The Trouble with Economic Forecasting is…

PricingSometime in May last year, I wrote a column for a digital publication, in which I said that the Modi government’s luck on the oil front would run out in 2015-2016. As is wont in such cases, I was more than a little vague about exactly when would the Modi government’s luck on the oil front run out.

I was just trying to follow an old forecasting rule: “forecast a number or forecast a date, but never both”. So, I sort of forecast a date. Honestly, I was wrong about it. The Narendra Modi government’s luck on the oil front continued through 2015.

Nevertheless, things have started to heat up in the recent past. Since February 12, 2016, the price of the Indian basket of crude oil has gone up by around 75%. As on May June 2, 2016, the price of the Indian basket for crude oil was at $46.83 per barrel.

This isn’t a column on trying to defend, what was a largely wrong forecast. What I want to explore in this column is the basic point about forecasting being a very difficult thing to do. While it’s always easy to explain things in retrospect, it is very difficult to predict how things will play out. And it is even more difficult to predict when things will play out, the way you expect them to play out.

Let’s take the basic forecast of oil prices going up. I was right about the point that when oil prices start to go up, the luck on which the good fortunes of the Modi government are built will start to run out. I will not explain it again here, given that I have explained it, often enough in the past, and perhaps might do it again, in the days to come.

Nevertheless, I got the timing wrong, despite making a very open ended forecast. There are two basic points to making a forecast—one is you expect the trend to continue—the other is you do not expect the trend to continue.

I expected that the trend of lower oil prices would not continue. While I have been right about that, but I have been wrong about the timing.

But what about forecasts, where economists and analysts, expect a trend to continue. Take the case of what economist Arvind Panagariya wrote in India—The Emerging Giant, a book that was published in 2008: “India has been growing at an average annual rate exceeding 6 percent since the late 1980s. During the four years spanning 2003-2004 and 2006-2007, its growth rate reached 8.6 percent—a level close to that experienced by the East Asian miracle economies of the Republic of Korea and Taiwan during their peak years. As the book goes to press, fears that the economy is overheating can be heard loudly, but virtually no one is predicting a significant slowdown in the growth rate in the forthcoming years.”

Panagariya, like most economists, did not see the financial crisis, coming. He also, like most economists, thought the current trend would continue. But that did not turn out to be the case. Also, most economists find it easier to say what other economists are saying. This is because if and when they are wrong, then they are wrong in a majority.

And it is safe to be wrong when everyone else is wrong. Nevertheless, if one economist forecasts something which goes against the trend and is wrong about it, then only he has to bear the consequences of being wrong. Life is easy, when everyone is wrong, and hence it makes sense to go with the herd.

Let’s take another example here of the economist Milton Friedman and the prediction he made when the price of oil started to go up in the early 1970s.

In January 1974, the Organisation of Petroleum Exporting Countries(OPEC) raised the price of oil to $11.65 per barrel. This was after OPEC’s economic commission had determined that the price of oil should be $17 per barrel.

It was around then that the economist Milton Friedman wrote in a col­umn in the Newsweek magazine where he predicted that “the Arabs … could not for long keep the price of crude at $10 a bar­rel.” For this prediction, Friedman was awarded the Booby Prize by the Association for the Promotion of Humour in International Affairs
The price of oil was quoting at more than $18 a barrel by the end of 1979. And by early 1981, it had risen four-fold and was quoting at nearly $40 a barrel. Friedman had been proven wrong for a long period of time.

In 1986, finally the price of oil was quoting again at $10 a bar­rel. And Friedman wrote a “I told you so” column in an issue of the Newsweek magazine which appeared on March 10, 1986. The column was titled “Right at Last, an Expert’s Dream.” This, of course, was in jest. As Friedman confessed, “Timing, as well as direction, is important…I had expected the price of oil to come down far sooner.”
Now does that mean that it makes sense to go against the herd? I wish I could say that. Over the last few years, a huge number of gold bugs have been coming out of the woodwork and predicting that gold prices will rise again. While, gold has done reasonably well in the recent past, a sustained rally in the yellow metal hasn’t been seen as yet.

So, next time you hear an analyst or an economist, make a forecast, with great confidence, it might be worth remembering that old saying in economics: “economists have predicted nine out of the last five recessions”.

The column was originally published on June 7, 2016

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Why oil prices have fallen by 63% and petrol prices by only 17%

light-diesel-oil-250x250One good news for the Indian economy during this financial year has been the huge increase in indirect tax collections. Customs duty, excise duty and service tax together form the indirect taxes collected by the central government.

