In a nation where a quarter of eligible voters are now between the ages of eighteen and twenty-five, the 2009 elections will see a potential 100 million young Indians heading to the polls for the first time between 16 April and 13 May. This isn’t any old India, as PepsiCo’s recent series of TV commercials suggests, this is “Youngistaan,” the Land of the Young. And just as the demographic reality of India’s youth bulge hasn’t passed soft drinks corporations by, neither has it escaped the attention of India’s political hopefuls. In the run-up to the elections, national and regional parties alike have been anxiously reworking their campaign strategies to appeal to youth – or what the media now chummily refers to as Young India.

At the heart of this drive is Obama-inspired online campaigning. Stirred by the Democrats’ success in the United States, India’s major parties have been eagerly integrating the internet into their election drives.

However, they have two big pan-India challenges to overcome: the myriad languages of India and the limited reach of the Internet. Read more here

Tying defence expenditure to GDP is no substitute for policy making.

India’s defence expenditure this year is pegged at less than 2 per cent of the GDP which is lower than India’s defence spending in 1962 — 2.1 per cent of the GDP. After the Chinese debacle, it jumped to 4.5 per cent in 1964. By 1994, it was slightly less than 5 per cent of GDP and it has been on a downward path since. In the mid 1980s, there was a demand to peg defence expenditure to a minimum of 5 per cent of the GDP.  For the last few years, the Parliamentary defence committee, Eleventh Finance Commission, retired military brass and strategic analysts have been active in the media asking for that figure to be pegged at 3 per cent of the GDP.

GDP is an important measure for determining how much India could afford to spend on defence, but it provides no insight into how much India should spend. Proponents of fixing a certain percentage of GDP as the minimum defence expenditure are status quoists, who use this argument as mere rhetoric, rather than as an articulation of defence policy. After the Mumbai terror attacks, it is politically taboo to disabuse this notion of a GDP-indexed minimum defence expenditure. Any analyst, politician or policymaker who dares to publicly question this argument risks being labelled unpatriotic, soft on terrorism and anti-national.

India could spend a great deal more or great deal less on its military capability than it does today, but that does not mean it should choose either course due to a mathematical formula. When there are fewer threats, the defence spending would be less. When there are more threats, a nation spends more. As threats evolve, funding should evolve along with them. Defence expenditure should be determined according to threat-based analysis and there are many substantive reasons why a proposal to bind defence expenditure with a fixed percentage of GDP is totally misplaced.

1] Using GDP to compare current defence expenditure to figures in the 1980s is misleading because India’s GDP has increased substantially over the last two decades. India’s GDP now is five times the size of what it was in 1980 (in dollar terms). Arguing that defence expenditure today is at a historic low as a percentage of GDP, and should thus be increased, is like a landlord arguing that because the tenant received a well-deserved pay hike, their rent should also be increased.

2] In the current economic climate, GDP does not necessarily provide the reliability in defence budgeting that many cheerleaders hope for; especially if India was to enter a recession, like the US or Europe. If India’s GDP decreases tomorrow, would the Indian armed forces support a concomitant reduction in their budget. Perhaps not, especially if India was at war or facing a threat on its borders.

3] Tying defence expenditure to GDP would erode budgetary flexibility and might threaten the civilian control of the military. By rigidly fixing defence expenditure to GDP, the prerogative of the civilian masters in determining whether defence expenditure should be higher or lower is curtailed. Civilian control of the military, an inviolable principle of Indian democracy, is likely to be undermined.

4] Another justification put forth by the proponents of linking defence spending to GDP is the erosion of the Indian armed forces under Nehru in the years after independence. While inadequate defence expenditure did play its part, it had also to do with post-independence downsizing of the armed forces, Krishna Menon’s failure to successfully manage military morale and Nehru’s misplaced belief in Panchsheel, UN and peaceful diplomacy.

