Yellow Metal, Yellow Fuel causing Economy Blues

Name: Vibhu Gangal

Institute: Symbiosis Centre for Management and Human Resource Development

A significant reason for the recent fall in rupee is attributed to macroeconomic deficiencies of India. The article below analyses the same and tries to establish a relation between the steep fall of rupee and the general tendencies, trends and situations prevailing in India that affect the economy eventually.

The demand equation states that the aggregate demand (and the national income at equilibrium) is an algebraic sum of consumption demand, investment demand, government expenditure and net exports. The moment we say 'demand', it is backed by money and indicates a destination where people roll out the money they possess. If this money is spent to fulfill any of these demands which add up to the national income, it’s a positive sign. The more this happens, the more the country grows economically, the more is the national income, the stronger is the home currency. One scenario, where possession of money with individuals of a nation can harm the economy, is when the money possessed gets expended big time towards imports, which makes net exports and overall national income negative, leaving the investment demand of the nation unquenchable. A similar thing seems to have happened in India. Let’s take a closer look at its causes and implications.

Consider an analogy, where we have a dam constructed with an aim to irrigate fields. It has some water collected in the reservoir. This water flows to the fields through channels. Thus, it’s the channels which ensure that the water in the dam gets utilized for growing crops and not for domestic purposes of farmers' households. Had the channels being broken and had the water been routed to households instead of fields, crops could never have grown due to lack of water and the production of the territory could have taken a severe hit. The water is equivalent to liquid rupee with the Indians, crops to the GDP, and channels to the government regulations and policies. In India, a major part of money (water) is spent in buying volumes of gold by families (household demand). If gold was available in India, the tendency of buying gold would have created better circulation of money and the multiplier effect would have done well to the economy. Unfortunately, out of 902 tones of domestic annual gold demand, India produces only two tones and the rest 900 tones is imported. 

More the demand for gold, more are its imports, more is the payment in dollars, more is the influx of rupee in forex market, more is the outflow of dollars from forex market, more depreciates the rupee,  more expensive becomes any imported item including gold. This self-feeding spiral continues and raises ringing-alarm-bells when it reaches a stage where RBI cannot save the rupee by adhoc workarounds like selling dollars and "trying" (rather struggling) to induce more FII participation.

Indians have imported gold worth $61.5 billion (or around Rs 341,000 crore) in 2011-12, recording a growth of 44.4 per cent during 2011-12. Same is the case with petrol. A consistent surge in demand eventually causes the same vicious circle of events. Together, gold and petrol are the biggest burden on trade deficit and have worsened current account deficit badly, causing the sharp decline in value of rupee vis-a-vis dollar. The trade deficit during 2011-12 was recorded at $184.9 billion than $118.7 billion during 2010-11 mainly on account of large imports of fuel, gold & silver accounting for 44.4 per cent of India’s imports. Reports suggest that gold imports contributed to almost one third of the incremental rise in Current Account Deficit over the 2008-2011 period.

Directly, gold contributes 0.36% to inflation index. Indirectly, it makes all imports including crude oil costlier fuelling input costs for all industries ranging from plastics to automobiles. If the input costs rise, so have to be the prices of finished products. Eventually it’s the inflation which kicks off. The time lags between rise in gold demand, rise in import prices and rise in end product prices make the three events appear disconnected to the general public and as the "safest" option, we end up blaming the government without any knowledge of ground level proceedings. Arithmetically, every dollar reduction in international oil prices translates into a cut in product price by 33 paisa.But every time the rupee depreciates against the US dollar by one rupee,it translates into a requirement to raise prices by 77 paisa.

Another aspect is, with booming inflation, with industrial products being costlier than earlier, why would a buyer in international market prefer buying Indian expensive goods when the same is available at a lower price in other countries? Together, with imports already being discouraged due to sharp depreciation of rupee, this fall in exports due to inflation exacerbates the trade deficit causing further decline in rupee value. It all gets again into the self-feeding loop discussed above.

So, where do we break this infinite-loop of events where every step, every action has a well justified reason behind it? But somewhere, somehow you need to break this to get things in place. Weakeningor breaking one block might give a temporary relief to figures, but in long run, this would cease growth. Instead, if every link in the chain is made to melt down in terms of its prominence, its just a matter of time, the whole chain shall cease to be prominent. What I wish to convey is instead of unplanned adhoc and short-term steps like giving subsidies on fuel prices and making efforts to attract hot money sources, this nation needs to plan for a durable strategy which would 'subtly' and 'indirectly' bring about relatively stiff and lasting changes in the economy. Here’s what I mean to say…

Whenever individuals hold disposable rupee, government should ensure that substantial part of rupee gets either invested into banks, corporate bonds, government securities and the share market or it gets to quench 'domestic' consumption demand of goods and services. Let’s remember in a dam, it’s the channels which ensure the usage of water in desired way and ultimately govern the production. Whenever it’sexpected to have an enhanced liquidity among individuals, it should be THE time for government to make capital investment attractive. This would trigger the multiplier to take effect and eventually translate liquidity into growth. As far as demand for gold is concerned, it can be discouraged by raising customs duty exorbitantly. Buying gold should be made at least half as tough as buying a scooter was in late 1980s... Even if the demand for gold reduces partially, this would mellow down dollar appreciation and prevent further damage.

On the other hand, the consumer which demands gold and oil so excessively needs to understand that if he chooses deliberately to intensify imports, he is fuelling inflation to such an extent that he himself is going to get in trouble. A major reason for S&P indicating to downgrade India in terms of its investment-grade rating was a drought of investment opportunities in India. With Indian businesses borrowing big-time from foreign sources, with other events increasing imports and causing rupee to depreciate, Indian borrowers will now pay more for every dollar borrowed. With every firm borrowing millions of dollars, the rupee loss is going to be phenomenally huge and shall reflect on a cost-cutting approach by companies' management which shall also include a cut in salaries. Eventually, a self-check on surge of gold demand can help prevent a number of significant things.

Recently, after a lot of hue and cry on oil price hike, the government declared a subsidy on petrol price. I say why? As a long term plan, the government should let the petrol price rise so that vehicular usage takes a hit, even though the hit is marginal. Towns, where bikes and cars are favorites for personal transport, should be picked up and transformed into towns with a quality mass public transport, quality in terms of speed, frequency, availability, ambience, approachability, grievance handling mechanisms and any and every aspect which makes mass transport well-preferred and equal in status vis-a-vis individual vehicles. This shall help in fading the rise in demand for crude oil and so shall prevent the rest of the spiral.

One may say that it’s the gold which facilitates loans and so fosters investment. But one misses to note that at the time of repaying the same loan taken against gold, the value of the money repaid plummets so much that the good done by the investment gets offset substantially by severe inflation, the root cause for the good and the bad being the same. One may say that if investment in India is on a backseat, why doesn't the government invest? But one misses to note that it would be dumb on the government's front to do so, as it is already burdened under a budget deficit of 5.19 percent and any further disbursement of money would widen it more. One may say that subsidies on fuel shall be continued for some more years as the inflation is cost-pushed and not demand-driven. But one misses to note that it’s the demand which drives the entire spiral discussed above and it’s the drive of this demand which ultimately coverts into a cost-push inflation. Thus, it’s high time now that the administration of the nation gets into a patient and consistent mission of correcting the fundamentals of economy at a macro-level with an aim to bring about a long-term change.