Category: Intelligent Investor

India is in a lot of trouble economically now but the government is trying to find a way out of this. Will it be able to?

All of us, while growing up, found economics a boring subject & kept ourselves studiously away from politics. And with time we must have realized that  both of them affect us tremendously

Today, the economy (and not just India’s but the world economy) is in major trouble. We have been discussing a lot about inflation and the falling rupee but all these factors have led to two new problems.

An increasing fiscal deficit and current account deficit.

Here we are making an attempt to explain what they mean and how the government plans to solve these issues.

As always, our first priority is explaining what these two jargons mean.

Deficit is a problem that almost all salaried individuals have faced one time or the other. It is when your expenditure exceeds your income.

The government also faces this problem sometimes. That’s when it is called a fiscal deficit.

Current account deficit is a little more specific, it is the amount by which the country’s import expenditure exceeds export revenue.

Now, these are not new issues at all. India, and for that matter many other countries, face these issues a lot of times. In fact, sometimes this deficit is also encouraged so, what’s the problem now? Why is everyone worrying about this “twin deficit”?

 Why Is There A Twin Deficit Issue?

Well, first, both fiscal deficit and current account deficit are set to reach record highs, especially the current account deficit which could hit a 10 year high soon, according to a report by Morgan Stanley.

Second, these problems coupled with high inflation and falling rupee spell major trouble for us. If the deficit continues to grow and the rupee continues to fall, we soon may not have enough money for fuel imports and other expenses.

But how did we get into this situation in the first place?

The global economic situation is to blame for that. The current Russia-Ukraine war has increased the costs of our imports by a lot. To make these imported products affordable for the public the government has had to waive off import taxes and increase subsidies.

That is the major reason for our fiscal and current account deficit to grow. And thanks to the falling rupee, this deficit will keep growing (because we will have to keep paying more money for the same amount of goods).

So, how can we solve this problem?

Well, the most common way to solve this problem would be to borrow more money. That’s what most economies do. But with countries around the world raising interest rates, borrowing would not be the best option right now (since we would have to pay more interest).

But the government has found another way to boost revenues.

It is now imposing a tax on the export of crude oil. Though this is mainly to increase the supply of fuel in the domestic markets, it will also help boost the government’s revenue.

What’s more, it is also imposing a windfall tax to cash in on the gains made by oil companies due to high oil prices.

Windfall Tax…..

Remember how your parents used to take away the extra pocket money your relatives gave you when you visited? Windfall tax is something like that.

It’s simply a tax on the excess profits made by any company or sector at a given time.

And this windfall tax is set to earn the government somewhere around Rs 67000-Rs 69000 crores, making up for most of the Rs 1 lakh crores, the government lost due to removal of excise duty on oil products.

But this alone obviously won’t help bridge our fiscal and current account deficit. In fact, an export duty will further curb exports increasing our current account deficit.

Government’s Gameplan…..

According to a recent interview of Finance Minister Nirmala Sitharaman, the government is focusing on capital expenditure. Which is basically spending more on building major assets like factories, roadways, and railways.

But then, how will spending more help us?

The age old gospel truth, money attracts more money.

Capital expenditure (or capex if you want to be all cool and jargony) boosts the economy by building assets that generate employment, attract private and foreign investment and open new revenue streams for the government.

By generating more employment they also increase people’s purchasing power, which further increases demand and boosts the economy.

Some facts & figures to substantiate this theory

The numbers claim that every Rs. 1 spent on capex earns Rs 2.45 in the next year and Rs 3.14 in the year after that.

This could help us eventually bridge our fiscal deficit before it becomes a major problem.

However, when the government is more focused on capital expenditure (it aims to spend Rs 7.5 trillion this year), companies often have to cut down on capital expenditure. That is because demand for money in the market increases and more people are willing to lend to the government (because it is more reliable & creditworthy).

So, borrowing costs for companies increase. This means they spend less, so they hire less, kind of bringing us back to square one.

