Wednesday, May 30, 2012

Price of financial profligacy

By KK Jain

For the last one year the rupee has been on a continuous fall against the dollar. Its value has gone down from Rs 45 to Rs 55 against a dollar. This downslide has become a major problem for our economy. With this our crude oil import bill has gone up by 20 per cent and has widened our current account deficit putting further pressure on rupee to depreciate. Most of the exporters, including companies offering IT services, had already their receipts hedged and hence they have not benefited from the fall of rupee.

Our political leadership and the Reserve Bank of India are perturbed about the situation. The immediate response of politicians are to direct the focus on the to economic problems in Greece. This response at best is abdication of responsibility. The first step to solve any problem is to own up to it. So long as one feels that someone else is responsible of the problem, no solution can be expected. The RBI, on the other hand, is trying cosmetic measures to make the rupee stronger by offering dollars to oil companies directly so that they do not have to purchase dollars in the open market. Another thing that the RBI is planning to do is to sell US dollars from its foreign exchange reserves to bridge the shortage of dollars. However, these measures would have only a temporary effect as they do not address the root causes for the fall of the value of the rupee.

The first major reason for the fall is due to an increase in the demand for US dollar for import of items like crude, edible oils and other commodities and import of automobiles and their components. The second major reason for fall of rupee is the lack of increase in exports from India. This cause also includes the decline of the industrial growth climate. The third major factor is the sharp reduction in inflow of US dollar by FIIs. These root causes for the fall of the rupee need to be addressed if we want the fall to be arrested or reversed. Simultaneous efforts to address all the root causes need to be initiated. The steps would take substantial time to make an impact. There is no magic wand to get quick and immediate results.

As the economy expands, the need for energy also grows proportionately. Our crude oil import bill has now ballooned to more than Rs 6,00,000 crore per year. We need to find out what can be done to reduce the energy bill for import of crude. One of the alternatives before us is to use more gas (than crude oil) to meet our energy needs. This is because cost of gas per million BTU of energy is ($ 11/mmbtu) which is half of crude oil ($ 22/mmbtu). We have higher deposits of gas, shale gas and CBM than the crude oil reserves. We need to draw out plans to utilise more gas as a source of energy to reduce crude oil imports.

The second alternative to reduce the crude oil requirement is to go for 10 per cent blending of alcohol in petrol. In the US, and many other countries, 10 per cent blending of ethanol is a standard practice, while we have still not implemented even 5 per cent blending of ethanol. We need to take urgent step to exploit both these alternatives. A 10 per cent blend improves the octane rating of fuel by 3 points and hence improves the engine performance. Ethanol blending also reduces pollution.

Import of edible oils is also on a steady rise. The import figures for 2012-13 is now likely to be around 9.6 million tons and is going to cost more than $ 11.5 billion (more than `60,000 crore) at current prices. The imports are continuously rising due to increasing per capita consumption, ever-increasing population and stagnating indigenous production. We need to immediately start technology missions to increase the indigenous production of edible oils to address the issue.

Another reason for the fall of rupee is that exports from India are not rising to cover for increasing imports. Most of the exporters, including ITES companies, have their earnings hedged and the benefit of fall of rupee is going to hedge companies. The decreased profitability of Indian industry and slowing down of new productive investments is also a reason for the fall of the rupee. A reason for this happening is the high interest rates maintained by the RBI. In the last two years the repo rates have been hiked 13 times and have now reached a level where it is affecting the performance of the corporate sector severely. With the decreased profitability outlook for the Indian corporate sector the stock market is down, the money flow by FIIs is now down to a trickle and has widened in the current account deficit further.

With reckless spending of money on non-project items like the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS), food subsidy, fertiliser subsidy, the proposed food security Bill etc, the fiscal deficit is also on a continuous rise. Exposure of largescale scams has also dented our reputation in the world. The confidence of world’s financial institutions in the Indian economy and its growth story is taking a beating. This financial indiscipline is thus another cause for fall of rupee.

Under the situation, when the fiscal and current account deficit both are on a continuous rise, the government’s response to the situation has been more than inadequate. At this juncture we need to restore the confidence of the world’s financial institutions. Our actions, however, are speaking otherwise. The proposed introduction of General Anti-Avoidance Rule (GAAR) and our efforts for amendment of rules with retrospective effect are creating further loss of trust with the world’s financial institutions and investors. Even the existing investors are now looking for going out of India. This is like scoring a self goal in soccer. The outflow of funds by FIIs is further putting pressure on rupee to depreciate. We therefore need to take urgent steps for restoring the trust of financial institutions and the investors. Any positive step in the right direction would be most welcome at this stage.

If simultaneous action on all the fronts mentioned above is initiated, it would help in gradual strengthening of the rupee and may help in containing inflation as well. This is because the falling rupee is closely associated with inflation.

(Views expressed here are the author’s own)

K K Jain is a professor at IBS, Mumbai.

This article is by the courtesy of

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