5] The defence ministry and the defence services have been unable to fully utilise the amount earmarked for them every year. Over the last four years, nearly 16,000 crore rupees have been returned unused by them. Tying defence spending to GDP throws more money at the problem but does not force the bureaucrats and the generals to find ways to streamline the acquisition procedures.

6] Pakistan spends 6 per cent of its GDP on defence while the corresponding figure for China is 4.5 per cent. Comparing the percentage of GDP spent on national defence by different countries represents a flawed analysis. The argument is that if India’s adversaries devote a higher percentage of their GDP to defence, it represents a threat to Indian security. It proves that India has to increase its defence spending to maintain a relative advantage over them. Leaving aside the fact that India is set to spend many times more on its defence than Pakistan (or many times less than China) in actual dollar terms, comparing India’s GDP to Pakistan’s or China’s GDP does not give an accurate sense of relative military capabilities.

7] The usual Guns versus Butter argument. Money spent on defence is money not spent on education, reducing fiscal deficit, infrastructure, public health and other important non-military priorities.

Defence planning is a matter of matching limited resources to achieve carefully scrutinised and prioritised objectives. Smart planning relies on requirements, tradeoffs and a thorough evaluation of threats, not GDP, to determine defence spending. Replacing sophisticated and rigorous analysis with rigid formulas severs India’s defence planning from the evolving threat environment and widens the chasm between policy, planning and execution. Retaining flexibility in defence expenditure should not be viewed as a weakness, but rather as being capable of adapting to the  rapidly changing security environment in this age of unprecedented, diverse and dangerous threats.

If the armed forces and defence ministry can make the case that the threats India faces justify larger defence budgets, then larger amounts should be allocated towards national security. Unfortunately, fixing defence spending at 3 per cent of the GDP is a lazy substitute for national vision, political will and coherent policy making at the national level. Such a step would, instead, shield the troika of inept politicians, inefficient bureaucrats and staid military brass from careful scrutiny and throttle a much needed debate on national security.

The entire China vs India debate is so overdone and (mostly) futile. Unfortunately, it seems to elicit the most number of comments on IEB – largely bakwaas, unfortunately – which we have to perforce edit or delete.

Here’s Gurcharan Das, one of my favorite essayists with a rather strange op-ed in the New York Times that begins with the Mumbai terror attacks and the public’s reaction thereof, and then flits from meme to meme — India vs China, the role of Vaishyas in India’s growth, the Argumentative Indian, the 21st century rise of India (and China) and the role (or lack, thereof) of government, and the need for India to get its infrastructure right. Talk about a khichdi of ideas. For all I know, there may be a couple of other memes that I’ve missed. My head was spinning at the end.

Anyone else with similar reactions?

The decade and a half following India’s economic reforms of 1990-91 has been an exciting and transformational one for India and its people, and has also had a significant impact on the entire world. Much good has happened, with increasing growth and prosperity benefiting millions. The world has observed the rise of a large and vibrant middle-class, an aggressive and innovative private sector, and the growth of a soft culture. It is true that severe challenges still remain, caused mainly by massive disparities in income and access to resources, which mean that over 300 million people remain desperately poor, and large parts of the country not benefiting from growth.

A lot of India’s growth and stability today has been credited to its overall political structure and institutions. This is what has kept the nation united through the numerous challenges it has faced, and continues to face. The federal nature of the government, coupled with the presence of an independent judiciary and a powerful media have all combined to create the unique phenomenon that is Indian democracy. There are notable flaws, such as weak law enforcement, and an excessive bureaucracy, but, for better or for worse, Indian democracy has worked.

However, over the past few years, a major development has occurred in India, almost silently, which illustrates the uglier side of this system. While the growth rates clocked by the economy over the years have been impressive, most of the major policy changes benefited big established business houses. This has resulted in the India of today being a highly oligarchic economy, with a relatively small population enjoying disproportionate power, wealth and influence (four of the world’s ten wealthiest individuals are from India). Actual market friendly policies, which would help the middle-class and poor by boosting entrepreneurship would often be to the detriment of this group, and are often inhibited. In the 1950′s, Eisenhower warned the Americans of a “military-industrial” complex which could skew American priorities. His fears might have been unfounded, or at the very least, quite exaggerated. However, India today does the face the danger of a political ? big business complex distorting its priorities.

