Subject: Economics

Inflation or price rise has been a major concern of policymakers for a long long time. Common man also lists price rise among his top most concerns. Responsibility of controlling price rise lies with government and RBI. But to control something, we need data which tells us direction in which we are moving.

In India, that data or measure of inflation is Wholesale Price Index (WPI) and Consumer Price Index (CPI). But of late both these data sets are moving in opposite direction.

Then are the prices rising or falling? What explains the difference b/w these two indicators? Which one should be used for taking important policy decisions which affect the whole economy? And finally why is inflation such a bad thing and if it were such a bad thing, surely deflation should be great. who wouldn’t like cheap goods! But why is then Japan struggling with precisely such a thing and Eurozone doing its utmost to avoid deflation?

Let’s understand inflation 

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.

Note here the term general price level i.e. increase in price of only 1 or 2 commodities is not inflation but increase in prices of a basket of goods and services.

Let’s understand this with a one commodity economy first-

Suppose in India only apples are consumed and they cost 100 rs a kg in 2010

Year	Commodity	Price	Quantity (Kg)	Bill	Inflation
2010	Apple	100	1	100	No data
2011	Apple	110	1	110	110-100/100
2012	Apple	130	1	130	130-110/110

But suppose both apples are oranges are consumed in India and prices of oranges actually fell from 100 to 95 and then 90.

Inflation in oranges 95-100/100 would be -5%

so general inflation would be 10% + (-5%) = 5% right? If you think so, CSAT mein kamjor lagte ho. Consider this

Year	Commodity	Price	Quantity (kg)	Bill	Inflation
2010	1.     Apple 2.    Orange	100 100	1 2	100*1 + 100*2 = 300	No data
2011	1.   Apple 2.  Oranges	110 95	1 2	100*1 + 95*2= 300	300-300/300 =

Here, we introduce the concept of weights. When calculating general inflation, we need to assign weights to different goods and services in the proportion they are consumed and then we take weighted average to compute general inflation.

The year whose consumption level is included in creation of basket of goods and services is called base year, in this case 2010. Base Year has to be frequently revised as consumption basket keeps on changing. For instance, pizza would not have been in the consumption basket about a decade back.

Base Effect

Scenario one,

Year	Commodity	Price	inflation
2010	Apple	100	No data
2011	Apple	150	50%
2012	Apple	140	140-150/150= negative inflation

 in 2012 there is negative inflation while w.r.t to 2010, prices have risen significantly.

Scenario two

Year	Commodity	Price	inflation
2010	Apple	100	No data
2011	Apple	120	20%
2012	Apple	140	140-120/120= 17%

In this scenario also prices in 2010 and 2012 are same but due to excessive inflation in 2011 in earlier case, 2012 appeared to be deflationary.  This anomalous situation is being created due to base effect.

What we were calculating till now was price rise in items average citizen consume. Because we are talking about consumers this is called Consumer Price Index (CPI) inflation.

Let’s know more about CPI inflation in India

Base year- 2012

Calculated by – Central Statistical Organization (CSO) in Ministry of Statistics and Programme Implementation (MoSPI) using  Laspeyres formula (basically our weighted average formula)

Basket: 

 

These broad categories are further divided into subcategories but that’s not important. What is important is that about 46% weight is given to food items and any increase in food prices will lead to increase in CPI inflation.

Other point to note is that health, education etc services are also there in CPI basket. we shall later see services are not in WPI basket and thus CPI gauges services inflation as well.

But food prices are highly volatile as food products can’t be stored for long and prices depend on agriculture output. Also food is an essential good and people will buy food no matter what the food prices are, food inflation is not much affected by central bank policies. It’s a supply side issue.

Similar is the case with fuel prices which are highly volatile.

• When we remove these components from overall inflation, we get core inflation
• Core CPI =Headline CPI MINUS (food and fuel components.)

Why is overall inflation called Headline Inflation?

That is what newspaper headlines report

Because consumption basket of rural and urban areas are different, CPI inflation is calculated separately for rural and urban areas.

CPI (rural) and CPI (urban) both have same 2012 base with slightly different weightage. For instance Rural CPI doesn’t consider Housing inflation. Weightage of food items is about higher in rural areas. Weighted average of CPI(R) and CPI(U) gives overall CPI inflation.

Earlier we used to calculate 4 different categories of CPI inflation

1. Agricultural Labourer (AL)
2. Rural Labourer (RL)
3. Industrial Workers (IW)
4. Urban Non-Manual Employees (UNME)

First 3 computed by Labour bureau, as you can guess and the last one by CSO. We continue to compute these indices but focus now is on CPI (rural), CPI (Urban) and overall CPI

Why is CPI important-

It directly affects what consumers pay to buy a select basket of goods and services. It is thus better indicator of the cost of living and, hence, reflecting the welfare objective of monetary policy.

Let’s now take a look at Wholesale Price Index (WPI) inflation.

As the name suggests it computes price rise at the level of goods and services sold at wholesale level

Base Year : 2004

Calculated by Economic Adviser in the commerce ministry using same Laspeyres formula

Basket 

Primary Articles include food, non food and minerals

Weightage of food items in WPI is weightage of primary food articles (cereal, pulses etc) + weightage of manufactured food items (ice cream, ghee, butter etc)

14% + 10% = 24%

• Core WPI  ignore Food and Fuel (volatile components)
• Core WPI is WPI of Non-food manufacturing industries
• Core WPI = Headline WPI – (primary + fuel + food mfg. industries)

Note here that WPI does not take into account inflation in services sector such as education, health etc. while 65% of our GDP comes from services sector i.e. it does not give complete picture of price rise in the economy.

