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GS Paper: Indian Economy

  • What is the Sovereign Right to Taxation?

    Scrapping the retrospective levy is believed to provide clarity to investors by removing a major source of ambiguity on taxation laws, the government has stressed the need to establish its “sovereign right to taxation”.

    Defining a Tax

    • A document on the Ministry of Statistics and Programme Implementation website quotes the definition of tax as a “pecuniary burden laid upon individuals or property owners to support the government; a payment exacted by legislative authority”.
    • It states that a tax “is not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative authority”.

    The ‘sovereign right to taxation’

    • In India, the Constitution gives the government the right to levy taxes on individuals and organizations but makes it clear that no one has the right to levy or charge taxes except by the authority of law.
    • Any tax being charged has to be backed by a law passed by the legislature or Parliament.

    Taxation in India

    • Taxes in India come under a three-tier system based on the Central, State, and local governments and the Seventh Schedule of the Constitution puts separate heads of taxation under the Union and State list.
    • There is no separate head under the Concurrent list, meaning Union and the States have no concurrent power of taxation, as per the document.

    Back2Basics:

    Taxation in India: Classification, Types, Direct tax, Indirect tax

  • Unpacking the resiliency of global trade

    Context

    Past experiences suggest there is hope for global trade recovery in the post-COVID-19 world.

    Impact of pandemic on the global and Indian economy

    • In the last year, the devastating impact of COVID-19 pandemic has shrunk the world economy by 4.4% and global trade by 5.3%.
    • Job losses in the world have been estimated to be to the tune of 75 million.
    • India’s GDP contracted by 7.3% according to the National Statistical Office.
    • About 10 million jobs were lost in India according to the Centre for Monitoring Indian Economy Pvt. Ltd.
    • Around the world, countries have responded to pandemic-induced shortages with protectionist reactions and nationalist aspirations.
    • Such a response has the potential to disrupt complex cross-border supply chains.

    How economic shocks in the past laid foundation for institutional changes

    • The Second World War was responsible for the creation of the Bretton Woods Institutions such as World Bank and International Monetary Fund (IMF) and International Trade Organisation (ITO) were created to help rebuild the shattered post-war economy.
    •  The General Agreement on Tariffs and Trade (GATT) was negotiated in 1947 as a means to reducing barriers to international trade.
    • The oil shocks of the 1970s led to the establishment of the International Energy Agency (IEA) in 1974 and went on to create awareness on the need for global energy security.
    • The financial crisis of 2008 led to the G20 Leaders Summit, an elevation from the G20 Finance Ministers forum in 1999.
    • Increase in global trade: As a result of these developments global trade increased from a mere $60.80 billion in 1950 to $2,049 billion in 1980; $6,452 billion in 2000; $19,014 billion in 2019.

    Changes in the global trade in post-Covid world

    • Financial buffers due to stimulus package: Stimulus packages and forced savings in several countries in the last year have created financial buffers.
    • Resilient supply chain: Global supply chains are expected to be resilient to help revive manufacturing with lower production costs, induce investments and promote technology transfers.
    • Anti-dumping measures at WTO: In a post COVID-19 world, members of the World Trade Organization are expected to make rules to discipline errant nations that are known to dumping goods and erecting trade barriers through multilateral rules.
    • Deeper economic integration through trade arrangements: Mutually beneficial trade arrangements that seek deeper economic integration will be entered into at the bilateral and regional levels.
    • Dominance of technology: Countries that harness technology are expected to dominate international trade in future with a transformational impact on the global economy.
    •  Businesses will aim to harness data for innovation to remain ahead of the curve in a post-COVID-19 world.