This phenomenon was partly displayed during the debate over the Indo-US nuclear deal. A seemingly innocuous bilateral treaty, it created frenzied debate, polarized the polity and the nation, and forced the government through a no-confidence motion. To a complete outsider, it all seemed a lot of action for something which appeared quite routine. To Indians though, it all seemed wearingly familiar.

The nuclear deal holds many ramifications for India, and the general consensus amongst the scientific, business and intellectual community is that it would be beneficial, if negotiated properly. Power generation is one area where the deal is said to have probable benefits. India remains critically deficient in power generation, with large parts of the country, including metros, suffering from severe power shortages. This has had a major impact on the growth of small business units, especially in manufacturing.

Since nuclear energy can be used to generate power, it appears that the deal could help meet the shortage, and thus, presents a huge opportunity for big business houses. Each major political alliance in India has its support base comprised of various business houses, and each alliance feels the pressure to make sure the deal goes through when it is in power, to ensure the maximum benefit for its support base. Simultaneously, policy changes such as decentralizing power production, removing subsidies or limiting power theft are often prevented, as those would enable the entry of other players into the sectors. It is like a double whammy effect.

Two other areas where the impact of the political-business nexus can be seen are agriculture and retail. Organized retail presents a massive opportunity for India to broad base its growth, and help kick start the agriculture sector, with estimates ranging from $ 500 billion to over $ 1 trillion. A large amount of agricultural produce in India is wasted each year due to the lack of cold storage, to the tune of $ 7 billion. Investments, both foreign and domestic, should be welcomed in this sector, as well as initiatives to promote local small businesses. Yet, the whole sector has been dominated by big players, who would rather establish consolidated supply chain which would squeeze prices all along the retail chain.

On a broader governance level, the negative impact of the political business nexus can be observed. Running for public office in India is an incredibly expensive proposition and campaign financing remains murky, with virtually no accountability. This works perfectly to the advantage of the business lobbies, in exercising control over political parties. The labor market also remains highly informal and unorganized, as this keeps labor prices cheap. Another good example is the real estate sector, where acquisition of land for commercial or private purposes remains incredibly difficult, for businesses which want to establish themselves. It needs to be pointed out that these phenomena were not the creation of the big players today, but it works to their benefit today to ensure that the status quo remains.

It is entirely likely that the influence of this group would diminish with the passage of time, and that fears about it would prove unfounded (as some of Eisenhower’s were, in the case of the US). Yet, in the Indian context, there needs to be a greater awareness of the dangers posed by such developments, and how they could impact the overall growth story.

What is the biggest lesson from the Great Depression? In my view, it is that monetary policy and the financial sector play a crucial role in economic development. Let me put it more precisely: good monetary policy is unlikely to accelerate the speed of economic growth – after all we have more income year after year because mankind comes up with new ideas, with new products, with more efficient ways of producing output. However, bad monetary policy can easily derail economic development. It is true for rich and poor countries alike.

Why are financial markets and the banking sector so important? Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.

Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers. On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.

And one thought like Ilian that this would be obvious to all the policy makers. However all the lessons from the Great Depression seem to have been lost within three-quarters of a century. It seems, to paraphrase Marc Bard, that politics [especially of the petty and partisan variety] eats policy for lunch seven days a week.

On September 19th, the U.S. Treasury Secretary Paulson issued a statement in which he said that the Federal government “must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy”. He called it the ‘Troubled Asset Relief Program’. Many have taken to abbreviating to TARP and from there, it is a short leap of imagination to call it a TRAP. The government had sent the legislation to the Congress for approval and it might be approved any time soon. We have something to say about it later.