In spite of that, RBI used to focus on WPI earlier as CPI basket and base year was not frequently revised and data set was not robust but after the signing of monetary policy framework RBI has decided to focus on CPI as it directly affects consumers and thus better indicator for policy formulation.

But if RBI is to focus on CPI only, what’s the importance of WPI and why so much divergence with WPI in negative and CPI 5% in positive.

1. Statistical difference –

• inclusion of services in CPI
• Different weightage to different items with food occupying highest weightage in CPI and food inflation being higher
• While reduced crude prices leading to negative WPI

2. Transaction costs – Middlemen might have increased their profit margin

3. Taxes – Indirect taxes 

If same item has higher inflation in CPI than WPI, possible reason could be higher margins and govt can target that area to bring down inflation.

Other measure of inflation is GDP deflator which we understood in this article

What is Produce Price Index (PPI)

PPI is inflation at producer level without any tax component

Advantage of PPI over WPI

• Majority of the OECD countries measure inflation based on PPI (International Best Practice)
• WPI includes taxes while PPI tracks inflation minus tax component
• PPI will track average change over time in selling prices received by domestic producers for their output for both goods and services while WPI tracks transaction only at the wholesale level for goods.

Govt set up a committee headed by Professor BN Goldar to devise PPI.

Earlier two separate groups headed by Abhijit Sen and Saumitra Chaudhuri underscored the importance of PPI but felt that more work and data was needed to fully construct PPI.

Let’s understand some other terms associated with inflation

Deflation- Opposite of inflation i.e. general decline in prices. it is generally associated with contracting economy i.e. recession and is much more dangerous than inflation.

Disinflation-Slow down in the rate of inflation i.e. prices are still rising but as the lower pace. Eg. If inflation rate was 10%, 2 years back, 8% last year and, 6% this year, economy is said to be in disinflation.

Hyperinflation– Very high and accelerating inflation which cause people to severely curtail their use of the currency as currency simply becomes worthless. For instance in Germany after 1st world war or in Zimbabwe a few years back. Prices rise 10% or more month on month.

Stagflation- 

stagnation plus inflation i.e. inflation in a stagnating economy. Generally inflation is associated with a booming, high growth economy but when economy is contracting, growth rates are coming down, unemployment is rising and there is high inflation , it is called stagflation.

What are the causes of inflation?

Essentially there is more amount of money to buy limited amount of goods and services leading to rise in prices (demand supply mismatch). It could be due to following reasons-

1. Demand pull inflation –  increases in aggregate demand due to increased private and government spending. Thus high fiscal deficits, high subsidies lead to demand pull inflation.
2. Cost push inflation– also called “supply shock inflation,” is caused by a drop in aggregate supply. This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example could be inflation due to high administered prices due to high MSP.

Monetary policy can mainly control demand pull inflation by raising interest rates, tightening liquidity thus reducing amount of money available. Supply side inflation is difficult to control by monetary authorities and in case of India main cause of inflation is high food prices which is a supply side issue due to rigidities in agriculture markets. Then why does RBI raise interest rate when inflation is due to supply side issues such as high food prices? 

Here comes the role of 3rd factor-

3. Built in inflation is induced by adaptive expectations, and is often linked to the price-wage spiral. Essentially workers try to keep their wages up with prices (above the rate of inflation), and firms pass these higher labor costs on to their customers as higher prices, leading to a ‘vicious circle’.

RBI raises rates to break this vicious circle.

For this very reason, RBI conducts survey of inflationary expectations and latest surveys suggest in spite of inflation being down to 5%, expectations are of double digit inflation due to very high inflation for a prolonged period.

Let’s now understand effects of inflation 

General Effects –

1. As same amount of money buys less goods, purchasing power of currency comes down, currency depreciates in international exchange rate market. How? Learn here
2. It benefit borrowers or debtors as in real terms they have to repay less amount in real terms while it hurts creditors or savers.

Year	Borrowed/ lent	Inflation	Apple price	Real amount Borrowed/ returned
2010	1000	No data	100	10 kg
2011	1000	10%	110	9 .1 kg

You can clearly see, borrower/ debtor has to return less in real term, thus advantage debtor/and disadvantage creditor / bond holder.

Negative effect-

• Uncertainty about future rate of inflation makes it difficult to conclude business deals, affects investment.
• Savers tend to park their money in fixed assets, financial savings fall. One of the reason for gold rush in India was high inflation.
• Hurts poor the most as they are not able to bargain for higher wages to keep up with the rising prices
• Hoarding– to take advantage of higher prices in future, this furthers inflation and vicious cycle starts. Recall the case of pulse hoarders when pulse prices were shooting up.
• Finally there is always that risk of inflation going out of control resulting in hyperinflationary situation which can cripple the whole economy

Positives

1.Most important positive is that it avoids deflationary tendencies which is the worst

Effects of deflation

1. As we saw above, it harms borrowers resulting in inability to repay loans. Companies and banks collapse
2. While in inflation people start hoarding, here people postpone their purchases in the expectation of future fall in prices. If nobody buys, demand goes down and economy goes under recession resulting in job losses and high unemployment

2. Labour-market adjustments- Nominal wages are slow to adjust downwards. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.

Consider this, real salary has decreased but person would feel he had been awarded 8% pay hike.

Year	Nominal salary	Inflation	Apple price	Real salary in apples
2010	1000	No data	100	10 kg
2011	1080	20%	120	9 kg

But if there were no inflation, he would have resisted wage decline, though it would have been same, worth 9 kg apples.

Year	Nominal salary	Inflation	Apple price	Real salary in apples
2010	1000	No data	100	10 kg
2011	900	0	100	9 kg

In emerging economies such as India, structure of economy changes rapidly and thus more frequent churning and adjustment in labour market is required. It is for this reason that inflation level of 4-6% is considered healthy in emerging economies while most advanced economies don’t like inflation beyond 2%.