Data released by the ministry of finance earlier this month showed that indirect taxes as a whole have grown by close to 36%, during the course of this financial year (April to October 2015). The accompanying table provides a breakup of the different kinds of indirect taxes collected during the course of this financial year.

Indirect Tax Collection:  April- October 2015

(Rs. in crores)

Tax Head

 

 

B.E.

2015-16

For October Up-to October % of BE achievement
2014-15 2015-16 % Growth 2014-15 2015-16 % Growth
 Customs 208336

 

16800 18998 13.1 104831 122448 16.8 58.8
Central Excise* 228157

 

13569 22550 66.2 87588 147685 68.6 64.7
Service Tax 209774

 

12528 17143 36.8 89379 112727 26.1 53.7
 

Total

 

646267

 

 

42897

 

58691

 

36.8

 

281798

 

382860

 

35.9

 

59.2

*Exclusive of cess administered by other departments.

What is interesting is that customs duty, central excise duty as well as service tax collected have grown at very good rates. The increase in the collection of indirect taxes between the end of 2013-2014 and the end of 2014-2015 had been just 9.1%. Also, the government failed to meet the indirect tax target of Rs 6,24,902 crore in 2014-2015. It managed to collect only Rs 5,42,325 crore.

Also, the indirect taxes collected during the course of this year up until now indicate that the government seems all set to meet its target of Rs 6,48,418 crore. This target is an increase of 19.6% in comparison to the indirect taxes collected during the last financial year.

Given that the indirect taxes collected have grown by 35.9% this year, meeting the indirect taxes target for this year, should not be a problem at all. As finance minister Arun Jaitley said earlier this month: “One of the greatest positives I can see is a huge increase in indirect tax revenues.”

The question is how genuine and sustainable is this massive growth in indirect taxes. As the ministry of finance press release put out earlier this month points out: “These collections reflect in part increase due to additional measures taken by the Government from time to time, including the excise increases on diesel and petrol, the increase in clean energy cess, the withdrawal of exemptions for motor vehicles, capital goods and consumer durables, and from June 2015, the increase in Service Tax rates from 12.36% to 14%. However, stripped of all these additional measures, indirect tax collections increased by 11.6% during April-October 2015 as compared to April-October 2014.”

Once we take these factors into account the rise in indirect tax collections is a much muted 11.6%. To be honest, the finance minister Jaitley acknowledged this recently.

The 68.6% jump in central excise duty is the main reason behind the massive jump in indirect tax collections. In fact, the jump in excise duty makes up for close to 60% of the overall jump in the indirect taxes collected this year.

This jump has primarily come due to the government increasing the excise duty on petrol and diesel five times between last year and now. In fact, the latest increase in excise duty on petrol and diesel came about earlier this month.

With these increases in excise duty on petrol and diesel, the government has more or less fully captured the fall in oil prices for itself, and not passed it on to you and me. A litre of petrol currently costs Rs 68.13 per litre in Mumbai. It was at Rs 80 per litre around the time, Narendra Modi was elected to power in May last year.

Between then and now, the petrol price has fallen by just 17.4%. In comparison, the price of the Indian basket of crude oil has crashed by 63%. On May 26, 2014, when Narendra Modi was sworn-in as the prime minister of India, the price of the Indian basket of crude oil was $108.05 per barrel. On November 16, 2015, the price was at $39.89 per barrel.

This clearly shows that the government has captured almost all the benefit of falling oil prices. A 63% fall in the price of oil has led to just a 17% fall in the price of petrol in Mumbai.

There are multiple problems with this approach.

The government talks about having dismantled the administered price mechanism on the pricing of petrol and diesel. But that is clearly not the case. A fall in oil prices does not immediately lead to a fall in petrol and diesel prices. The government has captured the fall by increasing the excise duty on petrol and diesel.

Further, the government has become heavily dependent on the revenue coming in from an increase in excise duty on petrol and diesel. What will it do if and when the oil price starts to go up? Will it cut the excise duty in order to ensure that price of petrol and diesel does not rise? Given that it did not pass on the benefits of a fall in the price of oil to the end consumer, isn’t it only fair that it shouldn’t be passing on the increase as well?

Also, it is worth remembering here that trying to forecast the price of oil remains tricky business.  As Philip Tetlock and Dan Gardner write in Superforecasting—The Art and Science of Prediction: Take the price of oil, long a graveyard topic for forecasting reputations. The number of factors that can drive the price up or down is huge—from frackers in the United States to jihadists in Libya to battery designers in Silicon Valley—and the number of factors that can influence those factors is even bigger.”