But, even before the bill is passed and its ramifications known, stock markets around the globe heaved a sigh of relief and rallied hard towards the end of last week. It is a delightful irony that most markets showed a flat profile from Friday, September 12th to Friday, September 19th at the end of an unprecedented week. It is not so much the news of the proposed U.S. government bailout that stock market investors welcomed. The squeeze on short-sellers that regulators around the world applied worked its magic.

Short-selling banned but SEC created the conditions

Bulls are taken by their horns but I do not know how bears are tamed. Try banning short selling. Well that is what authorities in the U.S. and the UK did on Thursday. UK banned all short-selling of financial stocks up to January 2009. The Securities and Exchange Commission (SEC) in the US banned all naked short-selling in all stocks. Hedge funds have to swear under oath their short positions. Canada, Germany, Ireland, Holland, Taiwan and some others have joined. That is a shame. There was no reason for many authorities to impose restrictions on short-selling. It is not only unprecedented but also largely unnecessary. Even now, with history and experience behind us, human beings remain capable of making collective mistakes. That is scary.

Forgotten in this persecution of short-sellers is a matter of tiny detail that in 2004, the SEC made two important changes to its rules on the amount of leverage that broker-dealers could take on. One, it removed the discounts (haircut) it applied on the assets that these institutions own, in calculating their net capital. Two, it allowed five broker-dealers to increase their leverage from 12:1 to 40:1. Those five were Merrill, Lehman Bear Stearns, Goldman and Morgan Stanley. Three of them are not around any more.

(Source: The Big Picture)

It is not clear what role the institutions themselves played in this rule change. It appears that the retribution for the egregious errors of the regulators and the regulated entities would be paid by the shortsellers who seek to throw a spotlight on such behaviour. Strange are the turns that American capitalism has taken in the last few years.

Banning short-selling is to akin to blaming the mirror for the ugly image. But then, these days, one is a suspect capitalist if one does not cheerlead rising asset prices even if the means are not exactly fair. Steve Randy Waldmann asks if selling short into a financial panic was not done, then isn’t going long into an asset price bubble equally wrong. In their defense, of course, authorities are justified in doing so if they suspect financial terrorism akin to the unusual activity seen in airline and financial stocks before the 9/11 terrorist attack in New York. But, Carl Sagan, as quoted by Paul Kedrosky of ‘Infectious greed’ says that extraordinary claims require extraordinary evidence. The authorities have not produced any.

However, for this writer, conviction remains firm that any recovery in global equities and the U.S. dollar would eventually turn out to be a comic interlude in an, otherwise, tragic drama except that the comic interlude could last long enough to make us all feel like we were watching a new play all over again.

Incentives to take on excess risk remain

Some argue that there is nothing called a stable financial system. As long as human greed and fear exist, financial systems would periodically become unstable. According to them, it is just in the nature of things for financial systems to fall into crises. The only avoidable cause, in their view, is to avoid reckless monetary and credit expansion that many central banks either deliberately or unconsciously permitted in the last several years (See, for example, Michael Pettis). Such excessive monetary and credit expansions do not end without extracting their price in terms of financial institutions’ failures and economic stagnation or worse.

Of course, while monetary policy and regulatory prudence is at the heart of the stability or instability of the financial system, that does not mean that other known or identified problems should not be addressed. Some of them might end up vastly amplifying the consequences of monetary excesses. One such problem is the role of incentives and reward-punishment structures in the financial industry. Simply put, far too little punishment is directly borne by the wrongdoers for their errors. Most executives are rewarded for successes or with golden parachutes if they fail while losses are borne by the shareholders and the society at large. That applies to executives at the top and at other levels. Returns are rewarded while risk is socialized and worse, since it appears with a lag, it is not even recognized and traced back to the acts of omission and commission. Even in late-2007 well after the crisis had broken out, compensation packages were not tailored to incorporate risk considerations in evaluating executive performance.