 

Inflation especially demand pull inflation is associated with high growth and low unemployment. As demand rises, industries increase their production leading to higher growth and employment. This holds true only for short term.

A few more terms before we wind up our discussion –

Phillips curve is a historical inverse relationship between rates of unemployment and corresponding rates of inflation.

Misery index – the sum of the inflation and unemployment rates

Modified misery index – sum of the interest, inflation, and unemployment rates, minus the year-over-year percent change in per-capita GDP growth

In the next article we shall discuss tools available with government and RBI to control inflation and why monetary policy transmission is very poor in India.

Now it’s time to solve a few questions asked in previous years IAS prelims-

#1. Which of the following brings out the ‘Consumer Price Index Number for Industrial Workers? (IAS pre 2015)

• (a) The Reserve Bank of India
• (b) The Department of Economic Affairs
• (c) The Labour Bureau
• (d) The Department of Personnel and Training

#2. A rise in general level of prices may be caused by

1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand

Select the correct answer using the codes given below.

1. 1 only
2. 1 and 2 only
3. 2 and 3 only
4. 1, 2 and 3

#3. Consider the following statements: (IAS Pre 2014)

1. Inflation benefits the debtors.
2. Inflation benefits the bond-holders.

Which of the statements given above is/are correct?

1. 1 only
2. 2 only
3. Both 1 and 2
4. Neither 1 nor 2

#4. India has experienced persistent and high food inflation in the recent past. What could be the reasons?(2011)

1. Due to a gradual switchover to the cultivation of commercial crops, the area under the cultivation of food grains has steadily decreased in the last five years by about 30%.
2. As a consequence of increasing incomes, the consumption patterns of the% people have undergone a significant change.
3. The food supply chain has structural constraints.

Which of the statements given above are correct?

• (a.) 1 and 2 only
• (b.) 2 and 3 only
• (c.) 1 and 3 only
• (d.) 1, 2 and 3

#5. A rapid increase in the rate of inflation is sometimes attributed to the “base effect”. What is “base effect”?(2011)

• (a.) It is the impact of drastic deficiency in supply due to failure of crops
• (b.) It is the impact of the surge in demand due to rapid economic growth
• (c.) It is the impact of the price levels of previous year on the calculation of inflation rate
• (d.)None of the statements (a), (b) and (c) ‘given above is correct in this context

#6. Economic growth is usually coupled with (2011)

• (a.) Deflation
• (b.) Inflation
• (c.) Stagflation
• (d.) Hyperinflation

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Having discussed how to read Economic Survey earlier, we now start our series on economic survey chapter by chapter. We shall follow a standard pattern across all chapters. We shall begin by highlighting ‘quotable quotes’ or observations which might not otherwise come for discussion but nevertheless very important for general understanding, general studies papers and essay. We shall then present some very basic statistics from the chapter and move to discuss broad themes of the chapter. In the end, important reading from the chapter shall be recommended.

I have hyperlinked text with articles previously covered. So go back in time and read the articles if any doubt. Take this opportunity to revise the economy section of syllabus.

So let’s get started

1. It’s futile to expect “Big Bang” reforms because of two reasons

• dispersed nature of power in India, too many veto centers
• the absence of that impelling driver—crisis

Note that reform of 1991 was in response to major crisis, SEBI was given statutory backing in response to major scam in stock market and recent merger of Forward Market Commission (FMC) with SEBI was also a response to major scam.

Therefore, “persistent, creative and encompassing incrementalism” will be the key.

2. Being pro industry and pro market or pro competition is not one and the same

• India has moved away from being reflexively anti-markets and uncritically pro-state to being pro-entrepreneurship and skeptical about the state
• But being pro industry must evolve into being genuinely pro competition, and the legacy of the pervasive exemptions Raj and corporate subsidies highlights why favoring business (and not markets) can actually impede competition
• Similarly, skepticism about the state must translate into making it leaner, without delegitimizing its essential roles and indeed by strengthening it in important areas

3. Amid the world economy which is full of turbulence and volatility, India is a refuge of stability and an outpost of opportunity

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1. Survey projects GDP growth of 7-7.75% for the financial year (FY) 17
2. For FY16, GDP growth is estimated to be 7.6%
3. Forex reseves have risen to >350b$

Let’s now discuss some broad issues

India becoming more and more intertwined with global growth

• the correlation between India’s growth rate and that of the world has risen sharply to .42 from .2 for the period 1991- 2002 i.e. 1 % decrease in the world growth rate # 0.42 % decrease in Indian growth rates
• India’s exports of manufactured goods and services now constitute about 18 percent of GDP, up from about 11 percent a decade ago

Realizing long term potential growth of 8-10% requires a push on at least three fronts-

1. Creating genuinely pro competitive market by allowing inefficient firms to exit (Chakravyuha challenge) – Govt response- new bankruptcy code, rehabilitation of stalled projects, Kelkar Committee guidelines on PPP renegotiation
2. major investments in people— health and education- to exploit India’s demographic dividend.
3. Don’t neglect agriculture as 42% of Indian households derive the bulk of their income from farming. Smaller farmers and landless laborers especially are highly vulnerable to productivity, weather, and market shocks changes that affect their incomes. Govt response – PM Fasal Bima Yojana

Evolution of relative role of centre and states in the delivery of services-

1. With increased devolution of resources (courtesy 14th Finance commission), states need to expand their capacity and improve the efficiency of service delivery.
2. shift the focus from outlays to outcomes, and to learn by monitoring, innovating, and even erring.
3. the Centre should focus on improving policies, strengthening regulatory institutions, and facilitating cooperative and competitive federalism
4. while the states mobilize around implementing programs and schemes to ensure better service delivery

How does competitive federalism help?