Further, if it cuts the excise duty, as and when the oil price goes up, it will have to borrow more and that will create its own set of problems. The fiddling around with excise duty on petrol and diesel, shows a lack of a stable policy on the tax front. The finance minister Arun Jaitley has often outside India talked about a stable tax regime for foreign investing in India. Why forget us Indians, who live in India?

Another impact of this massive increase in indirect tax collections has been the junking of the disinvestment programme, though no politician will admit to the same. At the beginning of the year, the government had set a disinvestment target of Rs 69,500 crore. But that is not going to be achieved. Meanwhile, the government will continue to waste the taxpayer’s hard earned money on dud companies like MTNL and Air India. Minimum government and maximum governance will continue to remain a slogan.

On the good side, the fiscal deficit number will look better than 3.9% of GDP it was projected at, in the budget document.

The column originally appeared on The Daily Reckoning on November 18, 2015

 

Busted: The ‘biggest’ myth about Indian exports

3D chrome Dollar symbolOne of the economic theories (I don’t know what else to call it) that often gets bandied around by almost anyone who has anything to say on the Indian economy, is that India’s economy is not as dependent on exports as the Chinese economy is. Honestly, given that China and the word “exports” are almost used interchangeably these days, it sounds true as well. Nevertheless, that is clearly not the case. While this may have been true in the 1990s, the most recent data does not bear this out.

Let’s look at exports of goods and services as a proportion of the gross domestic product (GDP, a measure of the size of the economy) of both these countries. In 1995, the Chinese exports to GDP ratio had stood at 20.4% of the GDP. The Indian exports to GDP ratio was around half of that of China at 10.7% of the GDP.

In 2014, the Chinese exports to GDP ratio had stood at 22.6% of the GDP. On the other hand, the Indian exports to GDP ratio was at 23.6% of the GDP. Hence, as a proportion of the size of the economy, Indian as well as Chinese exports are at a similar level. And that is indeed very surprising. It is not something that one expects.

As Rahul Anand, Kalpana Kochhar, and Saurabh Mishra write in an IMF Working Paper titled Make in India: Which Exports Can Drive the Next Wave of Growth?: “India’s exports have been increasing since the early-1990s – both as a share of GDP and as a share of world exports. Total exports as a share of GDP have risen to almost 25 percent in 2013 from around 10 percent in 1995. Likewise, Indian goods exports as a share of world goods exports have risen, with the share almost tripling to 1.7 percent during 1995-2013. A similar trend is visible in India’s services export – the share tripling to over 3 percent of world service exports during 2000-2013.” Computer services form around 70% of India’s services exports, which forms around one third of India’s total exports.

What these data points clearly show us is that the theory that India is not dependent on strong exports for a robust economic growth, is basically wrong, as exports now amount to nearly one-fourth the size of the Indian economy.

The Indian exports have been falling for the last nine months. In August 2015, the exports were down by 20.7% to $21.3 billion. Twenty three out of 30 sectors  monitored by the ministry of commerce saw a drop in exports in August 2015, in comparison to August 2014. Exports for the period of April and August 2015 stood at $111 billion and were down by 16.2% in comparison to the same period last year. Hence, there has been a huge slowdown in exports during the course of this financial year as well.

A major reason for the same has been a fall in commodity exports. As Chetan Ahya and Upasana Chachra of Morgan Stanley write in a recent research note titled What is Driving the Sharp Fall in India’s Exports?: “Persistent downward pressure from commodity prices has undoubtedly put pressure on commodity export growth (in value terms). Indeed, commodity exports (including oil), which account for 33% of India’s total exports, have been declining since Jul-14.”

Commodity prices have been falling because of a slowdown in the Chinese economic growth. China consumes a bulk of the world’s commodities.
Not many people would know that refined petroleum oil, much of which is exported out of the state of Gujarat, forms around one fifth of India’s exports.

Hence, while India benefits immensely due to a fall in the price of oil, given that we import 80% of what we consume, there is a flip-side to it as well.
Further, in India’s case, export of services, in particular computer services, has played a major role in driving up the exports over the years. The same cannot be said about India’s manufacturing exports. As Anand, Kochar and Mishra point out: “[India’s] services exports, as a share of total exports and in terms of sophistication, are comparable to high income countries, the share of manufacturing exports and their level of overall value content are still low compared to its peers, especially in Asia.”