In fact, incentives in the financial industry need to be addressed not just for reasons of financial system stability alone but also to ensure a fair deal to shareholders and clients of such institutions. Nick Leeson, who was responsible for the collapse of the Barings bank in Singapore, writes that he was offered five credit cards as soon as he had returned from Singapore, having been responsible for incurring GBP862 millions of losses in 1999 (See The Guardian).

U.S. Treasury announces a plan on Saturday

In an email exchange with friends in the industry in April, when I was asked whether the world would unravel via inflationary boom and bust or through a straight deflationary bust, I said that the outcome would eventually be deflationary and that, in the interim, inflationary solutions would be attempted. In other words, we would get there finally but through an inflationary route.

In that sense, the Paulson plan is not a surprise. It was always on the cards. Policymakers are not going to give up without a fight. Under the plan known informally as TARP, the Treasury is authorized to purchase USD700 billion worth of mortgage-backed securities from U.S headquartered institutions at an unspecified price and price mechanism. Decisions made by the Treasury under this special legislation have no judicial recourse. The Treasury would buy assets issued or originated on or before September 17th. By Monday (Sept. 22nd), this has been extended to non-America headquartered institutions and to many types of assets including commercial mortgages and non-mortgage assets. Macroman might succeed in selling his wooden cabinet to the U.S. government, after all!

For now, the proposal has no provision to help homeowners who are struggling to keep up with their mortgages. Also missing is any proposal to re-capitalize institutions that might find themselves undercapitalized once the Treasury buys its assets over at a price that could be less than the price at which the institution carried the assets on its books. Those wanting to understand these issues better could see here and here.

Further, the stunningly simple and yet sweeping nature of the authorization sought from the Congress has made many compare this to the “Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq” (see NYT). In fact, some find it plausible that the U.S. government allowed Lehman Brothers to fail to bring the system to the point of total collapse so that Congress could be steamrolled into authorizing the Treasury to do as it pleases, without judicial review.

Regardless of the merits of such a hypothesis, the mere possibility of it should make Congressmen move cautiously on the proposal and build in safeguards against abuse of power.

Different problems if the plan works

Even as a plan that focuses on the financial system, it is incomplete. The million-dollar question is if this plan would boost loan demand. The hope is that as mortgage rates come down, households would be able to refinance their mortgages and thus find the wherewithal to continue to spend. U.S. households have zero savings rate and those born around the World War II face immediate retirement. They need to save. To the extent any reduction in rates alleviates their conditions without a change in behaviour, global imbalances would remain. The U.S. would be saving too little and Asia too much. Second, return to spending habits by U.S. households would boost commodity prices and thus raise the specter of inflation all over again. Even if inflation were to return slowly in the U.S., it might return faster in Asia where the economies have barely cooled and where policy, on average, is still too loose. The world has, for the moment, run out of resources to support synchronized growth. Oil and gold have jumped already on Thursday and Friday.

If, unfortunately, inflation returned to the U.S., what happens to interest rates and would households really benefit then?

Then, there is the question of how the Treasury would find the money to do this. As a perceptive hedge fund insider pointed out, it was one thing for Asian nations to buy Treasuries and mortgage agency debt and accumulate reserves when they were deemed AAA credits. Can they do so even now and how would their public react? Of course, it is a stretch to think that most East Asian nations respect popular wish but it is not a stretch to state that they would fear the inflationary consequences of going back to reserves accumulation and thus entrench currency weakness.

Truth and reconciliation in America

Steve Randy Waldman’s two thoughtful pieces on his blog, ‘Interfluidity’ titled ‘To whom and for what’ (September 19, 2008) and ‘Inequality and credit crisis’ (August 31,2008) are worth reading. He also makes a compelling case for truth and reconciliation in America. Not just billions of dollars have been lost but also trust in America. He says that the process of rescuing financial institutions with government money should be transparent and institutions must come clean on the models and the prices that they had used in their books until the Treasury bought them over. This would enable the world to know whom to deal with in future and whom to avoid. He is right but the chances of this happening are fairly slim, however.