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States that perform well are increasingly becoming “models and magnets.”

• Successful experiments in one state are models for others states to emulate by showing what can be done and stripping away excuses for inaction and under-performance.
• They are also magnets because they attract resources, talent and technology away from the lagging states, forcing change via channel of exit.

Twin Balance Sheet Challenge

What are twin balance sheets – Bank balance sheet and corporate balance sheet

Basically both are interlinked, as asset on bank balance sheet is liability on corporate balance sheet and if corporate does not repay debt, asset turns bad (Non Performing Asset or NPA) and both balance sheets get stretched. It results in banks not lending and corporate not investing resulting in vicious circle.

Solution-

What has been done so far– Indradhanush scheme, Strategic Debt Restructuring (SDR) scheme, 5:25 scheme

What needs to be done– 4Rs

1. Recognition-  Banks must value their assets as far as possible close to true value i.e. recognize NPAs as NPAs
2. Recapitalization–  capital position must be safeguarded via infusions of equity
3. Resolution– the underlying stressed assets in the corporate sector must be sold or rehabilitated
4. Reform–  future incentives for the private sector and corporates must be set right to avoid a repetition of the problem

But where would resources for recapitalization would come from given that government is committed to the path of fiscal consolidation?

1. Divest govt. equities in non financial companies and invest in PSBs
2. Dilute RBI’s capital to capitalize banks
3. govt can dilute its equity in banks to raise resources from the market

What should be the stance of fiscal consolidation?

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Learn Various types of Budget Deficits here- Budget Deficits Explained

Govt announced revised FRBM timeline last year with fiscal deficit target of 3.9% for FY16 and 3.5% for FY17. In this context question arises whether or not we remain committed to the same path of fiscal consolidation.

Arguments for accelerated fiscal consolidation –

1. debt ratio of the consolidated government (Centre plus states), 67 per cent of GDP is high compared to some countries in Emerging Asia
2. would reinforce govt’s credibility
3. also why such a commitment should be abandoned when the economy is growing at more than 7 per cent
4. Higher deficits may increase short term interest rates and thus hurt corporate investment and increase govt spending on interest

Arguments against-

1. 7th Pay commission award will increase expenditure by about .5% of GDP, to maintain same fiscal deficit, govt might need to slash capital expenditure
2. Public investment may need to be increased further to address a pressing backlog of infrastructure needs
3. current global environment is fraught with risks and India should not take chances against growth

In this context it is important that government utilizes resources available to it to increase capital expenditure in roads, railways, ports etc which increases overall productivity and competitiveness of economy.

Update- Government chose prudence and stuck to fiscal deficit target of 3.5% of GDP in the budget announced today.

India and WTO

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Two issues in agriculture-

1. Special safeguard mechanism (SSM) which came for discussion in Nairobi ministerial meeting . The question which arises is whether India even needs such protection

• We are already allowed tariff  from 40 per cent to 100 per cent (India’s modal rate in agriculture) to 150 per cent.
• In a preponderance of tariff lines, there is a considerable gap between applied tariffs and the level of tariff binding
• India’s only real need for SSM arises in relation to a small fraction of its tariff lines—some milk and dairy products, some fruits, and raw hides—where its tariff bindings are in the range of about 10-40 percent, uncomfortably close to India’s current tariffs, limiting India’s options in the event of import surges

India should call for a discussion of SSMs not as a generic issue of principle but as a pragmatic negotiating objective covering a small part of agricultural tariffs.

2. Food security/ stockholding issue

• The particular policies (MSP) which are being defended are those that India intends to move out of in any case because of their well-documented impacts:
• decline in water tables, over-use of electricity and fertilizers (causing health harm), and rising environmental pollution, owing to post-harvest burning of husks
• the government is steadfastly committed to providing direct income support to farmers and crop insurance which will not be restricted by WTO rules

The way forward in WTO on agriculture

India should consider offering reduction in its very high tariff bindings and instead seek more freedom to provide higher levels of domestic support: this would be especially true for pulses going forward where higher minimum support prices may be necessary to incentivize pulses production

India’s “big-but-poor” dilemma

• India’s self-perception as a poor country translates into a reluctance to recognize and practice reciprocity (give-and-take) in trade negotiations
• India’s policies have a significant impact on global markets and it has become a large economy in which partner countries have a legitimate stake in seeking market access

Net effect- India is unable to play reciprocal game in trade negotiations and WTO is fast becoming irrelevant (not good for India)

Cost of reluctant engagement-

• India is excluded from Trans Pacific Partnership (TPP) and it is shaped in a way that do not take into account India’s important interests (the rules on intellectual property)
• If and when India joins, it will be not on India’s terms but on terms already cast in stone, terms that India could not influence because of being perceived as not engaged fully

What should be India’s response-

We should use our growing markets as leverage to attain our own market interests abroad, including the mobility of labor and engage in reciprocal game to strengthen WTO.

How should trade policy deal with ongoing stress?

Chinese dumping, weak global environment, protectionist measures abroad, beggar thy neighbor policies etc .

Broad principle- resist calls to seek recourse in protectionist measures, especially in relation to items that could undermine the competitiveness of downstream firms and industries. For instance– imposing higher duty on imported steel hurts domestic manufacturers such as cycle manufacturers and lead to inverted duty structure.

Three sets of responses-

1. Exchange rate. Keep rupee’s value fair, avoid strengthening using some combination of monetary relaxation, allow gradual declines in the rupee if capital flows are weak, intervention in foreign exchange markets if inflows are robust.
2. India should strengthen procedures that allow WTO-consistent and hence legitimate actions against dumping (anti-dumping), subsidization (countervailing duties), and surges in imports (safeguard measures) to be taken expeditiously and effectively.
3. India should eliminate all the policies that currently provide negative protection for Indian manufacturing and favor foreign manufacturing. Implement GST asap.