The reasons for this are well discussed. They include an unpredictable tax regime (which the government keeps promising to correct), complicated labour laws and land acquisition policies, inspector-raj and a shaky physical infrastructure.

And this best explains why unlike China, India’s manufacturing exports are not a major part of its goods exports. As Anand, Kochar and Mishra point out: “For example, in 2013, manufacturing exports accounted for 90 percent of total exports in China, almost double the share during 1980-85. Indian exports have also undergone transformation during the decade of high growth, though to a lesser extent compared to peer emerging markets. The share of manufacturing in total merchandise exports has increased to 57 percent in 2013 from 41 percent in 1980.”

Also, given the problems an entrepreneur faces in India, in getting a manufacturing unit going, India’s share in global goods exports may have plateaued as far back as 2012. Data from Morgan Stanley suggests that India’s good exports as a proportion world goods exports has plateaued at around 1.7%.

As Ahya and Chachra of Morgan Stanley point out: “India’s market share in exports of goods for which we have monthly data has declined marginally over the last 12 months but has remained largely flat since 2012…The structural bottlenecks in the form of inadequate infrastructure, outmoded labour laws, a cumbersome taxation structure and systems, and poor ranking in terms of overall ease of doing business are probably making it harder to make gains in market share at a time when external demand has been weak and excess capacities in competitor economies have rise.”

And this is something that cannot be set right overnight.

The column originally appeared on The Daily Reckoning on Sep 28, 2015

Random ruminations on acche din and oil price

narendra_modi
One of the more interesting books that I have read this year is Humphrey B Neill’s
The Art of Contrary Thinking. The book was first published in the early 1950s and remains in print till today. One of the things that Neill talks about in the book is propaganda. Propaganda is essentially the official communication of a government to the public, which is designed in a way so as to influence public opinion.
As per Neill, propaganda that is “brought down to the level of a school child” works the best. Take the case of George Bush Junior and the American attack on Iraq. The American government propaganda(along with some help from the British) justified the attack on the ground that Iraq had weapons of mass destruction, which the country never did.
As Tim Vanech writes in the introduction to Neill’s book: “governments who wish to go to war prepare their case and go about manipulating the masses into required support.” The American government manipulated its masses by putting out the story of weapons of mass destruction in Iraq to justify the attack. The story worked because it was so simple that even a “school child” would have understood it—the Americans were the good guys going out there to save the world by killing the bad guys in Iraq. And who doesn’t want to listen to and believe in such a heroic tale?
In fact, all communication that works is normally very simple and is dumbed down to a level of a school child. Take the case of Narendra Modi’s election slogan — “
Achche din aane waale hain, hum Modi ji ko laane waale hain.” The fact that the slogan was as simple as it was, was a major reason for its success.
In an economic environment which was extremely negative because of high inflation and slow economic growth, the positive slogan caught the imagination of the nation. Neill quotes another writer Gustave Le Bon, who wrote
The Crowd: A Study of the Popular Mind, as saying: “Given to exaggeration in its feeling, a crowd is only impressed by excessive sentiments”. And the “excessive sentiments” in acche din aane waale hain influenced voters across large parts of India.
In fact, the slogan was not even original. It was lifted from Franklin Roosevelt’s election slogan in the 1932 US presidential elections “
