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Understanding India's stagflation

By Sonali Ranade
May 17, 2012 09:27 IST
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The only response from the government so far has been a 20 pc devaluation of the Rupee by stealth. In a roundabout way, this is the price we must all pay for as a tax on wealth, says Sonali Ranade

Indian flagLet us set up a simple equation based on a standard definition of national accounts to understand what has been going on in the Indian economy since the financial crash of 2007.

Let all domestic private household and firms' savings be S, the investments made by the domestic private firms in businesses be I.  Then [S-I] represents the net incremental cash available in the economy from the private sector. 

Likewise, T represents the totality of all tax revenues available to the government while G represents the totality of all its expenditure. Thus [T-G] would then give us the net incremental cash generated or used by the government in a year. 

The sum of [S-I] + [T-G] then represent the net cash generated by the economy in a year and should be reflected as an increase or decrease in the reserves held by the central bank.

On the other hand, let M be the totality of all imports into the economy, and X the exports out of the economy. In that case [X-M] represents the surplus on the external trade front and will be reflected as a increase or decrease in reserves of the central bank which then has to be deployed overseas or financed overseas. 

In short, we have: [S-I] + [T-G] = [X-M]

We must note two things in the Indian context in relation to the above equation. The gap in external trade account is financed by flows from [1] incremental NRI deposits, [2] FII investments and [3] FDI and external borrowings. All these sources are in the nature of financing decisions made by us and are independent of the investment decisions or the I part of the [S-I] in our equation. 

If there were other funding sources available, I could still be high even if FII or FDI flows diminished. Investments, or I, depend on the attractiveness of an investment considering its profitability and the aggregate demand in the economy. It is in a sense independent of how it is financed. 

Second, to the extent [S-I] is positive, or the private households save more than they investment in businesses, the government has to run a deficit in order to offset the excess saving, else aggregate demand in the economy would fall leading to a recession in the economy because we always have an excess of imports over exports which reduces domestic demand and increases demand overseas. 

In other words, given the "structural" constraints in our export mix and import needs, so long as [X-M] is negative, the government must, repeat must, run a deficit [T-G], else the excess of savings over investment in the private sector and households would deflate demand and lead to a recession. 

Actually, the deficit created by T-G has to not just offset S-I surplus but must be slightly larger -- something like 3-4 per cent of GDP -- in order to stimulate the economy by creating incremental domestic demand. This is crucial to sustaining aggregate demand in the economy.

We need to make one additional modification to the simple logic of the algebra of national accounts and we will be ready to go. This is due to our peculiar affinity for gold, which got pronounced after the financial crash of 2007. Where does gold fit into the national accounts considering all of it is basically imported? We will consider the net gold imports for simplicity, which are total gold less what is exported as jewelry. These are approximately of the order of $20 billion a year. Let D [for dead investment] be the net gold imports that are used by households for investment. 

Our equation for cash generated in national accounts then becomes: [(S - D) – I]  + [T - G]  = [X – (M + D)]

That is to say, since any savings diverted to gold cannot be used to finance domestic investment by businesses, we remove D, the value of gold used as dead investment, from the total stock of private savings from the economy. Our new level of saving is thus (S-D) and these are used to finance I. [T-G] remains the same.

On the external balance front, we basically split imports as all imports as before, less gold, which is shown separately as D. So the change in reserves is now given by [X-(M+D)]

Now we are ready to resolve some, not all, the mystery of the emerging stagflation that is getting a grip on the economy over the last three years. 

Consider first the conundrum that despite the financial crisis in 2008, and global recession, we had a fairly resilient economy and a robust growth rate. How did that come about?

Consider our revised equation. Let us say, gold imports suddenly jump by $20 billion because of a certain perception that it is a good investment. When that happens, the supply of savings by the households goes down by D since only (S-D) is now available to finance investment by firms. Firms will continue to invest the same as before because I is fairly independent of financing and is determined by aggregate demand and the profitability of the investment. Therefore, I remains the same.

Our imports, other than gold, are largely oil and industrial machinery and raw materials and do not change in the short term. Neither do our exports, given their nature. So to accommodate the same level of I to sustain the supply side of a given level of GDP, the government deficit must increase by D. 

That is the hidden implication of gold imports for investment purposes by households.  To the extent households divert savings to gold, the government has no option but to increase its deficit by a like amount to support a given level of investment. Failure to do so will result in investment being crowded out due to lack of domestic savings, resulting in lower output and supply side constraints to future growth. 

Gold imports for investment by households must result in an increase in government deficit. Which is precisely what the government did in 2008-09. It responded to a quantum increase in gold imports by stepping up its deficit. That may have boosted aggregate demand, saved investment levels in the two years following the crash. But that's not the full story.

The crunch comes because government deficit cannot be increased indefinitely without letting other genies out of the bottle. There is an upper limit to sustainable government deficit at given level of exchange rate. To go into that would complicate the picture. So let's keep the argument accurate but simple. Remember, [X-M] the trade deficit has to be financed. And foreign investors, well aware of the exchange implications of an unsustainable large fiscal deficit, will simply not lend/invest money in your economy unless the fiscal deficit is capped. So governments don't have the luxury of offsetting a fall in availability of domestic savings by running up correspondingly higher deficits.  We had reached that limit by the end of 2010.

If government deficits cannot increase, but gold imports remain stubbornly high, what must adjust to meet the constraints imposed by the national accounting equation other than simply exhausting reserves?

A shortage of savings will drive up interest rates. We saw that happen. Higher interest rates will curb investments, leading to a fall in aggregate demand and reduced future profitability of investments. But the most important factor is that since government deficit no longer offsets gold imports, there is an immediate fall in aggregate demand that brings about a deflationary pressure on the economy. 

The latter factor is the one we must focus on because it is not so obvious unless we explicitly take gold into account in the national accounts. Gold imports, apart from driving up cost of investment via interest rates, also result in an immediate drop in aggregate demand if not offset by an increase in government deficit. And that precisely is what we are seeing now -- a steep fall in domestic industrial growth due to the cumulative and combined effects of gold imports not offset by an increase in government deficit. I hope that is crystal clear.

Now consider financing the gap represented by [X–(I+D)].  As we know, the entire gap of $90 billion or so [I assume services exports are more properly treated as part of X here] is met by NRI flows, FDI and FII investments each of which averages about $30 billion a year. Policy paralysis by the government has vitiated the attractiveness of India an investment destination. If we are lucky FDI + FII may total about $30 billion this year. 

Since there is no way to finance the gap, either reserves must fall, or the government must cut its fiscal deficit, further triggering even more severe deflationary pressures.  Note, there is no option. If financing for the external gap is not available, either D must fall to 0 and/or government deficit must be cut to balance accounts. The world is a very cruel place when you run out of money.

The only response from the government so far has been a 20 pc devaluation of the Rupee by stealth. In a roundabout way, this is the price we must all pay for as a tax on wealth. Its real impact will come when the import prices of stuff like petro products are passed on to us through increase in domestic prices. So far we have hardly noticed the pain as if the devaluation in no way concerns us. A far more detailed analysis than possible here is required to suggest ways to save the economy from a severe deflation. Unfortunately, we have a government in denial and a people who don't care to look at numbers.

The 20 pc devaluation is but the first step towards recovery.

Sonali Ranade is a trader in international markets

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