What you have to read for yourself-

1. All the boxes- read especially Box 1.5: El Niño, La Niña and Forecast for FY 2017 Agriculture
2. Open all the hyperlinks. Learn, understand and revise.

Ask all your doubts in the comment section below or in doubts clearing forum . all your suggestions, criticism and feedback is most welcome.

Suggested Reading

1. Economic Survey For IAS | Chapter 02
2. Economic Survey For IAS | Chapter 03
3. Economic Survey For IAS | Chapter 04

Countries trade with one another to buy goods not produced in domestic economy. With the advent of globalization, investment to and fro have also increased many fold. A country’s trade and other economic exchanges with the world are recorded on its external account in the form of balance of payment (BoP) transactions.

There are two components of BoP

1.  Current Account
2.  Capital Account

Let’s understand about these 2 accounts in detail and analyse what happens in case of deficit or surplus in any of the accounts.

#1. Current Account – It deals with current, ongoing, short term transactions like trade in goods, services (invisible) etc. It reflects the nation’s net income.

For instance, if you a buy a laptop from US, it will be a current account transaction and it will be debit on current account as you have to pay to US.

There are 4 components of Current Account-

1. Goods – trade in goods
2. Services (invisible) – trade in services eg. tourism
3. Income – investment income
4. Current unilateral transfers – donations, gifts, grants, remittances

Note that grants might appear as component of capital account but are included in current account as they are unilateral, create no liability. Recipient does not have to give anything back in return.

#2. Capital Account – It deal with capital transactions i.e. those transactions which create assets or liabilities. It reflects the net changes in the ownership of national assets.

For instance, if you buy a stocks or property in US, it will be a capital account transaction and it will be debit on capital account as you have to pay to US to buy the asset.

Components of Capital Account

1. Foreign Direct Investment (FDI)
2. Foreign Portfolio Investment (FPI)
3. External Borrowings such as ECB
4. Reserve Account with the Central Bank

Note here that foreign investment is under capital account but dividends and income from investment comes under current account in the category income from abroad as dividend is transferred periodically, does not result in creation of asset or liability.

Balance of Payment (BoP) = Current Account + Capital Account = 0

Why?

Current Account and Capital Account always balance each other because a country always has to pay for its imports. It does so by exports or other two components of current account. If it can not, it runs deficit on current account and has to pay off by drawing off on its assets i.e. running capital account surplus.

What is Current Account Deficit?

• It’s simply deficit on all 4 components of current account.
• (Export – Import) + Net income from abroad + Net Transfers
• (Export – Import) is trade deficit
• CAD = Trade Deficit + Net Income From Abroad + Net transfers

Note that Trade Deficit and CAD are not one and the same. Trade deficit is only a component of CAD.

What does deficit on Current Account imply?

If we forget income and transfers for a moment, what it means is that we import more than what we export.

How do we pay for that extra import?

Either we get more foreign investment (FDI & FII) and pay via that or we borrow from foreign banks (ECB) or we will have to dip into our external reserves to pay for that amount and in the process our forex reserves come down. When forex reserves come down below a critical level, country appears on the brink of BoP crisis.

So, is CAD such a bad thing?

Depends on what you do with those extra imports and how you finance the deficit!

CAD is bad because –

1. If a CAD is financed through borrowing, it is unsustainable because borrowing lead to high interest payments in the future
2. Attracting capital flows (hot money, FII) to finance the deficit is risky as when confidence falls, hot money flows dry up, leading to a rapid devaluation and crisis of confidence. Eg. East Asian Crisis
3. Run a CAD necessarily means running a surplus on the capital account. This means foreigners have an increasing claim on your assets, which they could redeem any time

However a current account deficit is not necessarily harmful

1. CAD during a period of inward investment particularly stable long term FDI may not be a bad things as investment can create jobs. Investments will lead to higher growth will be able to pay debts back
2. Developing countries may use CAD to buy Capital goods and later export consumer goods and thus repay the debt

Moderate current account deficit (2% of GDP) financed mainly by stable foreign investments which creates jobs and infrastructure in the economy can be helpful in the long run as it improves productivity.

What is this twin deficits?

Current Account Deficit and Fiscal Deficit together are knows as twin deficits and often both reinforce each other i.e. High fiscal deficit leads to higher CAD and vice versa.

Now it’s time to answer a few questions-

#1. which of the following constitutes/constitute the Current Account?

1. Balance of trade
2. Foreign assets
3. Balance of invisibles
4. Special Drawing Right

Select the correct answer using the code given below.

1. 1 only
2. 2 and 3
3. 1 and 3
4. 1, 2 and 4

#2. The balance of payments of a country is a systematic record of

1. all import and export transactions of a country during a given period of time, normally a year
2. goods exported from a country during a year
3. economic transaction between the government of one country to another
4. capital movements from one country to another

#3. Which of the following constitute Capital Account?

1. Foreign Loans
2. Foreign Direct Investment
3. Private Remittances
4. Portfolio Investment

Select the correct answer using the codes given below.

1. 1, 2 and 3
2. 1, 2 and 4
3. 2, 3 and 4
4. 1, 3 and 4

Want to read more –

1. Budget Deficits Explained 
2. GDP Calculation 
3. Beggar thy neighbour

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Having already discussed how to best read volume one of economic survey,  I shall now discuss, what to focus on and what to leave in the volume two of this amazing document.

Those who haven’t read part one, don’t move ahead without reading part one – How to read the Economic Survey

At the very outset let me tell you that volume two is not that interesting and is full of facts and figures and not much of analysis. Hence only selective reading is recommended.

