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Falling Fortune of India

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Rapid decline of the fortune of India in recent months can imply a number of aspects. It can mean the economy is adjusting for the growing inflation in India and the resultant falling export volumes. Or it can mean there is a fear for the greater deficits in balance of payment due to rapidly rising cost of imports of petroleum. It can also mean fear among the so-called short run institutional investors, who have invested through Mauritius, that the government may clamp down on them sooner or later through GAAR (General Anti-Avoidance Rules). It can also mean India is heading for a disaster after having a reckless party financed by foreign borrowing as it had happened in both 1960 and 1991.

Past Mistakes:

A few years ago BJP’s finance minister Jaswant Sinha, in order to enrich his relatives who are financial agents, allowed India’s black money which was taken out of India through hawala channels to come back to India through Mauritius, where is no capital gains tax, as new foreign investments thus avoiding taxes in India but receiving subsidies. Swami Nathan Gurumurthy of the Swadeshi Jagaran Manch has resigned in protest from the ministry. Mr.Gurudas DasGupta said in the parliament that India was losing at least Rs.6500 crores of taxes as a result every year even in 2005. However, the Congress finance minister  Chidambaram refused to take any action and removed the actions taken by the former finance minister Pranab Mukherjee to plug the Mauritius loophole. The same Chidambaram in 2007 has allowed freedom for the foreigners to invest in the stock market and the real estate sector of India. Due to these measures growth rate of India shoot up suddenly since 2007 because of the massive inflows of short term investments, the most volatile component of a country’s balance of payments. Inflation came to India as result.

Current Helplessness:

Former finance minister Pranab Mukherjee decided to plug this Mauritius loop holes by introducing GAAR( General Anti Avoidance Rule), which has created some panic among the financial routers of Mauritius. They have started taking out their money from India, and India’s foreign exchange reserve fell.   Given the fact that about $1500 Billion (according to the media report more than $2500 Billion) of India’s black money, money that have avoided taxes and money obtained bribery and corruptions, were parked in various Swiss banks, a fraction of  that money can change the direction of the exchange rate of Rupee violently by coming back to India as foreign investments via Mauritius or going out of India legitimately as withdrawals  of foreign investments. About 40 percent of India’s total foreign investments are coming via Mauritius i.e., India’s black money coming back to India. GAAR has provoked that withdrawals thus creating rapid depreciation of the exchange rate of Rupee and forced Pranab Mukherjee, as the captains of Indian industry the black money holders insisted, to defer the implementation of GAAR, to leave the finance ministry and to retire from politics.

Structural Factors:

However, there are other structural reasons for the fall of Rupee over the last year. Since 1992 when the `Reform Process`, imposed on India by the IMF and World Bank, had started, Rupee has depreciated by about 70 percent against US Dollar. However, considering the trade pattern of India, Rupee has appreciated in recent years since 2007 against the basket of currencies of six major trading partners of India. That made the Chinese products cheaper in India than in China itself, and India has lost already 36 percent of the employments of its manufacturing industries to China. Thus, a fall of the exchange value of Rupee is beneficial to protect Indian economy against these Chinese invasions, but it is not happening.

Most of India’s import costs, about 80 percent, are due to petroleum. India has deficits in trade. Value of India’s exports in 2011 was of $303 Billion, but the cost of imports was about $488 Billion, thus creating a huge gap, which normally get filled up by remittances of the Indians working abroad and foreign investments. Short- term foreign investments are attracted by the prospect of the Indian economy which used to have a very high growth rate for a few years, but it has gone down since 2011. That has discouraged flows of investments. Increasing price of crude petroleum has increased the cost of India’s imports too.

Foreign investors are worried that due to the deficits in India’s balance of payments, India’s foreign debt, which is now $327 Billion, will go up. With the obligation of current debt service of $85 Billion a year, India may have difficulties to repay the debt, particularly when the short term debt of India is about 22 percent of the total debt. Short term debts can be recalled anytime thus creating a situation of default for India if the reserve of India’s foreign currencies and gold will go down due to continuous deficits in the balance of payments.