Happy Days Are Here Again.” The 1932 election was fought when the Great Depression was at its worst, and Roosevelt’s slogan offered a lot of hope to people and it worked. Roosevelt won and continued to remain President till 1945 (those were days when the two term limit for a US president did not apply).
What worked for Roosevelt, worked for Modi as well and in the 2014 Lok Sabha elections, the Bhartiya Janata Party won 282 seats. The slogan worked because the people believed in it. They believed that “happy days” were about to come. And Modi like a quintessential politician never explained anything, but promised everything. But all that was nearly one year ago. What the “
acche din” slogan also did was that it set the bar very high for Modi. And now one year later, whenever anything negative happens, people are likely to ask (and are asking): “kahan hain acche din? (where are the happy days?)”
A Facebook friend recently wrote about his experience of visiting a petrol pump and the petrol pump attendant asking him: “
sahab kahan aaye ache din? (Sir, where are the good days?)” He was referring to the price of petrol and diesel having gone up over the last one month. Petrol prices in Mumbai have gone up by more than 11% since mid April to a little over Rs 74 per litre.
And this is where the
acche din slogan is likely to cause problems for the government if oil prices keep going up in the months to come. The price of the Indian basket of crude oil has gone up by 52% since mid January 2015. As on May 15, 2015, the price of the Indian basket was at Rs 4,097.73 per barrel.
When the oil prices were falling between May 2014 and January 2015, people close to the government even credited this fall in price to Narendra Modi. As a February 2015 editorial
in the Business Standard had pointed out: “The president of the ruling party, Amit Shah, for example, repeatedly took credit on the campaign trail for lower prices, as did the Union home minister, Rajnath Singh. Even the prime minister has mentioned lower fuel prices, though he has specified that it is because of his “luck”.”
In some conversations that I had (along with some material shared over the social media) I realized that many people seemed to believe, that the Modi government has brought down petrol and diesel prices.
Those who believed that the government was responsible for bringing down the price of petrol and diesel, will now ask—if the government can bring down the price of petrol and diesel, it can also ensure that their prices do not go up. And they will also ask, “
kahan hain acche din?” if prices continue to go up.
In fact, things are likely to get difficult for the government as and when the price of petrol and diesel crosses the May 2014 level. In May 2014, the price of diesel in Mumbai was Rs 65.21 per litre and that of petrol was Rs 80 per litre. If oil prices maintain their recent rise these levels will be breached very quickly.
The government can control this price rise by cutting the excise duty on petrol and diesel. Since October 2014, the government increased the excise duty on petrol and diesel four times. This was done to spruce up the revenues of the government and control the burgeoning fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. What it also meant was that a dramatic fall in the price of oil was not passed on to the end consumer.
Once the petrol and diesel prices cross the May 2014, the pressure on government to control their price will go up. What will not help is the fact some of the top BJP leaders (Modi and Smriti Irani to name two) used the social media extensively in the years running up to May 2014, to criticize the petrol and diesel price hikes carried out by the Congress led UPA government. Also, Bihar elections scheduled for later this year will play a role on this front as well.
My guess right now is that if the oil price continues to rise, the government will have to start cutting the excise duty on petrol and diesel, if they want to ensure that people don’t start asking: “where are the
acche din?”. Let’s see how this goes.