Also, this high capex could increase our inflation problem by injecting more liquidity in the economy.

But promoting growth is also important, otherwise we are just inviting stagflation. As you notice, there are no straight answers for the economic trouble we are in right now.

The government and the RBI will just have to make what they think are the correct moves and wait for the repercussions.

And why just India. Central banks and governments across the world are currently engaged in an intense game of chess with the larger economic forces. And though game theory could potentially predict what the possible outcomes will be, we will simply have to wait and watch to see if we can checkmate inflation or will it knock us down.

Summarizing – GOI is trying really hard to fight its twin deficit problem by imposing new taxes , but new steps are only causing newer problems. It has actually become the proverbial, Hobson’s choice.

The current spurt in inflation could have been prevented. Here are the consequences of not checking this inflation in the first place.

Inflation.

This word has been weighing heavily on the minds of the world’s biggest leaders and economists for quite some time now. And rightly so. After all this record-high inflation is emptying all our pockets faster.

Currently, there’s a lot of debate about whether this inflation could have been predicted and prevented and how it got so out of hand.

Let us look at a recent paper published in the RBI bulletin which makes an attempt to highlight what exactly went wrong.

Factors leading to Inflation….

A lot of economists believe that this inflation was inevitable.

After all, the RBI and other central banks and governments had infused a lot of liquidity in the market during Covid in the form of low interest rates and stimulus cheques.

So, more money was chasing the same amount of goods, thus leading to inflation.

However, the new paper suggests a different reason.

The paper’s authors (who belong to the Department of Economic and Policy Research) claim that unlike what was previously believed, their research suggests high liquidity did not lead to inflation (at least in India) when the economy has slowed down.

At times like these, the demand is low, so more money is not necessarily chasing the same amount of goods (the criteria necessary for deman pull inflation)

So, what led to this sky-high inflation then?

The central banks, “Jaisa chal rah a hai chalne de” attitude.

You see, they thought that the high liquidity which had kept people financially afloat by ensuring that income doesn’t fall and businesses don’t close during Covid, could help sustain economic growth even when we opened up. But this became a problem when we finally went back to normal and the demand for things shot up.

High demand + high liquidity + low supplies due to supply chain crisis = Perfect recipe for record-high inflation.

And the longer the central banks waited to raise interest rates, the higher inflation grew.

Until finally, central banks raised interest rates (not once but multiple times) to make sure we can control it.

And this has worked actually, as our inflation rate has gone down from 7.79 % to 7.04% after two successive rate hikes.

But raising interest rates has led to newer problems.

The whole world has woken up to the inflation threat at roughly the same time. So, central banks everywhere are raising interest rates.

This, plus the high inflation, has caused the rupee to decline. How?

You see, as the US Federal Reserve and other central banks are raising rates, more people are withdrawing cash from India. They will now get a higher rate of return if they invest it in other countries.

Result? Foreign currency is becoming rarer in India.

And this imbalance, just like the imbalance between demand and supply, leads to a lot of issues.

Supply of foreign currency is low, while demand for it is high (thanks to our numerous imports) which eventually leads to foreign currency getting more expensive.

The rupee has hit an all-time low recently of 78.29 as compared to the dollar.

And this is a major problem for us as we import a lot of stuff, especially oil, which is anyway getting more expensive every day.

So, we need to boost the rupee but how?

Don’t you worry, the RBI is working on it.

It is selling dollars from our foreign reserves in the markets to make sure there is an ample supply of the currency and the rupee doesn’t lose its value.

But the problem with this is that dollar reserves are limited.

We’ve already come down to $ 596 billion in reserves from an all-time high of $ 642 billion in September 2021.

And this amount is enough for only 10 months of imports.

The other way to boost the rupee?

Reduce inflation, increase interest rates and strengthen the export industry.

All of this we’re already working on.

