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Home > Archives (2006 on) > 2008 > July 19, 2008 > Not Oil, Infatuation with Foreign Capital will drown the Government

Mainstream, Vol XLVI No 31

Not Oil, Infatuation with Foreign Capital will drown the Government

Tuesday 22 July 2008, by Bharat Jhunjhunwala

The government is sinking everyday in the quicksand of inflation. It did not pass on the increase in international price of oil to the consumer. Instead it asked the public sector oil companies to buy expensive oil in the international markets and sell it cheap to domestic consumers. This may be a good political strategy. It helped contain the price rise. But there is no such thing as a free lunch. The price of this profligacy has to be paid. The public sector oil companies incurred heavy losses. They issued oil bonds backed by the Union Government and raised money from the market to meet their cash deficit. Say, Indian Oil purchased petrol at Rs 100 a litre from the international market and sold it at Rs 55 to the domestic consumer. Simultaneously it issued oil bonds of Rs 45 and lifted that money from the market. This money will have to be repaid by Indian Oil when the bond matures—say, after three years. At that time Indian Oil will have to pay Rs 45 to the buyer of the bond; and the Union Government will have to pay this money to Indian Oil. The fiscal deficit of the government will increase then. The consequences of maintaining cheap price of oil today will be borne by the Union Government at that time.

Inflation was not contained by this strategy either. Oil is only one source of inflation. Prices of food products and minerals are rising in tandem. This increase in price was fuelled by the increasing demand from India and China due to their high rates of growth. Indian companies are establishing new factories, which is increasing demand for steel and cement. Foreign investors were making a beeline to invest in Indian share markets. They wanted to profit from the golden future of Indian companies. The Sensex scaled 21,000 on the back of these inflows. The temperature of the Indian economy was already high because of the frenzied activity by the Indian companies. It was raised further by the inflow of foreign capital. Inflation was not brought under control despite the low price of oil because of this pressure of growth just as the temperature of a patient chewing lavang is not brought down by keeping a face pack.

The two sources of inflation, in addition to oil, were domestic and foreign investments. Accordingly there were two ways of cooling these—curb domestic or foreign investment. Our government is especially fond of foreign investors. Their interests are most important in policy- making. Thus the government curbed domestic investment by raising interest rates while, at the same time, opening the doors wider for foreign investment. The policy had some desirable effect. Domestic investment was dampened. Our economic growth rate declined from 10 to about eight per cent. Inflation, which could have reached 15 per cent, was held at 11 per cent. At the time of writing this article, the government is determined to pursue this path deeper because an 11 per cent rate of inflation is still politically unpalatable. Indications are that a further increase in the Cash Reserve Ratio is being contemplated by the Reserve Bank which will lead to a parallel increase in domestic interest rates.

Alas! The Government’s determination to protect the interests of foreign investors is not being fulfilled. The burden of redemption of oil bonds is becoming large. The Reserve Bank has recently increased the daily borrowing limit against these bonds from Rs 1000 crores to Rs 1500 crores. Foreign investors are factoring in this future burden here and now. They anticipate a huge increase in the fiscal deficit of the government in the coming years which will derail the growth trajectory of the economy. Foreign investors have started withdrawing as a result and the Sensex has fallen to 14,000. This trend is likely to continue as long as the government continues to follow the policy of cheap oil.

In the end the government’s policy of selling cheap oil is a big zero. Inflation is increasing because the demand for steel, cement, minerals and food is increasing leading to increase in prices. Foreign capital is fleeing despite the government opening its doors wide because the fiscal situation is likely to soon deteriorate. And, the golden hen of domestic investors has been put into the incubator by the repeated increase in interest rates. All this because the government is especially fond of foreign investors and unwilling to put brakes on the inflow of that capital.

The alternative was to pass on the increase in price of oil to the domestic consumer. Taxes could be reduced on other items that are produced domestically to contain inflation. The increase in inflation due to oil would be balanced by decrease due to reduction in prices of cement and steel. The share of oil in the Wholesale Price Index is seven per cent while that of manufactured items is 63 per cent. The impact of doubling of price of oil could, therefore, be nullified by a 12 per cent reduction in the price of domestically manufactured commodities. Such a policy would lead to reduced consumption of oil due to the increase in prices. In turn, that would lead to less demand for dollars for oil imports. The value of the rupee would remain firm, lead to cheaper price of imports and help in containing inflation. On the other hand, lower taxes on manufactured items would buoy investment and keep the economy on a high-growth path of 10 per cent plus level. This policy would be beneficial for both the domestic consumer who would be overall shielded from price rise and domestic industries that would face a low tax regime.

The government could not implement this because it was unwilling to put a brake on foreign investors. Such a high-growth scenario would lead to huge foreign capital inflows into our share markets as was taking place till January 2008. The combined impact of large domestic and foreign investment would again increase the temperature of the economy and fuel inflation. It was necessary to put brakes on foreign investment while encouraging domestic investment. But the interests of foreign investors hold the highest priority for our government; hence the government choked domestic investment instead. In the end the government has failed on all fronts. Inflation is unabated because subdued domestic investment is yet putting pressure on the demand of steel and cement. Foreign investors are fleeing because of the rising fiscal burden of oil subsidies.

The government should change gears immediately. The increase in the price of oil must be passed wholly to the domestic consumer. Oil should be taxed even more heavily. Taxes should be reduced on other domestically manufactured goods to balance the price rise. Domestic interest rates should be kept low to promote investment and high growth. Entry tax should be imposed on foreign investors to prevent overheating of the economy. It is unfortunate that our government led by an economist Prime Minister is unwilling to implement this simple formula due to its infatuation with foreign investors.

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