    Way forward for India

    • The projections of the International Monetary Fund for India’s economic growth ahead are positive and in line with the general trends world-wide.
    • Focus on value-added manufacturing: Building an ecosystem that incentivises value-added manufacturing and technology-induced finished products should form a part of our long-term strategy.
    • Production Linked Incentive Scheme (PLI) schemes, if carefully nurtured, could lead the industry on that path.
    • Support MSMEs: Supporting MSMEs with cheaper input costs, including raw material and intermediate goods would help sustain them with job creation at the local level.
    •  Developing a synergistic relationship between the big industry and MSMEs is at the core of a successful Atmanirbhar Bharat.
    • Skill upgradation: Skills upgradation to global standards should form a part of India’s strategy in a post-COVID-19 world.

    Conclusion

    The patterns in the past leave much hope for optimism for global trade in the post-COVID-19 crisis in the collective belief that international trade is vital for development and prosperity.

  • The sovereign right to tax is not absolute

    Context

    A bill introduced in Parliament last week aims to nullify the 2012 amendment in the Income Tax Act which made the income tax law retroactively applicable on indirect transfer of Indian assets.

    Issue of taxation as a sovereign right of the state

    • Several  Investor-State Dispute Settlement (ISDS) tribunals have recognised the fundamental principle that taxation is an intrinsic element of the state’s sovereign power. 
    • The ISDS tribunals have also held that whenever a foreign investor challenges states’ taxation measures, there is a presumption that the taxation measures are valid and legal.
    • For instance, an ISDS tribunal in Renta 4 v. Russia said that when it comes to examining taxation measures for BIT breaches, the starting point should be that the taxation measures are a bona fide exercise of the state’s public powers.

    What are the limits on the taxation rights of a Country under BITs

    • The two most used BIT provisions to challenge a state’s taxation measures are expropriation and the fair and equitable treatment provision.
    • 1) Expropriation: In the context of expropriation, one of the key ISDS cases that explained the limits on the state’s right to tax is Burlington v. Ecuador.
    • In this case, the tribunal held that under customary international law, there are two limits on the state’s right to tax.
    • First, the tax should not be discriminatory.
    • Second, it should not be confiscatory.
    • 2) Fair and equitable treatment: In the context of the fair and equitable treatment provision, foreign investors have often challenged taxation measures as breaching legal certainty, which is an element of the fair and equitable treatment provision.
    • Although legal certainty does not mean immutability of legal framework, states are under an obligation to carry out legal changes such as amending their tax laws in a reasonable and proportionate manner.

    So, what happened in Cairn Energy v. India case?

    • The tribunal in Cairn Energy v. India said that taxing indirect transfers is India’s sovereign power and the tribunal would not comment on it.
    • Legal certainty: The tribunal said that India’s right to tax in the public interest should be balanced with the investor’s interest of legal certainty.
    • The tribunal held that the public purpose that justifies the application of law prospectively will usually be insufficient to justify the retroactive application of the law.
    • India argued that the 2012 amendment was to ensure that foreign corporations who use tax havens for the indirect transfers of underlying Indian assets pay taxes.
    • However, the tribunal held that this objective could be achieved by amending the income tax law prospectively, not retroactively.
    • The tribunal did not rule against retroactivity of tax laws per se but against the retroactive application that lacked public policy justification.

    Way forward

    • Carving out taxation from BITs: India in its 2016 Model BIT carved out taxation measures completely from the scope of the investment treaty.
    • Nonetheless, carving out taxation measures from the scope of the BIT does not mean that states are free to do as they please.
    • India should exercise its right to regulate while being mindful of its international law obligations, acting in good faith and in a proportionate manner.
    • ISDS tribunals do not interfere with such regulatory measures.

    Conclusion

    In sum, the debate never was whether India has a sovereign right to tax, but whether this sovereign right is subject to certain limitations. The answer is an emphatic ‘yes’ because under international law the sovereign right to tax is not absolute.

    Back2Basics:  Investor-State Dispute Settlement (ISDS) tribunal

    • ISDS is a mechanism included in many trade and investment agreements to settle disputes.
    • Settling these investor disputes relies on arbitration rather than public courts.
    • Under agreements which include ISDS mechanisms, a company from one signatory state investing in another signatory state can argue that new laws or regulations could negatively affect its expected profits or investment potential, and seek compensation in a binding arbitration tribunal.
    • The system only provides for foreign companies to sue states, not the other way around.

