higher fiscal deficit in the form of subsidies has pushed up the trade deficit which in turn has led to the rupee losing value against the dollar. The solution is to get consumers to pay the “right” price. With this the fiscal deficit can be brought down to some extent.
If these products are priced correctly, their consumption is likely to come down as well in the near future, given that their prices will go up. Lower consumption is likely to lead to lower imports and thus a lower trade deficit. A lower trade deficit would also mean that the fall of the rupee against the dollar may stop. This, in turn, would mean a lower price for the oil we import in rupee terms and that in turn helps overall economic growth. A lower fiscal deficit will lead to lower government borrowing and hence lesser “crowding out” and so lower interest rates, which might get corporates and individuals interested in borrowing again.
The long term solution
What has been suggested above is a short term solution, which given the way the Congress-led UPA government operates, is unlikely to be implemented. The main problem is that while it’s quite a noble idea to provide subsidies in the form of food, fertiliser, kerosene, etc, to the India’s poor, it has to be matched with an increase in taxes. An increase in income taxes rates isn’t going to help much because only a minuscule portion of India pays its full income tax (basically the salaried class; companies get many tax hedges).
What is needed is to get a larger number of people to pay tax to pay for all the subsidies that are doled out. This can be done by simplifying the Income Tax Act. This was tried when the government tried to come up with the Direct Taxes Code (DTC), which was very simple and straightforward and had done away with most exemptions. In its original form, the DTC was a pleasure to read. But, of course, if it had been implemented scores of people who do not pay income tax would have had to ultimately pay income tax. In its current form the DTC is another version of the loophole-ridden Income Tax Act.
Another way is to target specific communities of people who do not pay income tax even though they earn a huge amount of money, but all in “black”. For starters, targeting property dealers that line up almost every street in Delhi might be a good idea. Once people see that the government is serious about collecting taxes, they are more likely to pay up than not. And there is no better way than starting with the capital.
Vivek Kaul is a writer and he can be reached at email@example.com