The column appeared on The Daily Reckoning on May 19, 2015

Is Modi’s luck on oil running out?

narendra_modi
In mid April earlier this year, the finance minister Arun Jaitley spoke at the Peterson Institute, a Washington based think tank.
In his speech, Jaitley said that in late 2013, India was “teetering” and was “on the edge of a macro-economic crisis”. “Inflation was at double-digits, the current account deficit at 4 percent of GDP, growth was decelerating sharply, investor confidence was evaporating, capital was fleeing the country, the rupee was plunging; fiscal deficits were high; and India was reeking with the odour of corruption scandals and weak governance,” Jaitley went on to add.
After the Narendra Modi government came to power, most of these economic problems have been corrected, Jaitley said during the course of his speech. Jaitley further said that: “A budget…which reinivigorates growth by emphasizing public investment while maintaining fiscal discipline and protecting the vulnerable,” was passed.
What Jaitley, like a good politician, missed out on saying was that a lot of economic factors improved simply because the oil prices crashed. On May 26, 2014, when the Narendra Modi government took oath of office, the price of the Indian basket of crude oil was at $108.05 per barrel. It fell by around 60% to $43.36 per barrel by January 14, 2015.
This rapid fall in the price of oil helped set many economic factors right. India imports close to 80% of its oil requirements. As the oil price fell, oil imports came down in dollar terms bringing down the current account deficit. In technical terms, the current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Or to put it in simpler terms, it is the difference between outflow (through imports) and inflow (through imports and foreign remittances) of foreign exchange.
Further, oil is bought and sold in dollars. When Indian companies buy oil, they need to pay in dollars. This pushes up the demand for dollars and leads to the value of the rupee falling against the dollar. When oil prices rise, Indian companies need more dollars to buy oil. And this in turn puts a greater amount of pressure on the value of the rupee against the dollar. With oil prices falling dramatically, the total amount of dollars needed to buy oil also fell. This, to some extent, stabilized the value of the rupee against the dollar.
Falling oil prices even had an impact on the fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. When the oil prices were rising the Congress led UPA government did not allow the oil marketing companies (Indian Oil, Bharat Petroleum and Hindustan Petroleum) which sell oil products, to sell them at a price at which it was financially viable for them to do so.
In the process they incurred under-recoveries. The government along with oil production companies like ONGC and Oil India Ltd, compensated the oil marketing companies for these under-recoveries. This led to the government expenditure going up and in the process the fiscal deficit also went up. A higher fiscal deficit leads to the government borrowing more, in the process pushing up interest rates, as the amount of money that others can borrow comes down.
Falling oil prices also had some impact on taming rampant double digit inflation.
In his Washington speech Jaitley took credit for all of the above economic factors improving because of the change in government. Nevertheless, falling oil prices had a huge role to play in the improvement on the economic front, Jaitley’s speech notwithstanding.
Oil prices have been rising in the recent past. On March 31, 2015, the last day of the financial year 2014-2015, the price of the Indian basket for crude oil was at $53.64 per barrel. On May 8, 2015 (the most recent data point available), the price of the Indian basket of crude oil was at $64.05 per barrel. Hence, the oil price has risen by close to 50% from mid January 2015 onwards.
What does not help is the fact that one dollar is now worth close to Rs 64. This means that the Indian companies buying oil will have to pay more. As long as they are able to pass this on to the end consumers of oil products like diesel and petrol, it does not really matter. But what if they are not?
In October 2014, the government had deregulated the price of diesel, allowing the oil companies to set the price of diesel depending on the prevailing international price of oil. Interestingly, the government used the fall in oil prices as an opportunity to shore up its revenues from oil by increasing the excise duty on petrol and diesel multiple times.
At close to $64 per barrel, the price of oil is still around 41% lower than where it was on May 26, 2014, when the Modi government took oath of office. Nevertheless, the price of petrol in Mumbai is at Rs 70.84 per litre, only 11.5% lower from the time when the Modi government came to power. The price of diesel is 12.8% lower.
The real test of deregulation will come if the price of oil keeps going up and the price of petrol and diesel cross the levels they were at when Narendra Modi came to power. In fact, the oil minister
Dharmendra Pradhan recently said: “The subsidy-sharing formula…can be extended…if the current market situation prevails.” He was referring to the compensation paid by the oil production companies like ONGC and OIL to the oil marketing companies. The compensation has come down because of the fall in the price of oil. The oil production companies still continue to compensate the oil marketing companies for the under-recoveries suffered on selling cooking gas etc.
But what Pradhan did not say is what happens if the current market situation does not prevail and the oil prices continue to go up? Will the compensation provided by the oil production companies go up? This would mean that the government would force the oil marketing companies to sell oil products like diesel and petrol at an unviable price.
It would also mean that the government would have to share the compensation provided to the oil marketing companies for their under-recoveries, with the oil production companies. It would lead to a higher fiscal deficit. Rising oil prices will also put pressure on the current account deficit as well as the value of the rupee against the dollar. Inflation will also go up to some extent depending on how much increase in the price of oil is allowed to be passed on to the end consumer. A higher inflation will mean that the Reserve Bank of India will not cut interest rates.
To conclude, the Modi government was very lucky with the price of oil falling by 60% between May 2014 and January 2015. That luck might now have started to run out, as it completes its first year in office.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on DailyO on May 11, 2015

Fiscal deficit is not for our grandchildren to repay: Here’s why I agree with Arun Jaitley