The mood in the financial market now is not to ask these uncomfortable and important questions. Whatever makes them live for another day is good enough now, for the industry and for investors. Once Congress approves this bill, investors, instead of feeling chastened, might feel that they have survived a bad crisis and that could embolden them to take on more risks unless regulators begin to take their jobs seriously. That is why I feel that stock markets, in the next few months, would do well. Reality would begin to bite again in 2009, as expectations are too high for economic growth and corporate profits. Enduring floor stock markets is a long-way off. Hopes over the miracles expected of the plan would turn to disillusionment. Market turmoil would return.

It is important to remember that what have been impaired are not just mortgage related assets but also trust in the U.S. financial system and capitalism, across the world. The consequences of that are not easily identifiable and would linger on long after this crisis is over. It is equally important to remember that the Treasury rescue plan contains nothing to repair the impaired trust and integrity.

A year ago, in an interview to Bloomberg, I had said that, by the time the crisis ended, the world of investors would be sick of stocks and real estate. Judging from the market reaction in the last two days, we are far from that point. I stand by that forecast. To that, I would add two more: by the time this is over, the U.S. dollar would no longer be the world’s reserve currency and America would have lost its AAA credit rating.

(These are Dr Anantha Nageswaran’s personal views)

Since then, the government has collected Rs.74972.36 crore as cess, but only Rs.902 crore has been allocated to the Oil Industry Development Board (OIDB) that is supposed to disburse the money to the industry.  In fact, the last allotment of Rs. 95 crore to the OIDB was done in 1991-92. The balance money has gone to the Consolidated Fund of India and added to other revenue accruals.

The cess was doubled in 2002 from Rs. 900 per tonne to Rs.1800 per tonne, and further increased to Rs. 2500 per tonne in 2006, on the ground of providing subsidies to LPG and kerosene. As per the Oil Industry (Development) Act, the amount collected by levying cess on indigenous crude is to be utilised for the development of petroleum sector; the cess was never intended to cover subsidies – either directly or through oil bonds.

Cess is only applicable to pre-NELP [New Exploration Licensing Policy] blocks or acreage given to national oil companies (NOCs- ONGC and OIL) on a nomination basis in which the licensee may be one of the NOCs. The blocks that pay cess on oil are: nomination blocks held 100 per cent by NOCs (for example, Mumbai High), joint venture blocks that were awarded as field development contracts (such as Mukta, Panna, Ravva), and exploration blocks that went on to production (such as PY-3, CB-OS/2).

Now that the petroleum sector has been deregulated and opened for private sector, there is no justification of continuing this cess at all. The private companies still pay about half the cess not paid to the government as increased profit oil [amount of production paid to the government under the production sharing contract] and corporate taxes. Recent newsreports indicate that-

The government is obtaining legal opinion for imposing a special oil tax on the domestic crude oil production under the New Exploration Licensing Policy (NELP). The proposed tax is supposed to kick-in after price of domestically-produced crude oil crosses the $75/barrel mark. While public sector oil producers like ONGC and Oil India would have to fork out to the government 100% of additional realisation beyond the cut-off price, private companies like Reliance Industries (RIL), Essar Oil and Cairn India would be required to pay 40% of their windfall gains.[ET]

Cess, customs duty, excise duty, sales tax, education cess, pollution cess and now a special oil tax. Considering the amount of revenue collected by the government[central and state], the net subsidy provided  to the public on petroleum products is only a political statement, with insignificant net financial entailment.

Coupled with the charade of Oil Bonds, the cess imposed on the indigenous crude oil produced by NOCs is an implicit arrangement of meeting the subsidy burden and artificially containing government’s budgetary deficits. All these measures are but an indicator of the byzantine and befuddled nature of the government budgetary process. It is time someone took up cudgels to streamline and simplify the convoluted government fiscal setup, both of revenue collection and of expenditure.