There are nine chapters in volume two which basically cover happenings in the economy during last one year with some forward guidance. Chapters are pretty longish with most of them crossing 20 pages (only 9-13 pages in volume one).

Chapter one gives broad overview of the economy and glimpses of what to expect from the subsequent chapters. After that there are chapters on fiscal policy, monetary policy, external sector, agriculture, economy and services, climate change and human development. As I have already mentioned, there’s not much of analysis and most of the chapters make for very boring reading and not much important for examination.

There’s only one chapter which I would recommend you to read line to line, for every word is a virtual gold mine and that chapter is chapter eight, climate change and sustainable development. Please note down important points and try to understand the analysis of double counting of aid as climate finance, why CDM market is down and various issues associated with green finance.

What else to study?

1. As mentioned in the part one, boxes are important. But in this volume many boxes are rubbish. I am highlighting not to be missed boxes, rest you can skim through. Box 1.1, 2,3, 3.2, 3.3, 3.4, 3.5, 4.1(very imp), 4.2, 4.3 (very very imp), 5.1, 5.2, 6.1, 6.2 (very imp), 6.4 (imp), 6.5, 6.6, 7.1 (read), 7.2 (only first part related to medical tourism), 9.2.9.3
2.  Following selected portions are recommended for line to line reading

• Pathways to productivity in agriculture in chapter five from 5.26 to 5.61,
• Tourism including medical tourism in chapter seven from 7.25 to 7.29
• Issue of women employment, unpaid work and care economy in chapter nine from 9.5 to 9.23
• Draft bankruptcy code on page no. A 4 of statistical appendix

What else is important in volume two?

Authentic data about GDP growth, share of agriculture, industry and services in GDP and employment, savings, investment, gross fixed capital formation, major export and import items, major trading partners etc.

Data is dispersed in the survey so, let us make it easier for you. We will bring to you all the important data at one place as we cover economic survey chapter by chapter. In the meantime, start reading volume one from cover to cover for as I said before, they could be the best 150 pages you would ever read for exam purpose.

“I am the chief economic adviser, not the chief political decider,” chief economic advisor Arvind Subramaniam said in response to a question about whether the suggestions in the Economic Survey 2015-16 will find space in the budget.

But, you are an aspirant, aren’t you? And in a rare case that the interview panel grills you on your analysis on the Economic Survey, here’s what can save your ass!

#1. Do something urgently on subsidies

The survey lists seven items – kerosene, electricity, LPG, railways, petrol, diesel, aviation turbine fuel and gold – on which the implicit subsidy to the rich amounts to RS 10 lakh crore! “. . . rectifying some egregious anomalies may be good not only from a fiscal and welfare perspective, but also from a political economy welfare perspective, lending credibility to other market-oriented reforms,” the Survey says.

#2. Work seriously on ending tax exemptions

• No profession should escape the tax net
• Clear reference to agricultural income, which is not taxed at all
• While the government is working on ending tax exemptions for the corporate sector, what about the agriculture sector!

#3. Don’t raise exemption thresholds

• The Survey junks the theory put out by Thomas Piketty that India under-taxes and under-spends
• Bring more people under tax net. Let the threshold stay where it is!

#4. Spread the JAM (Jan Dhan Yojana, Aadhar and Mobile transactions) trilogy to new areas

• How to go about it? What about its efficacy? The Survey suggests doing this based on two criteria – the extent of leakages and the extent of central government control
• Subsidies with higher leakages have larger returns after introduction of JAM
• It will be easier to roll out JAM in areas where the central government is the main provider of the subsidy

#5. Focus on easier exits

Not just about corporate exits! The Survey expands the paradigms of exits

• Allow easier entry to encourage competition; address legal lacuna through laws (which is being done with the new bankruptcy law)
• In the case of agriculture, exit from the current cereal-centric, regionally concentrated, input-intensive policies to pulses-oriented, regionally-broad based, more-for-less inputs system

#6. Undertake serious reform of the fertiliser sector

The Survey suggests a cap on the number of subsidised bag each farming household can purchase and insistence on biometric authentication at the point of sale (POS)

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Source: Swarajyamag

PS: This was just a trailer. Original series on Economic Survey with back2basics reference coming soon.

Welcome to the introductory post. Read the subsequent parts of this exhaustive series on the Indian Economic Survey (Click Here).

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Economic survey for 2015-16 has been released. As we all know, it’s a very important document for exam purposes. You can download it for FREE from here.

As with the last year, this year’s survey is a two volume book. Volume one deals with conceptual and analytical issues while volume two deals with the state of economy and sectors of economy in some detail with more focus on immediate issues and statistics. I have just finished reading volume one and I am going to discuss how to read this document effectively.

There are 11 chapters in the volume one. Every chapter is important, so sit tight and read one chapter at a time and take notes. Except for chapter 1 which is some 36 pages long, every other chapter is only 9 to 13 pages long which will take about 45 min to 1 hour each for reading and taking notes.

Chapter one basically gives broad overview of the economy, challenges and opportunities, analyses pros and cons of rapid fiscal consolidation. It also gives glimpses of what to expect from the subsequent chapters. I will suggest, you all begin with chapter one.

Three most enlightening chapters of the survey are-

1. Chapter 2, The Chakravyuha Challenge of the Indian Economy – It highlights the problem of difficult exit of firms just as Abhimanyu could not exit from Chakravyuha. The survey aptly describes it as “From socialism with restricted entry to “marketism” without exit“.
2. Chapter 6, Bounties for the Well-Off – It’s a real eye opener and describes in detail government subsidies (implicit and explicit) for the well off section of society, what could only be described as Socialism for the rich and Capitalism for the poor.
3. Chapter 7, Fiscal Capacity for the 21st Century – Best chapter of the survey by many miles. It would clear all your doubts regarding government taxation and expenditure, whether government spends less or more and how middle class simply exits from the state if state’s role is seen as primarily distributional.