Problem in the Financial Market:

However, looking at the international experiences, market expectations may not provide clear signals considering some recent episodes. Interest differentials (the difference between domestic and foreign interest rates, themselves a function of monetary policy and other factors as well) did not widen significantly prior to the Mexican crisis in 1994. Spreads or the difference between the standard interest rate on loans and the enhanced interest rate the borrowing country must pay, on US bonds, or loans from US banks, and Eurobonds, or loans from European banks, appear to have widened only at the time currency pressures were already well under way, instead of providing an early signal of worsening of confidence. In the Asian crisis of 1997-98, spreads hardly increased in the months prior to the flotation of the Thai currency baht, and rose only in late October 1997, four full months after the event.

Considering the debt crisis in Latin American countries, one of the most important policy prescriptions of the IMF was to pursue sound macroeconomic policies especially with reference to fiscal deficits but also keeping an eye on current account deficits that were the counterpart of excessive spending by the private sector.

Problems in Public Finance:

Unfortunately India has not done that in both 1984-89 and in 2007-2011. Recent fiscal deficits in India are caused by two main reasons: reductions of import duties and serious reductions in personal income taxes, both of which have reduced revenues from taxations. At the same time the Government is spending a lot to buy military hardware from Western sources, causing huge expenses and balance of payments deficits.

Today, India is the biggest spender on weapons from Western sources. It was the same in 1980s as well, when India ignoring the fantastic facility USSR provided by accepting Indian Rupee as payment over a period of 50 years without any interest, India started buying military equipments from the Western sources like Bofors of Sweden, Westland of Britain and Dassault of France, thus wasting valuable foreign exchanges. The same is true today. Private sector of India, which is responsible for at least half of India’s foreign borrowing is continuously buying foreign companies, building private palaces in London, or donation millions to foreign universities, thus causing drains on India’s balance of payment

Problems in the Foreign Sector:

Large current account deficits, which are resulted from an overvalued currency after a difficult inflation process as well as the abnormal debt management policy, has caused the accumulation of sizable short-term dollar or Euro or Yen denominated debt. The rapid expansion in the private financial sector had created a situation of poor quality loan portfolios, where the default on these loans are highly likely. Thus, a possible banking crisis is inevitable because the captains of Indian industry avoid paying back their loans and can get away with due to their close contacts with the politicians. These are factors that have exposed India to the risk of exchange rate devaluation and defaults.

If India could keep the current account balance within moderate bounds, with deficits not exceeding 5 percent of GDP,  it would reduce vulnerability to speculative attacks on Rupee by international foreign currency dealers. Speculative attacks are more intense when the deficits are financed by short-term debt or other easily reversible financial instruments like derivatives (bets on financial futures) or shares of Indian companies. These dangers were invited by Chidambaram in 2007 by allowing foreigners to invest in the stock market and the real estate sector.

The experience of the Asian crisis of 1997-98 put privatized financial markets as the main culprit.  In the affected Asian countries, traditional sources of financial crisis were absent. With the exception of Thailand, real exchange rates had not displayed any significant appreciation in the years leading to the crises. Slowdown in export growth had been recorded in some of the economies of the region since 1996, but it had come after several years of very strong expansion and due to the rise of China on the back of the artificially low exchange rate of China. The loan portfolios of financial institutions, on the other hand by contrast, had deteriorated significantly with massive amount of non-performing loans as the private sectors of these South East Asian countries were unable to pay back. Their corporate sectors were excessively indebted and financially fragile, as a result of years of poor management and wrong investment decisions. Weaknesses in the financial and corporate sectors seem to be the only common factor in all these  affected countries in the region. The crisis then was intensified by the herd behavior of the private foreign investors, not only in terms of joining in the stampede out of a currency but also in their propensity to flee from other countries in South East Asia. The situation is the same in India today.

The vulnerability of an economy to a balance of payments crisis increases significantly when the level of international reserves is inadequate, which was the case during the 1980s in India but not today. Even if the currency is not fully convertible or purchases of foreign exchange are restricted, the money supply could fuel the demand for foreign currency through parallel markets of the black money holders, through the `Hawala` traders, or through rough banks like HSBC. Thus, level of liquid money, legal or illegal,  in the country, which is the source of inflation in India,  is a natural measure of potential demand for foreign currency from the domestic private commercial sector. This is particularly true after the arrival of foreign banks, foreign institutional investors and foreign companies in partnership with the Indian private sector. As a result, the Reserve Bank of India has lost control over the flows of money in or out of the country

Foreign Debt:

The volume of both foreign debt payments and domestic debt payments coming due in the short term is an appropriate yardstick to judge whether the level of reserves is adequate. When both domestic and foreign investors are holding the “domestic” debt or bonds issued in the domestic financial markets, the distinction between domestic and foreign debt becomes blurred, as it is now in India since 2007, when foreign investors are allowed to invest in the domestic financial market in India. The Reserve Bank of India now does not know whether its foreign exchange reserve is adequate to meet the demand for repayments of short tern debts, foreign or domestic, private and public.