Vivek Kaul

In my past columns I have been critical of finance minister Arun Jaitley for saying things that he has. Take the case of people not buying as many homes as they were in the past. Like the real estate industry in India, the finance minister seems to believe that Indians are not buying homes simply because interest rates and EMIs are on the high side. “If you bring down the rates, people will start borrowing from banks to pay for their flats and houses. The EMIs will go down,” Jaitley had said in December 2014.
This as I have explained more than a few times in the past is the wrong argument to make. The EMIs simply don’t matter any more when it comes to buying homes—Indians are not buying homes because homes prices are way beyond what they can afford given their income levels. Figuring this out isn’t exactly rocket science and given this, the finance minister of the country shouldn’t have been making such statements.
Nevertheless, for once I agree with Jaitley. He recently told an industrial gathering: “The whole concept of spending beyond your means and leaving the next generation in debt to repay what we are overspending today is never prudent fiscal policy.”
As Mihir S. Sharma writes in his new book
Restart—The Last Chance for the Indian Economy: “Economics has very few real laws. In fact, it only has one, but that one is of iron: you cannot spend more than you earn forever.”
Typically governments spend more than they earn and thus run a fiscal deficit. This deficit is financed through borrowing. When the borrowing keeps piling up, it needs to be repaid by taxes paid by future generations(our children and their children). And that can never be a prudent policy. The fact that Jaitley understands this (or at least says so in the public domain) is a good thing. It will work well for him during the process of formulation of the next budget which is scheduled to be presented on the last day of this month.
It has been suggested that the finance minister should not bother much about the fiscal deficit while presenting the next financial year’s budget. He should unleash a public investment programme in order to ensure that the Indian economy grows at a much faster rate in the years to come, than it currently is.
Leading the increase in public investment charge is
 Arvind Subramanian, the Chief Economic Adviser to the ministry of finance. In the Mid Year Economic Analysis released in December 2014, Subramanian wrote: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.”
This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing. In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
A major reason being offered in favour of the government increasing public investment is the fact that oil prices have crashed. As on February 6, 2015, the Indian basket of crude oil was priced at $$55.62 per barrel. On May 26, 2014, the day the Narendra Modi government took oath of office, the oil price was at $108.05 per barrel. Hence, the price of Indian basket of crude oil has fallen by 48.5% since then.
This fall has ensured that the amount of money that the government would have had to pay out as subsidy to oil marketing companies has come down. Oil companies suffer from under-recoveries while selling kerosene and cooking gas. The government compensates them for a part of this loss. Further, it is being assumed by analysts and economists that oil prices will continue to remain low and this will help the government limit the oil subsidy payout in the next financial year.
With the oil subsidy payout being limited the government can spend more money on public investment is a theory that has been put forward.
As analysts Neelkanth Mishra, Ravi Shankar and Prateek Singh of Credit Suisse write in a research report titled
FY16 Budget: From famine to feast and dated January 27, 2015: We believe that the government can raise capex[capital expenditure] by at least 1.2% of GDP in FY16E. It is pocketing a large part of the gains from the oil price decline, and can spend to generate growth.”
This is a reasonable assumption to make if the current state of affairs continues. But as I have often pointed out in the past forecasting oil prices is a risky business. There are too many variables at play, especially politics. And once politics enters the equation, normal demand-supply analysis goes out of the window.
As Eric Jensen writes in writes in 
The Absolute Return Letter for January 2015 titled Pie in the Sky: “ “It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window.” The Saudi Arabia and the OPEC, the United States, Russia and many other countries are players in this political game.
Also, it is worth remembering that budgets of countries that produce oil are not balanced at the current level of oil prices. As Eric Jensen writes in The Absolute Return Letter for February 2015 titled
The End Game:The one additional dynamic to consider is the large fiscal deficits in most oil producing countries which is only made worse the further the price of oil drops. Clearly the biggest risk factor in this context is Russia which needs an oil price of around $105 to balance its budget this year.”
Countries typically borrow money when their expenditure is more than their earnings. But as Jensen puts it: “It is a fact that virtually none of the world’s leading oil producing countries have as easy access to bond markets as we are used to in this part of the world.” Hence, low oil prices are hurting oil producing countries the most.
Given this, it is in their interest to ensure that oil prices start rising again in the days to come. In fact, oil prices have been rising from mid January onwards. The price of the Indian basket of crude oil as on January 14, 2015, was at $43.36 per barrel. Since then it has risen by 28.3% to $55.62 per barrel.
Hence, it is important that Arun Jaitley and his team while making the budget make a conservative estimate for the oil price and not get carried away by the recent low levels.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.firstpost.com on Feb 10, 2015 