All other chapters are equally great but I found these three very different and interesting.

Some do’s and don’ts

1. Don’t try to finish the survey or even first volume in one go, read one chapter at a time
2. You should read volume one from cover to cover. It’s very interesting and will help you in essay, paper 2, paper 3 as well as paper 4, yes in ethics paper
3. Volume two is not that important. What is to be read from that will be updated tomorrow
4. Take simultaneous notes while reading a chapter, note down important points and doubts and get them resolved in doubts clearing forum
5. Many times, the stuff put in the box have been directly asked in Mains. Do read them properly. But some box are highly technical, for instance first two boxes of chapter one, no need to go into nitty-gritty of them. Just try to understand the basic idea.

These could be the best 150 pages you would ever read for exam purpose. So, don’t wait for the substandard summaries to arrive in the market. You all have ample time before prelims, start reading one chapter a day. You will gain immense knowledge.

Of course, we shall be covering important portions of survey here at CD but you should read the full volume, especially the three chapters I mentioned.

Suresh Prabhu has set out an ambitious medium-term goal to reset the country’s oldest institution, including its governance, and restore its key place in the Indian economy. Railway is facing twin challenges of finances and ability to be a growth driver for the economy

Few Glimpses of Railway Budget 2016-17

• The minister fixed the revenue target for next fiscal at Rs.1.84 trillion, marginally above the budget estimate of 2015-16, though it failed to achieve its target for this year by a big margin
• Railways will have to bear the burden of an additional payout of Rs.28,000 crore as part of the 7th Pay Commission recommendations
• The railways will end up with operating ratio of 90 for 2015-16. For 2016-17, it expects the operating ratio to further worsen to 92 
• No changes in passenger fares and freight rates

Finances

the

There is shortfall in traffic receipts worsened by low freight demand from core sector. The Railway minister outlined the medium-term plan of investing Rs.8.5 trillion by 2019-20. The investment plan for 2016-17 is Rs 1,21,000 crore –

• Transfer from the Union budget – Rs.45,000 crore
• Internal resources – Rs.12,700 crore
• Partnerships with state governments – Rs.18,000 crore
• Life Insurance Corporation of India – Rs.23,000 crore
• Indian Railway Finance Corporation – Rs.21,700 crore

Do you know about Sundry earnings of Railways?

Sundry Earnings: All earnings on add-on services (which are not free of cost), including WiFi, concierge service, advertising, etc. Simply put, Railway puts all its non-tariff earning as Sundry Earnings in its account books. 

These earnings stood at an estimated Rs. 6229 crore this year.

Budget Proposal

• The target of non-tariff earnings for next year has been scaled up by 53% to Rs. 9590 crore
• Advertising is a major source of non-tariff revenues. So, Railways will install around 20,000 screen across its ecosystem to display ads
• The Railways will also monetise its data bank on passengers so that frequent travellers get value-added, targeted services
• Railways to monetise land on tracks by leasing out for horticulture and tea plantation
• Holding company to be explored for monetising assets of Railway companies

Freight

Challenge: The freight business provides two-thirds of Indian railways’ revenues, but it is struggling with capacity constraints and slow industrial demand. Also, our freight rates are among the highest in the world, which make our products uncompetitive.

Budget Proposal: To expand the list of commodities it services—increasing it to 40 from nine at present by including automobiles, packaged consumer goods, cotton, fruits and vegetables.

Dedicated Freight Corridors: It is proposed to take up the following freight corridors:

• North-South connecting Delhi to Chennai,
• East-West connecting Kharagpur to Mumbai
• East Coast connecting Kharagpur to Vijayawada

Impact: They can radically slash transit time for goods. Also, shifting of freight traffic from existing tracks to the new corridors would release capacities, helping increase speed of passenger trains.

Criticism: The high freight rates have diverted railway traffic to roads. In fact, discounting for the fuel component in freight charges, the rates should have been reduced this year.

New Trains

The budget announced 4 new types of trains:

• Antyodaya Express: A long-distance, fully unreserved, superfast train service, for the common man, to be operated on dense routes
• Humsafar: It will be a fully air-conditioned train for the budget passengers
• Tejas: It will showcase the future of train travel. It will travel at 130 km an hour and offer on-board WiFi services
• Uday: It will be an overnight double decker service for the busiest routes in the country with 40% more carrying capacity

Better Governance

Challenges: Departmental orientation, absence of cross-functional collaboration and lack of business focus

Budget Proposal: To reorganize the Railway Board along business lines and suitably empower Chairman, Railway Board to lead the organization effectively

Vulnerable Sections : Old People/ Disabled/ Women/ Porters

• A “Saarthi seva” will be introduced to help the old and disabled at stations. Railways to increase lower berth quota for senior citizens by 50%.
• Disabled enabled toilet in 11 Class-A stations this year
• 33% reservation to women in reserved quota in Railways
• Porters to be called ‘Sahayaks’ now. They will be trained in soft skills

Sanitation

• 17000 bio toilets and additional toilets at 475 stations will be provided before the close of this year
• World’s first Bio-Vacuum toilet was developed by IR and is being used in Dibrugarh Rajdhani Express
• For those queasy about train travel because of dirty toilets and coaches, the minister has “clean-my-coach” on demand through SMS

Improving Railway Stations

• 400 stations to be re-developed through PPP
• Beautification of stations at pilgrimage centres: Ajmer, Amritsar, Gaya, Mathura, Nanded, Nashik, Puri, Tirupati, Varanasi, Nagapattinam and others

Technology

• 400 railway stations to be equipped with wifi, 100 this year.
• To reduce the waiting period for passengers, the railways will introduce bar-coded tickets at select stations.
• Scanners and access control on a pilot basis on major stations.

