An edited version has appeared in Financial Express on 13 Oct 2017
Currency Correction or Fiscal Stimulus?
The feeling of sluggishness is palpable everywhere. There are talks of stimulating the economy by fiscal incentives etc. This can be a very innocuous medicine for reasons of (i) dosage, (ii) potency, and (iii) long lead time.
First the dosage. The government may throw Rs 50-60K crores as fiscal stimulus. This is about 0.4% of our GDP. Given the current moribund state of economy with 25-30% underutilised capacities it is too tiny to have any impact. The current closure of capacities or lack of investments have not become so for 1-2% poorer realisations or profitability. While the figures vary for different industries, it is substantial – more in the range of 10-20%. We need a correction of this magnitude. The gaps in our competitiveness with countries exporting to us like China, ASEAN and Korea is 10-15%; not a 1-2% pittance.
Next the potency and wastage. Any incentive will reach both Units operating at full capacity and units with low utilisation and poor profitability. Units which are closed or NPA currently could hardly be revived with a small ‘spread thin’ incentive. The incentives reaching units operating at full capacity will neither create incremental growth nor new employment. There will be a lot of wasted (applying where not needed) efforts.
Finally, the lead time. If stimulus is by way of Income Tax rebates, it will be a year or many quarters before the recipient feels it and reckons it in his decisions. If it is by way of Indirect tax cuts, the recipient knows that it is for a limited period and will not motivate him for taking a long term investment decision. We need some immediate actions and most fiscal measures take a long lead time to get results. It may be well beyond 2019 that one would see perceptible results.
The current problem
The economy is stuck at a low and unresponsive equilibrium. The current economic impasse is born out of 3 main factors (i) high internal value of currency (low inflation targets resulting in high real interest rates), (ii) may be partially from it, high external value of Rupee and high real interest rates attracting too much forex flows which are beyond the capacity of economy to absorb and (iii) free trade with ASEAN which kicked in from Jan 2014 in full.
ASEAN FTA did increase supplies and kept prices under check. It made import parity as the main basis of price determination for many manufactured goods. But it also eroded domestic industry’s profitability since manufacturing prices have hardly risen to cover inflation of inputs in wages and inputs from agriculture. It delivered customer stable or reduced prices but took away their jobs. India’s growth is creating Jobs but in other countries!
Somehow inflation control has become the focal point of our monetary management in recent years just like fiscal deficit is for our Union Budgets. While the fiscal deficit control is understandable, in an open globalised economy when product of every description could be freely imported, supply shortfall induced inflation is out of question. From Pulses and rice, to apparels, to electronics and Ganesha and Navrathra idols everything can be imported these days. So supply constraint induced inflation is the least that RBI or the Government needs to worry about.
Ways to correct imbalances
The main contributory reason for our lack of competitiveness with other regional players is the high external value of our currency. The sooner it is corrected the better, either by devaluation or dis-incentivising inflows. But devaluation can cause inflation. As is reasoned out below inflation can be phantom enemy if things are calibrated well.
The first thing is to reduce debt limits available to overseas investors and strictly adhere to such limits. There is nopoint accumulating reserves to earn 1-2% returns by paying 4-5% overseas as interest in $ terms.
Secondly, there could be a temporary tax on overseas investments into India. This can be even for ECBs, investments into government debt and all inflows which are not required for physical imports. Taxing interest on GOI bonds will lower their yields and contain inward flows. There could be a surcharge on inflows till the related imports also take place. These could be used for re-capitalising our banks.
As a corollary, Government can mandate that fresh foreign investments can only be in new government bonds issued, on which the GOI can offer much less interest rate. Such an exercise will help the GOI as well. Such issuances can be allowed for secondary trades may be a separate bond segment with lower interest will develop as a result.
Containing Resultant Inflation
The Government should bite the bullet like it did with GST and correct the near 22% over valuation in one substantial go. It can reset $=Re at Rs 71-72, which is 11% correction.
Monsoon is good throughout the country and agricultural inflation may not be a risk. If in fact there is excess production, a good forex rate might help evacuate some surplus so that domestic prices don’t crash due to oversupply.
In the long term, a 11% devaluation is about $ 40 billion in added inflation. This on a GDP of approx. $ 2400 is about 1.6% – may not be unbearable. But it’s the short temr effect on imported products and their immediate derivatives and next level products.
Oil is the largest at 25% of import bill. Government (state and Central) should put a price cap. Their duties (customs, Excise and VAT together) account for a third of final price. There can be a freeze for 12-18 months in Re-terms on these. Oil marketing companies which have expanded their margins in the last few months can be told to absorb a third and the rest can be passed on. An additional 3.7% inflation on oil will amount to about a 1% on final inflation. Gold and Diamonds are next. We should not bother with Gold (the costlier it is, the better) and Diamond is largely for processing and hence related exports will make up for the input inflation.
That will confine inflation largely to manufactured goods. Most prices today in manufacturing sector are determined by import parity prices. A 10-11% correction would most likely translate into a similar uptick in their prices, which could help several factories (most especially textiles) to start chugging again. In any case, buyers of manufactured goods have had it too good for the last 5-6 years without much inflation.
Protecting the pensioners and interest earners needs to be balanced with the interest of freshers in the job market. The total interest paid on all bank deposits and Small savings and MFs is less than 5.5% of GDP. If we remove the government pensioners and those who have not yet retired from this, it would not be more than 1-2%. The number of those entering the job market and finding themselves without jobs will far outnumber those surviving solely on interest.
Currency correction will also solve a lot of NPA issue. A 10-12% increase in industrial realisations will turn many industrial units from potential NPAs to preforming ones.
Superiority over fiscal stimulus
Currency correction will hit the problem where it is. The dosage at 11% on the total value of trade (both imports and exports) is huge. It will alter the domestic profitability substantially and have an immediate impact – from the following day morning.
Sure forex borrowers will suffer. But those who have covered their exposure need not worry. For those who have not covered or partially covered, they have made good gains for the last 12 years on the trot. Why should not they not be made a pay some back now?
An equilibrium cannot be corrected by fiscal stimulus which will be better for rectifying confidence issues.
(The writer is the author of Making Growth Happen in India, Sage Publications).