  • Taxation Laws (Amendment) Bill

    Context

    With the government proposing to repeal the ‘retrospective tax’ amendment introduced in the Union Budget 2012-13, a 14-year-story has come to an end.

    Background of retrospective tax

    • In 2007 Vodafone acquired Hutchison Essar, the telecom company, for $11 billion. But the deal did not take place in India.
    • Yet, Vodafone was slapped with a huge income tax demand in India.
    • The Supreme Court rule in favour of Vodafone and said that the Indian authorities could not tax a deal executed in Cayman Islands.
    • This verdict led to the 2012 amendment in the Income Tax Act, to the effect that if an Indian asset was held by a foreign company and an acquirer bought this holding company, such a transaction was deemed to be taxable in India because the underlying asset was located in India.
    • More importantly, this change was made retrospectively from 1962.
    • Now, the government has introduced The Taxation Laws (Amendment) Bill, 2021 to undo this insidious provision from the Finance Bill, 2012.
    • The government will not raise tax demands in any such case if the transaction occurred before 28 May 2012.
    • The tax on the indirect sale of assets located in India still stays on the statute books, but it is fully visible to and understood by any parties looking to enter into such a transaction.

    Why repeal of retrospective taxation is a good move?

    • Resolution of case the cases: This will potentially help resolve 17 cases in which income tax demand had been raised, including two high profile cases—Cairn and Vodafone.
    • Visibility and stability: The government is putting to rest the concept of retrospective taxation and is also creating visibility and stability for the future.
    • Predictability: The most important aspect of any tax regime is its predictability and this decision helps bring that.
    • Honouring the rule of law: It also reiterates India’s commitment to honour the rule of law and treaties.
    • Build confidence: Apart from the various reform measures and incentives being offered, the sanctity of contracts is a key factor that any investing entity will look at when deciding on expanding business operations in India.
    • The government’s move would help build confidence and provide a fillip to Atmanirbhar Bharat.

    Conclusion

    As the post-covid recovery picks up, focus needs to be on the future rather than keeping a sword of uncertainty for the past dangling on potential investors. Such a decision needs political capital and ownership, which comes through strongly in this case.

     

  • South Asia’s emerging digital transformation

    Context

    COVID-19 has forced South Asia to take a quantum leap in digitalisation, which will help shape its future prosperity.

    Spike in digitisation due to Covid

    • In India, COVID-19 accelerated the launch of the National Digital Health Mission, enhancing the accessibility and the efficiency of health-care services by creating a unique health ID for every citizen.
    • Pandemic accelerated South Asia’s embrace of e-commerce, boosted by digital payment systems.
    • Bangladesh alone witnessed an increase of 70-80% in online sales in 2020, generating $708.46 million in revenues.
    • Even smaller nations such as Nepal recording almost an 11% increase in broadband Internet users.

    The dangers of a digital divide

    • A wide digital divide persists in access and affordability, between and within the countries of South Asia.
    • Despite having the world’s second-largest online market, 50% of India’s population are without Internet with 59% for Bangladesh and 65% for Pakistan.
    • This divide could permanently put children out of school, place girls at risk of early marriage, and push poor children into child labour costing economies billions of dollars in future earnings.
    • Businesses too have paid a heavy price for the gap in digital solutions, whereby many South Asian firms failing to embrace e-commerce or other cloud-based technologies to survive the financial chaos of the novel coronavirus pandemic.

    Asian digitalisation

    • Digital transformation is a global imperative with the adoption of advanced technologies.
    • At the forefront of Asian digitalisation are countries such as Singapore, Japan, and South Korea recognised as global technological hubs.
    • The digital boom in the Association of Southeast Asian Nations (ASEAN) economies is pushing a “common market” initiative, fostering regional economic integration and enhancing global competitiveness.
    • South Asia has also made significant strides in the adoption of digital technologies such as the Digital Bangladesh Vision 2021.

    How digitalisation can help South Asia?