There are three duties/ taxes collected by the government on the sale of petroleum products. The state governments collect the sales tax while the excise and custom duties go into the kitty of the central government.

Now, let us take a look at the actual revenue collected by the government from excise and customs and subsidies provided via the oil bonds and direct subsidies on LPG and PDS kerosene. During the last three years:

The government has now announced that it will issue oil bonds worth Rs 94,600 crore in the fiscal year 2008-09. If the revenue collection rises at the same rate, it would be to the tune of around Rs 77,000 crore in 2008-09. The subsidy for kerosene and LPG is at around Rs 3000 crore. So, the government will suffer a net loss of nearly Rs 20,000 crore in providing petroleum products to the citizens of India. Phew! 0.4% of GDP wiped out in one go.

These figures might themselves portray a wrong picture. For the first quarter of 2008-09, the government had decided to issue bonds worth Rs 24,500 crore while estimated losses of the Oil Marketing Companies (OMC) were at Rs 52,000 crore during the period. Moreover, the government’s share of meeting under-recoveries through oil bonds is now 57% from the earlier 42.7% of the total under-realisation on fuel sale. Another 33 per cent comes from upstream companies like the ONGC, GAIL and OIL. The remaining losses are borne by the OMCs themselves.

These oil bonds are a very neat short-term solution that pledge our tomorrow for a cosy today. The interest rates at these bonds are estimated at around 8.75 to 9.5% and reports suggest that the RBI has now stopped purchasing them under the special market operations(SMO). Under the SMO, the central bank used to buy the oil bonds directly from the OMCs and pay them the equivalent amount in dollars, allowing them to buy supplies. In the current year, the interest burden on the oil bonds is budgeted at Rs 5520 crore. With the  issue of oil bonds this year, this burden will become onerous and will cost the exchequer around Rs 13,000 crore in the next fiscal.

All this will add to the burgeoning fiscal deficit this year. But the finance minister, with his wizardry, of keeping the oil bonds out of the official fiscal deficit, will still be able to peg the the fiscal deficit at 2.5% of the GDP.

The more prudent mechanism of granting statutory liquidity ratio (SLR) status to the oil bonds has also not been accepted by the government. The SLR status gives immediate relief to OMCs by way of liquidity induced by participation of bigger players like banks, gilts and mutual funds, apart from existing pension, provident fund and insurance players that trade less and hold on to the papers till maturity (around 10 years). The SLR bonds are highly secured and liquid in nature as they are sovereign guaranteed. SLR bonds are those issued by the government at market rates to fund its various borrowing activities every year. Banks are required to subscribe to them, as they are mandatory requirement stipulated by the Reserve Bank of India. Currently, banks maintain 25% of their net demand and time liabilities in SLR.

Thus, while free pricing mechanism for oil products in India remains a pipe dream, granting SLR status to oil bonds seems to be the judicious course of action. However, the bonds that typically come under SLR, or statutory liquidity obligation, form part of the fiscal deficit. The government, bound by the FRBM act, is thus avoiding the SLR status for oil bonds like a plague.

There is big trouble with this sanctimonious approach of the government towards maintaining the fiscal deficit within the stipulated target. A similar exercise at fudging the balance sheets by a corporate house would have attracted the ire of the government auditors. Keeping the ethics of governance apart, the present approach has far-reaching implications for the oil industry. OMCs will continue to bleed and the cost of burden-sharing on the part of the upstream companies will rise. Both will become victims of a serious financial crunch, which will adversely hit their plough back and investment plans.

The government, too, will not emerge unscathed. This resort to oil bonds, besides being blatantly unethical, is neither fiscally prudent nor does it tackle the problem posed by spiralling oil prices, falling growth rates and rising inflationary pressures effectively.