Lesson from the rouble crash: Don’t put all your eggs in one basket

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Vivek Kaul

The Russian rouble has been crashing over the last few days. On December 10, 2014, one dollar was worth 55 roubles. After this, the rouble started crashing against the dollar and it even touched 73 to a dollar on December 16, 2014. This happened despite the Russian central bank raising interest rates to 17%.
Interestingly, as I write this in the late evening on December 17, the rouble has recovered to 62 to a dollar, after the Russian central bank promised to sell close to $7 billion to buy roubles, in a bid to push up the value of the currency.
The Russian government is totally dependent on revenue from oil. With the price of Brent Crude Oil falling below $60 per barrel, the Russian economy is expected to contract majorly next year. This has led to foreign investors exiting Russia.
When foreign investors exit Russia they sell the roubles they have and buy dollars. This leads to an excess supply of roubles in the market and a demand for dollars. This led to the rouble crashing against the dollar. The Russian central bank is now selling dollars and buying roubles being sold and in the process has managed to stop the crash for the time being.
But that’s the simple bit. The first question that arises here is how did the Russian economy become so heavily dependent on money coming in from selling oil. Currently, nearly 50% of government’s income comes from oil. Oil also makes up for two-thirds of Russian exports.
The answer to this question is provided by Yegor Gaidar in an excellent research paper titled
The Soviet Collapse: Grain and Oil. Between 1991 and 1994, Gaidar was acting prime minister of Russia, minister of economy and the first deputy prime minister.
The story starts with Joseph Stalin who was the leader of the Soviet Union from 1922 till his death in 1952. Stalin essentially forced collectivization and expropriation of agriculture. “The result of the disastrous agriculture policy implemented between the late 1920s and the early 1950s was the sharpest fall of productivity experienced by a major country in the twentieth century,” writes Gaidar.
In the 1960s, this “state production of grain stabilized” and remained fixed at around 65 million tonnes per year, until the late 1980s. The trouble was that the urban population was increasing and more grain was needed. This led to Russia becoming a major importer of food grains.
As Gaidar points out: “The cities, however, continued to grow. What policy could succeed if a country had no increase in grain production and an 80 million–person increase in its urban population? The picture was bleak. Russia, which before World War I was the biggest grain exporter—significantly larger than the United States and Canada—started to be the biggest world importer of grain, more so than Japan and China combined.”
So, the harebrained agricultural policies of Stalin turned the world’s biggest exporter of grains into the world’s biggest importer, in a matter of a few decades. The trouble was that the imports had to be paid for in hard currency (largely dollars). Nations like Japan were also importing food grains, but then they also were exporting a lot of goods using “their machine-building and processing industries” as well. This helped Japan earn the foreign exchange it needed to pay for its imports.
The Soviet Union did not have this ability simply because it had followed a policy of “socialist industrialization” which had resulted in “in the Soviet industry being unable to sell any processed (value-added) products”.
Since no one would buy machine products manufactured in the Soviet Union, it became a big exporter of raw materials which included oil and gas. As Gaidar writes: “The Soviet economy thus hinged on its ability to produce and export raw commodities—namely, oil and gas. The Soviet leadership was extremely fortunate: at almost exactly the time when serious problems with the import of grain emerged, rich oil fields were discovered in the Tyumen region of Western Siberia.”
So, oil and gas helped the Soviet Union earn enough dollars to pay for the food grains that it needed to feed its citizens. The country was totally dependent on the revenue from oil and gas.
In fact, its leaders had to get the Tyumenneftegaz (the  production association of the oil and gas industry in the Tyumen region) to produce more than what had been initially planned for. “The Soviet premier, Aleksey Kosygin, used to call the chief of the Tyumenneftegaz, Viktor Muravlenko, and explain the desperation of the situation: “
Dai tri milliona ton sverkh plana. S khlebushkom sovsem plokho” [Please give three million tons above the planning level. The situation with the bread is awful],” writes Gaidar.
After the breakup of the Soviet Union in 1991, this model has been followed by Russia as well. The trouble is that over the years Russia started to assume that high oil prices would stay forever. As Gaidar puts it: “ the idea that “high oil revenues are forever” has gained an even wider acceptance.”
Interestingly,
The Financial Times reports that around two weeks back, the current Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” As I write this Brent Crude Oil is selling at around $59.3 per barrel, inflation is about to cross 10% and the economy is expected to contract in 2015. Hence, the assumptions are going all wrong.
The Russian government’s budget becomes balanced at a price of close to $100 per barrel, which is nearly 66% higher than the current price of oil. Interestingly, Russia is not the only country which has worked out its government finances assuming a high price of oil.
As Ambrose Evans-Prtichard
recently wrote in The Daily Telegraph: “ The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.”
This applies to the Organization of Petroleum Exporting Countries as well.
As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment.”
Moral of the story: Countries cannot be dependent on revenue from just one major source like oil sales. It is like the old investment wisdom which the financial planners never get tired repeating: “Don’t put all your eggs in one basket”.
What applies to long-term investing applies to countries as well. The basic lesson is the same.

Postscript: Yesterday I had written about why the government should not be bailing out SpiceJet. But what has happened is exactly the opposite. In fact, the ministry of civil aviation said in a statement: “Indian banks may be requested to give some working capital loan based on the assurances of the promoter. Banks or financial institutions to lend up to Rs 600 crore backed by a personal guarantee of the chairman, SpiceJet.”
The question is if the promoters of SpiceJet are not willing to sink in any more money into the airline why are banks being
“requested” to lend? This in a scenario where the stressed assets of public sector banks is already greater than 10% of their total advances. Beats me totally.

The article originally appeared on The Daily Reckoning, on Dec 18, 2014