    • The region still has a long way to go.
    • Jobs in e-commerce: E-commerce could drive the post-pandemic growth in South Asia, providing new business opportunities and access to larger markets.
    • In India, e-commerce could create a million jobs by 2030 and be worth $200 billion by 2026.
    • Growth driven by Fintech: Fintech could drive significant growth and reduce poverty by building financial inclusion.
    • Increase in productivity: A timely, inclusive, and sustainable digital transformation can not only bolster productivity and growth but also serve as a panacea for some of the region’s socio-economic divides.

    Steps need to be taken

    • To reap the dividends of digital transformation, South Asia needs to address legal, regulatory and policy gaps as well as boost digital skills.
    • Digital infrastructure: A robust digital infrastructure is a sine qua non and there exists a huge financing gap.
    • India alone needs an annual investment of $35 billion to be in the top five global digital economy.
    • Private-public partnership: Public-private partnership needs to be leveraged for the region’s digital infrastructure financing.
    • Regulatory roadblocks need to be addressed as e-commerce regulations are weak in South Asia.
    • Digital literacy: There would be no digital revolution without universal digital literacy.
    • Governments and businesses need to come together to revamp the education system to meet the demand for digital skills and online platforms.
    • Cybersecurity measures: The crossflow of data and personal information calls for stringent cybersecurity measures as many have experienced painful lessons in data privacy during the pandemic.
    • Digital Single Market Proposal: By addressing issues such as regulatory barriers on currency flows inhibiting online payment to transport-related constraints for cross-border e-commerce activities, South Asia can emulate the European Union’s Digital Single Market Proposal.
    • Collaboration: Concerted collaboration at all levels is needed to push South Asia out of stagnancy and towards a digital future of shared prosperity.
    • Partnership for digital revolution: During the pandemic, South Asian nations joined hands to collectively battle the crises by contributing towards a COVID-19 emergency fund, exchanging data and information on health surveillance, sharing research findings, and developing an online learning platform for health workers.
    • If the eight nations (Afghanistan, Bangladesh, Bhutan, India, Nepal, Maldives, Pakistan and Sri Lanka) can start walking the talk, partnership for a successful digital revolution is plausible.

    Conclusion

    A shared “digital vision” could place the region on the right track towards the Fourth Industrial Revolution.

  • Centre moves to redact Retrospective Tax Law

    The government took the first step towards doing away with the contentious retrospective tax law of 2012, which was used to raise large tax demands on foreign investors like Vodafone and Cairn Energy.

    Retrospective Tax Law: A backgrounder

    • The roots of this law date back to 2007, when Vodafone bought over a majority stake in the telecom operations of Hutch in India for $11.1 billion.
    • While the deal involved the changing of hands of Indian operations of Hutch, the companies party to it were registered outside India and all the paperwork and financial transactions, too, were done outside the country.
    • But the Indian government ruled that Vodafone was liable to pay capital gains tax to it as the deal involved the transfer of assets located in India.
    • Importantly, there was no rule in the Indian statutes then that allowed such taxation.
    • Vodafone challenged this claim and the case went to Supreme Court, which ruled in 2012 that there was no tax liability on Vodafone’s part to Indian authorities.

    What was the law made then?

    • In 2012, Parliament amended the Finance Act to enable the taxman to impose tax claims retrospectively for deals executed after 1962 which involved the transfer of shares in a foreign entity whose assets were located in India.
    • The target, of course, was the Vodafone deal. Very soon, tax claims were also raised on Cairn Energy.

    How did the Companies react?

    • The changes to the Finance Act allowed India to reimpose its tax demand on Vodafone.
    • Tax authorities had slapped a tax bill of Rs 7,990 crore on Vodafone, saying the company should have deducted the tax at source before making a payment to Hutchison.
    • By 2016, reports say, the bill had risen to Rs 22,100 crore after adding interest and penalty.
    • The demand on Cairn was for Rs 10,247 crore in back taxes over its move, beginning in 2006, to bring its Indian assets under a single holding company called Cairn India Ltd.
    • A few years later, when Cairn India Ltd floated an IPO to divest about 30 per cent of its ownership of the company, mining conglomerate Vedanta picked up most of the shares.
    • However, Cairn UK was not allowed to transfer its stakes as Indian officials held that the company had to first clear the tax liability.