Now, only time will tell if these policies will actually be able to help us reduce inflation and boost the rupee or if we’re truly in for a difficult time ahead.

Summarizing: Inflation is out of control because of RBI’s policy of keeping interest rates low even after the economy opened up and even though we have now raised interest rates, the rupee is still tanking.

An analysis as to why do we import majority of our crude oil demand

Oil is precious. But did you know that India’s economy would only continue to grow at an 8%-8.5% rate if oil prices stayed around $70-$75/barrel?

We aren’t saying this, the recently concluded Economic Survey is. But prices won’t go down if the imports (that currently stand at 85% of the oil we need) won’t go down.

And here lies our biggest problem. Curtailing our imports is difficult because our oil production is severely declining.

This month it reached a 28-year low of 28.4 million tonnes (roughly 3,817,204 barrels of oil).

But why is our oil output declining, when the world’s output is rising?

Our perennial Oil challenge….

As far as oil is concerned, India is doomed by mother nature.  The oil reserves that we have are very low as compared to countries like Saudi Arabia.

But they aren’t that low. We have reserves worth 4,728,790,000 barrels , much higher than that of some developed countries like the UK (crude oil output of 1,083,928.37 barrels per day ).

So, why has our production output gone down to 0.08% of our reserves?

The problem here is that we haven’t discovered any major oil wells in quite some time.

Our last major oil well discoveries took place in 2004.

So, why aren’t we exploring? Because not only is exploring difficult, but it is also very costly.

Companies need to invest in high-end tech to make sure they are able to discover oil.

And this expensive process, which also ends up taking years on end, doesn’t always promise results. So, most private companies do not invest much in oil exploration.

Especially because even though they are successful they have to share profits with the government and also have to pay a 20% cess on any crude oil that they produce.

This also increases the costs of domestic crude oil putting producers at a disadvantage as compared to importers.

So, the major burden of exploration falls on state-owned ONGC which is also India’s biggest oil producer, (accounting for 76.7% of all domestic production).

But even ONGC has been unable to explore much. It has become an acquisition machine.

When the Gujarat State Petroleum Corporation wanted to divest off its Deen Dayal Field to avoid a loan default, ONGC stepped in to buy it even though it did not have the tech to extract oil from it.

In 2018, when the government wanted to increase its revenue and meet disinvestment targets, ONGC bought Hindustan Petroleum Corporation Limited from it.

These acquisitions, plus orders from the government to subsidies crude oil products, have put the company in major debt. It currently has an outstanding debt of Rs. 1,23,945 crores.

So, exploration is not an option. What’s the solution then?

Is Partnering with Foreign Companies, the solution…

Many foreign companies have developed tech that has made exploration much easier and faster. That’s how Cairn was able to find an oil field in Rajasthan where even ONGC and other companies could not.

But because of an internal reorganization, India demanded retrospective taxes worth Rs. 10,200 crores from the company.

And when it refused, the government seized dividends and withheld tax refunds (it has since returned these refunds after a court sided with Cairn ).

Such mistreatment could have alienated further foreign participation in India.

But we are trying to rectify this by introducing new laws that make investing in India more lucrative.

Companies can now identify areas they want to explore and bid for them instead of exploring only in government-identified areas.

They are now allowed to pay the government a share in profits only after their initial investment costs have been recovered.

The process of getting exploration and production licenses has also been made easier.

Also, to make sure the development of fields continues despite ONGC’s debt and its slow approach, the government is also privatizing some ONGC owned fields that are lying unused.

After these new rules, some private players have shown an interest in oil exploration. Vedanta pledged $4 billion towards oil exploration this year.

However, given the fact that we have limited resources and a lot of our oil wells are drying up, maybe we should look to exploring alternatives to crude oil.

Like sustainable biofuels made from algae and microbes.

This could help us reduce import dependence until we can go fully green.

Summarizing, India has enough oil reserves to greatly reduce our imports but because companies aren’t looking for it we have to keep importing.