Update – Vikram S Mehta in today’s Indian Express asks some pertinent questions on oil pricing:

…why does the government persist in appointing committees comprised of professionals to address what is essentially a political subject? Surely they must know that no individual worth his professional salt can help the government skirt the political conundrum of volatile petroleum prices. Why does the government not now contemplate kicking the ball into the court of the politicians? After all if there is to be progress it can only be if the politicians resolve somehow the political dilemmas of oil. My suggestion is that the next committee on petroleum should comprise of politicians and should be asked to come up with bold and practical suggestions on ‘how’ to implement what everyone knows must be done.

Update 2 (September 04) – Urjit Patel, writing in the Business Standard, highlights the dangers of RBI acting as an oil spigot and contends that the scenario is emblematic of the insidious distortions in virtually the entire energy chain.

It is estimated that oil bond issuance over the current fiscal could be about 2 per cent of GDP; therefore, the money due to the oil companies from the Union government is expected to be huge for the foreseeable future. Unless there is a sharp correction in oil prices or a policy combining adjustment in domestic retail prices and reduction in government duties, the oil companies will continue to require help to source the foreign exchange to import crude oil (although the SMO has been ascribed as a temporary facility). If demand does not adjust, supply will; reports of long lines at diesel pumps in several states show that the oil companies are responding in a manner that is feasible for them. In some parts of the country, demand for diesel for generation sets has increased after the recent price hike because electric supply shortages have intensified. The whole scenario is emblematic of the insidious distortions in virtually the entire energy chain in India.

Several conclusions and observations can be made. First, the dire fiscal situation that the central government finds itself in has now sucked the RBI in its vortex, but it is to be hoped that a durable alternative mechanism will be put in place with alacrity to ensure that the SMO is not further resorted to; it can be argued that some of the hard work over the past decade to ensure that the RBI’s proximate objective for conducting monetary policy is not compromised — by getting stuffed with government paper — has been undone. Secondly, we would be hard-pressed to name another country (even among those that subsidise fuel) that has had to resort to the central bank in this manner. Thirdly, praying for international crude prices to adjust sharply downwards soon does not constitute government policy, sound or otherwise. Fourthly, the proceeds of the oil bonds upon maturity will be in rupees, hence the RBI, if it wants to rebuild official foreign currency assets to make up for the decline on account of the SMO, will have to intervene in the market at the time and buy foreign currency at the ruling market exchange rate (the central bank shoulders an exchange rate risk if rebuilding foreign currency reserves is an objective).

Long-time reader and IEB friend, Joydeep Mukherji sent us this article with a comment:

The West Bengal government has decided to import one lakh tonne of coal at higher rates to fuel the thermal power plants which have not been able to meet the power demand recently for wet and substandard coal.

The resulting rise in the cost of power would have to be borne by the consumers, State Power Minister Mrinal Banerjee said when replying to a motion moved by the Leader of the Opposition Partha Chatterjee in the Assembly today. (ET link)

This article highlights the lunacy behind the intersection of economics and politics in India. India has the third largest deposits of coal in the world, and much of that is in Bengal. However, India imports coal since it is easier to procure and cheaper to buy abroad. Even Bengal is now importing coal since its own coal industry is hopeless.

The problem lies with the monopolies granted to Coal India and other public sector companies, leading to government restrictions and pricing policies that breed black markets and shortages. The coal sector has barely been liberalized despite nearly two decades of reform.

Politically, any ambitious politician from Bengal, Jharkhand or Bihar imemdiately seeks the Coal Ministry (or the Railways as a back up). The goal is not to develop the coal sector to make Bengal and Eastern India a prosperous region based on ample energy. On the contrary, the goal is squeeze as much bribery out of that industry and employ as many party workers in it as possible.

With such an outlook, is it a surprise that Bengal is importing coal? The fact that few people in India even see the irony of this situation shows how deeply the rot has set in.

Strategic fools occasionally write about Indian energy companies buying or investing abroad, often in competition with Chinese firms, describing such actions as if they were epsiodes of combat in a ‘Great Game’. Note that no one points to the reasons at home that lead firms to look for supplies abroad.