    Note: This story is of no use to aspirants. But one must understand how such cases create regression for the Indian economy in the long run.

    A case in the Hague

    • That prompted Cairn UK to move the Permanent Court of Arbitration to The Hague, Netherlands.
    • It said that India had violated the terms of the India-UK Bilateral Investment Treaty by imposing a retrospective tax due on it.
    • The treaty provides protection against arbitrary decisions by laying down that India would treat investment from the UK in a “fair and equitable” manner.
    • Vodafone, too, had sought arbitration before the Permanent Court of Arbitration, citing the “fair and equitable” treatment clause in the India-Netherlands BIT.

    India’s response

    • In September last year, the Hague court ruled in favour of Vodafone, quashing India’s tax claim after holding that it violated the “equitable and fair treatment standard” under the bilateral investment treaty.
    • India refused to pay the compensation, Cairn launched recovery proceedings across countries as part of which a French court ordered the freezing of some Indian assets in Paris.
    • This move discourages foreign investors from coming to India and that the Centre should look to resolve the case at the earliest.
    • The amendments now mooted are designed to do just that.

    Taxation Laws (Amendment) Bill, 2021

    • The Bill offers to drop tax claims against companies on deals before May 2012 that involve the indirect transfer of Indian assets would be “on fulfilment of specified conditions”.

    Various conditions:

    • The condition includes the withdrawal of pending litigation and the assurance that no claim for damages would be filed.
    • As per the proposed changes, any tax demand made on transactions that took place before May 2012 shall be dropped, and any taxes already collected shall be repaid, albeit without interest.
    • To be eligible, the concerned taxpayers would have to drop all pending cases against the government and promise not to make any demands for damages or costs.

    Why is the amendment necessary?

    • The retrospective taxation was termed “tax terrorism”.
    • It is argued that such retrospective amendments militate against the principle of tax certainty and damage India’s reputation as an attractive destination.
    • This could help restore India’s reputation as a fair and predictable regime apart from helping put an end to taxation.

  • Need to deal with the flaws in the existing structure of GST

    Context

    After four years, the promise of the Goods and Services Tax (GST) remains substantially unrealised.

    Why tax base of GST is not expanding

    • The GST is strongly co-related to overall GDP.
    • Revenue collection of the GST is dependent on the nominal growth rate of Gross Value Added (GVA) in the economy.
    • Since inception, GVA per quarter has been between ₹40-lakh crore to ₹47-lakh crore and GST revenue has not been higher than ₹2.7-lakh crore to ₹3.1-lakh crore.
    • The Tax to Gross value addition is only about 5% to 6.5% though GVA growth was much higher.
    • Issues: A very large segment is covered by exemption, composition schemes, evasion and lower tax rate.

    Five Issues with the GST structure

    1) Dominance of the Centre

    • The political architecture of GST is asymmetrically loaded in favour of the Centre.
    • No body to adjudicate: There is no particular body is tasked to adjudicate if there is a dispute between States and between the Centre and the States.
    • Centre’s domination: In the voting, the central government has one-third vote and States have two-thirds of total votes.
    • All states have equal voting rights regardless of size and stake.
    • With the support of a dozen small States whose total GST collection is not more than 5% of the total central government can dominate the decision making process in GST Council.
    • Small states dictate the terms: With equal value for each States’ voting, larger and mid-sized States feel shortchanged.