There are obvious advantages of a devaluation of Rupee for the export oriented industries in India that they can increase their competitiveness in the world market. Other industries may benefit due to higher import costs and the consumers may switch to ‘Made in India’ products rather than buying Chinese. However, all these advantages can be negated if there is a speculative attack on the Rupee created by the international currency dealers and as a result, short term investors will withdraw their investments. Fear of forthcoming recession in Europe and higher international price of petroleum due to deteriorating condition in the Middle East may trigger such a move. The recent decision of Warren Buffet to withdraw his investments from HDFC is the early signal.

Solutions:

For the solution, in the short term, all liberalization measures taken since 2007 must be reversed back; all loopholes of money launderings through Mauritius by India’s bribe takers and black money holders must be plugged in by implementing GAAR irrespective of the opinion of the captains of Indian industry;  unnecessary expenses by the Indian corporate sector must be curbed; sovereign guarantee for the debt made by the Indian corporate sector should be abolished; revenue collection by the government should be enhanced by increased personal and corporate income taxes; new taxes should be introduced to include property, inheritance, gifts and excessive luxury consumptions; tax base should be enhanced by making agricultural income and land holding taxable. India government must make serious efforts to get back the illegal money holding in the Swiss Banks; unpaid loans taken from the Indian banks and unpaid taxes. Rather than waiting for the IMF to force it, India should devalue Rupee by 30 percent immediately and impose a fixed exchange rate with exchange control so that short term investors cannot take their money back immediately.

For the long run solution, it is essential to look at the composition of India’s balance of payments. Military and non-military spending should be from non-Western sources like Russia and Eastern Europe to reduce the costs. A new transport policy, away from road transport and private transport, should be implemented to reduce the level of petroleum consumption. Increased and better public transport, redesign of the cities, reduced freight rates of railways, increased emphasis on both nuclear and solar energy also can help India greatly. Automobile running on electricity and hybrid vehicles also can reduce India’s petroleum consumption, which is the most important cost of imports.

As in 1984-89 India government has the emphasis only on the growth rate of the economy and forgot about the danger of borrowing from abroad to enhance these growth rates. During 1984-89 India had achieved very high growth rate of more than 10 percent per year, but as soon as the foreign exchange facility provided by the Soviet Union disappeared in 1991, India was unable to repay its debt. The same situation may develop soon for India if the foreign investors suddenly go away along with their investment and there will be a rapid fall of the India’s foreign exchange reserve. It is essential to accept that the financial liberalization introduced by Chidambaram in 2007 has created a bubble in the Indian economy with the resultant very high inflation, which is eroding India’s competitiveness in the international market by making India’s exports very expensive with rising cost of production and increasing debt of the India’s corporate sector. The only way out is to reintroduce sanity and put emphasis on job creation rather than just growth rates through a proper investment planning. Capitalism for the last 20 years failed to reduce the number of very poor people in India, who are now almost 90 percent of the population.

Nearly hundred years ago, in 1929, Jawaharlal Nehru said the AITUC gathering that, ” It is the system that is wrong, the system that is based on the exploitation of the few and the prostitution of labour….. if you would do away with this system you will have to root out both capitalism and imperialism and substitute a saner and healthier order. You will not rejoice if a handful of Indians draw bigger dividends and your miserable conditions remain”. Unfortunately, since the assassination of Mrs. Indira Gandhi, India has gradually lost its way and now in the wilderness of a failed economic system introduced 20 years ago.

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Written by

I am now Professor in International Economics in Nagasaki University Japan. I did my PhD on model building for development planning in the University of Birmingham, UK. I was then Research Officer in Department of Applied Economics in Cambridge University and Lecturer in the Institute of Agricultural Economics in Oxford University. I have published 8 books and more than 70 papers in academic journals on economics.


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One Response to "Falling Fortune of India"

  1. Anand says:

    Another socialist article. How many socialist countries should fail before you realize that socialism doesnt work?

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