    2) Flaw in tax structure

    • Nearly 45% to 50% of commodity value is outside the purview of the GST, such as petrol and petroleum products.
    • Certain states not getting revenue as origin state: States which export or have inter-State transfers or mineral and fossil fuel extractions are not getting revenue as the origin States and need a compensation mechanism.
    • The pre-existing threshold level of VAT has been tweaked too often which has led to an evaporation of tax base incentivising, enabling evasion and mis-reporting.
    • Most trading and retail establishments, (however small) are out of the fold of the GST.
    • At the retail level, irrespective of whether Input Tax Credit (ITC) is required or not, the burden can be passed off to the consumer.
    • As a result, the loss could be as high as one third.

    3) Exemptions

    • Exemptions from registration and taxation of the GST have further eroded the GST tax base compared to the tax base of the pre-existing VAT.
    • Ground for evasion: Exemptions are purely distortionary and also provide a good chance to remain under the radar, thereby directly increasing evasion or misclassification.
    • Theoretically, exemptions at the final stages reduce tax realisation.
    • Multiple rates: As multiple rates are charged at different stages, it goes against the lessons of GST history.
    • This tax works well with a single uniform tax rate for all commodities and services at all stages, inputs and outputs alike.
    • While most countries have a single rate, India stands out and is among the five countries to have four rates/slabs.

    4) Exclusion

    • Against the interest of States: Petroleum products remaining outside the purview of GST has helped the Centre to increase cesses and decrease central excise, in what would otherwise have been shareable with the States.
    • Now, States will be keen on including petrol and diesel under the GST as their share of tax goes up in the process, even if there is a special rate fixed for it.
    • Equity requires that petrol and diesel be brought under the GST.
    • Cascading of taxes: Apart from the complexity it creates in record keeping and ‘granting ITC’, in the present form it also leads to a cascading which the GST avowedly tried to avoid.

    5) Lack of compliance

    • Compliance with GST return (GSTR-1) filing stipulation and the resultant tax information is not up to date.
    • Fraudulent claims of Input Tax Credit (ITC) because of a lack of timely reconciliation are quite high though it has come down by two thirds.
    • Tax evasion, estimated by a National Institute of Public Finance and Policy’s paper, is at least 5% in minor States and plus 3% in the major States.

    Conclusion

    Policy gaps along with compliance gaps do need to be addressed. Without proper tax information, infrastructure and base, the States would go in for selective tax enforcement. In the long run, voluntary compliance will suffer and equity in taxation will be violated.

  • Vaccination and normalising of monetary policy hold key to economic rebound

    Context

    Increasing pace of vaccination and normalising of monetary policy hold key to economic rebound.

    K-shaped recovery and its impact

    • Growth indicators so far suggest resilience in the short term — a shallow dent in May’s economic activity followed by a recovery in June, back to April’s levels.
    • K-shaped recovery: The external, investment and industrial sectors have been relatively resilient, with consumption and services bearing the brunt.
    • Notwithstanding signs of some fatigue in ultra-high frequency indicators in July, damage from the second wave seems largely limited to April-June 2021.
    • However, K-shaped recovery means light cracks on the top conceal much larger structural faultlines below.
    • Rising poverty: The Pew Research Centre estimates that the pandemic has led to India’s poor rising by 75 million while the middle and upper-middle class has shrunk by 39 million.
    • MSMEs and informal workforce worst hit: A recent survey by the ILO finds that the worst-hit — MSMEs and their informal workforce — have struggled to access the government’s pandemic support programmes.
    • These more structural scars may become blurred in the GDP data in coming quarters but will almost certainly affect the medium-term growth story.

    Way forward in the near term

    1) Policy

    • Achieving two objectives: When inflation is under control, then flush liquidity and ultra-accommodative monetary policy will help achieve two objectives—
    • 1) Ensuring easy financial conditions.
    • 2) Help control borrowing costs of the government’s expansive borrowing programme.
    • Inflation risk: The above strategy is not costless, it effectively uses the central bank’s credibility in controlling inflation as “collateral”.
    • So when inflation flares up and remains sticky, this arithmetic becomes increasingly complicated.
    • The RBI’s consistent message recently has been to view the current inflation surge as a “temporary hump”.
    • Much as the current monetary policy stance maintains that the economy is ill-equipped to handle policy normalisation, it is a matter of when rather than if.
    • As growth strengthens and the RBI’s inflation-targeting credibility comes under greater scrutiny, a policy pivot would become increasingly likely.

    2) Vaccination

    • The “ultimate unlocking” of the economy remains contingent on a critical mass getting vaccinated, which on materialising should trigger a revival in consumer and business sentiment.
    • The uptick in the pace of vaccination over the last few days and higher seroprevalence reported in some states are welcome news.

    Conclusion

    Even with widespread vaccinations, future pandemic waves may well be unavoidable. Fiscal, monetary and administrative policies cannot remain in a suspended emergency.

    Back2Basics: K-shaped recovery

    • A K-shaped recovery occurs when, following a recession, different parts of the economy recover at different rates, times, or magnitudes.
    • This is in contrast to an even, uniform recovery across sectors, industries, or groups of people.
    • A K-shaped recovery leads to changes in the structure of the economy or the broader society as economic outcomes and relations are fundamentally changed before and after the recession.
    • This type of recovery is called K-shaped because the path of different parts of the economy when charted together may diverge, resembling the two arms of the Roman letter “K.”

  • The goal of making the rupee a global reserve currency

    Context

    India will celebrate 100 years of Independence in 2047.  This article makes the case that prosperity is possible and best accomplished by the goal of making the rupee a global reserve currency by India@100.

    What is the purpose of having forex reserves?

    • Official foreign exchange reserves of about $12 trillion across 150 countries are currently stored in eight currencies: 55 per cent in US dollars, 30 per cent in euros, and 15 per cent in six other currencies.
    • Protection in case of volatility: This concentration is inevitable given exploding trade, rising capital flows, and the less acknowledged motivation of protecting your reserves from your currency’s volatility.
    •  A reserve currency has to serve as a medium of exchange, a store of value, and a unit of account. 

    Steps India would require to take

    • Full capital account convertibility: To fulfil the ambition of becoming the reserve currency, the first step is full capital account convertibility, as suggested by the Tarapore Committee in 1997. 
    • Advocate rupee invoicing: Dollar investors in the last decade not experiencing the usual big bite out of rupee returns is useful for advocating trading partners to start rupee invoicing.
    • Offshore corporate rupee borrowing: Raising corporate rupee borrowing offshore and onshore will also help.
    • Digital currency: We need to accelerate our CBDC (central bank digital bank currency) plans.
    • Take payment networks to a global level: We need to take our UPI payment technology to the world, the dollar gets heft from global networks like Visa, MasterCard and Swift.
    • Raise tax to GDP ratio: Fiscal policy must raise our tax to GDP ratio, raise the share of direct taxes in total taxes, and keep our public debt to GDP ratio under 100 per cent.
    • Monetary policy: Monetary policy must control inflation while moderating central bank balance sheet size.
    • Economic policy: Economic policy must raise the productivity to reach goals in formalisation, urbanisation, financialisation (100 per cent credit to GDP ratio), industrialisation (less than 15 per cent farm employment), internationalisation (higher share of global trade) and skilling.
    • Institutional reforms: These goals must be complemented by reinforcing institutions that signal rule of law; cooperative federalism, press freedom, civil service effectiveness, and judicial independence.

    How it will help India?

    • Becoming a global reserve currency is helpful because it indirectly aligns fiscal, monetary, and economic policy.
    • Low-interest rate: The main advantage is the “exorbitant privilege” of lower real interest rates.
    • Edge over China: The 2 per cent renminbi share in global reserves — despite a 25 per cent increase last year — doesn’t reflect their status as the world’s second-largest economy and biggest trading nation.
    • China’s astounding economic success seems to be making China overconfident.
    • Chinese overconfidence creates an opportunity for India. 

    Conclusion

    Prosperity for all Indians by India at100 — a precondition for a country where the mind is without fear and the head is held high — needs bold reforms in the next 25 years. These reforms are best measured by the wholesome and achievable goal of the rupee becoming a global reserve currency by 2047. The journey is the reward.

  • A cycle of low growth, higher inflation

    Context

    In recent times, several economists have been arguing that the Government does not need to do anything with the economy. They argue that like after the Great Depression, the economy rebounded worldwide, and so will it with us. The argument is fallacious on four accounts:

    Four factors that make recovery different from the recovery after the Great Depression

    1) Demand destruction

    • In the case of the Great Depression, demand was created by the Second World War effort, especially in the United States.
    • Demand destruction: In the current scenario, the COVID-19 pandemic has resulted in demand destruction.
    • This is because many jobs have been lost, and even where jobs were retained, there have been pay cuts.
    • Both of these trends were confirmed in the Centre for Monitoring Indian Economy and other surveys.

    Bright spot on export front

    • The only bright spot in this dismal scenario is that the western world has spent a lot of money stimulating the economy.
    • However, the Indian exporter face the challenge of rising freight costs and structural issues such as a strong rupee relative to major competitors.
    • Only the Indian IT sector is placed well to capitalise on rising demand in the world markets.

    2) Inflation and factors driving it

    • India is suffering from stagnant growth to low growth in the last two quarters.
    • As in the low initial base set by last year, almost any growth this year is seen as a significant growth percentage.
    • Commodity prices and monetary policy: Inflation in India is being imported through a combination of high commodity prices and high asset price inflation caused by ultra-loose monetary policy followed across the globe.
    • Liquidity infusion: RBI is infusing massive liquidity into the system by following an expansionary monetary policy through the G-SAP, or Government Securities Acquisition Programme.
    • Foreign portfolio investors have directed a portion of the liquidity towards our markets.
    • India has a relatively low market capitalisation, therefore, India cannot absorb the enormous capital inflow without asset prices inflating.
    • Supply chain issues: Additionally, supply chain bottlenecks have contributed to the inflation we see in India today.
    • Rising fuel prices: India’s usurious taxation policy on fuel has made things worse.
    • Rising fuel prices percolate into the economy by increasing costs for transport.

    Impact of inflation

    • The middle and lower-middle-class get destitute due to regressive indirect taxes and high inflation, with their wealth eroding due to said inflation.
    • Especially in the case of the lower middle class, inflation is lethal as they do not have access to any hard assets, including the most fundamental hard asset, gold.
    • The increase in fuel prices will also lead to a rise in wages demanded as the monthly expense of the general public increases.
    • This leads to the dangerous cycle of inflation and depleting growth.

    3) Interest Rate

    • The only solution for any central banker once he realises that inflation is entrenched is tightening liquidity and further pushing the cost of money.
    • If this does not dampen inflation, repo rates will need to go up later this year or early next year.
    • Tightening the money supply is a painful act that will threaten to decimate what is left of our economy.
    • Rising interest rates lead to a decrease in aggregate demand in a country, which affects the GDP.
    • There is less spending by consumers and investments by corporates.

    4) Rising NPA and its impact on credit growth

    • Rising interest rates, lack of liquidity, and offering credit to leveraged companies instead of direct subsidies to support small and medium-sized enterprises (SMEs) and micro, small and medium enterprises (MSMEs) to counter the COVID-19 pandemic and its effects will result in NPAs of public sector banks climbing faster.
    • Our small and medium scale sector is facing a Minsky moment. 
    • The Minsky moment marks the decline of asset prices, causing mass panic and the inability of debtors to pay their interest and principal.
    • India has reached its Minsky moment.
    • This means that the public sector unit and several other banks will need capital in copious amounts to make up for bad debt.
    • The Union government’s Budget is in no position to infuse large amounts of capital.
    • As a result of the above causes, credit growth is at a multi-year low of 5.6%.

    Way forward

    • Indian economy is in a vicious cycle of low growth and higher inflation unless policy action ensures higher demand and growth.

    Conclusion

    In the absence of policy interventions, India will continue on the path of a K-shaped recovery where large corporates with low debt will prosper at the cost of small and medium sectors. This means lower employment as most of the jobs are created by the latter.