Railway Budget: Few Shortfalls

• There is a shortfall in the number of engines required to run even our existing fleet of freight and passenger vehicles. With increased capacity, we will need many more locomotives. The budget does not indicate a comprehensive strategy for these issues
• Most tracks and rolling stock are already fit for speeds above 100 kmph for passenger services and above 75 kmph for goods services. However, average speeds of passenger services are around 40-50 kmph and those of freight 20-25 kmph. This is because we don’t have the capacity to run them at optimum speed. Increasing capacity by doubling/ quadrupling lines would in itself improve speeds. Budget does not have much to offer to overcome this lacunae

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Want to read more?

• Railway Reforms
• Ministry of Railways : Important Updates

Published with inputs from Pushpendra

This is an oft confused sphere of economics and often impedes with your understanding of the world affairs. We often read terms like FTA, PTA, Economic Union in articles related to WTO, bilateral talks etc etc. and breeze past them with a rough understanding or what they might mean.

• FTA (Free Trade Agreement) – Free mein trade? Possibly no money to be paid for trade barriers etc etc.
• PTA (Preferential)? Some kind of preference, maybe
• CEPA, CECA – God knows what!

This rough understanding may not be always correct. To give you an example – PTA is almost similar to FTA (every PTA eventually becomes an FTA), CECA and CEPA are quite similar.

What is economic integration & why go for it?

Economic integration refers to trade unification between different states by the partial or full abolishing of customs tariffs on trade taking place within the borders of each state.

1. The objective of this integration is to increase the combined economic productivity of the countries – easier access of goods and services
2. Other by-product of integration is competitiveness. If 4-5 countries come together to form a closely knit family (of sorts), they would create barriers to entry of an external (possibly much larger player) to disrupt the region with cheaper goods

What is a trade agreement?

A trade agreement is a contract/agreement/pact between two or more nations that outlines how they will work together to ensure mutual benefit in the field of trade and investment.

This can be bilateral (2 countries) or multilateral (2+ countries). 

Once a trade agreement is finalised, we get to read about these Trade Blocs – a type of intergovernmental agreement, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated among the participating states.

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All the gyan about FTA, PTA, CECA/PA, EU!

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#1. PTA – Preferential trade agreement

A preferential trade agreement, is a trading bloc that gives preferential access to certain products from the participating countries.

This is done by reducing tariffs but not by abolishing them completely. A PTA can be established through a trade pact. It is the first stage of economic integration. 

Some examples:

• Asia-Pacific Trade Agreement (APTA): formerly known as the Bangkok Agreement, was signed on 31st of July 1975 as an initiative of the United Nations Economic and Social Commission for Asia and the Pacific (ESCAP). ESCAP is the regional development arm of the United Nations for the Asia-Pacific region.
• India-Mercosur Preferential Trade Agreement (PTA): Mercosur is a sub-regional blogs with its member countries – full members are Argentina, Brazil, Paraguay, Uruguay and Venezuela.

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#2. FTA – Free trade agreement

A free-trade area is a trade bloc whose member countries have signed a free-trade agreement (FTA), which eliminates tariffs, import quotas, and preferences on most (if not all) goods and services traded between them.

Please note that you cannot distinct PTA and FTA by just saying that the former has fewer barriers and later has no barriers at all. FTA does not mean everything is free! PTA closely follows FTA.

• Evolution of SAPTA to SAFTA (South Asian PTA to FTA)
• ASEAN FTA (Trade agreement within the Southeast asian nations)

What would happen if countries want to move more closer (beyond material trade)?

When the countries go beyond FTA and agree for a greater degree of economic integration which includes improving the attractiveness to capital and human resources, and to expand trade and investment, it would result in CECA or CEPA.

• CEPA = Comprehensive Economic partnership Agreement
• CECA = Comprehensive Economic Cooperation Agreement

CECA and CEPA have very minor differences, if you will. While CECA comes first with elimination of tariffs, CEPA comes later including trade in services and investments. CEPA has a bit wider scope than CECA.

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#3. Customs Union

An agreement among countries to have free trade among themselves and to adopt common external barriers against any other country interested in exporting to these countries.

Some examples:

• Southern Common Market – Mercosur (Argentina; Bolivia; Brazil; Paraguay; Uruguay; and Venezuela)
• Gulf Cooperation Council (GCC) – Its member states are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates
• East African Community (EAC) – composed of 5 countries in the African Great Lakes region in eastern Africa: Burundi, Kenya, Rwanda, Tanzania, and Uganda

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#4. Common Market

A type of custom union where there are common policies on product regulation, and free movement of goods and services, capital and labour.

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#5. Economic Union

An economic union is a type of trade bloc which is composed of a common market with a customs union. The participant countries have both common policies on product regulation, freedom of movement of goods, services and the factors of production (capital and labour) and a common external trade policy.

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#6. Economic and monetary union

When an economic union involves unifying currency it becomes a economic and monetary union. Eg – Euro!

Economics just became a whole lot more edible this week. It all started rather unexpectedly, with a student asking the RBI governor why dosas have become more expensive despite the disinflation phenomenon in India. Pat came the answer.

It’s not the dosa, stupid. It’s the tawa! It’s the tawa that has retained its price and reluctance to change the tawa technology has cost us, dear. Pun intended. And it doesn’t quite end there, does it? The hand that rocks the cradle, rules the earth. And the hand that rules the ladle, rules the worth.

Simple! Labour prices have skyrocketed, so much so that they nullify the reductions we get from ingredients. Ahem, not that we are getting too many reductions from those ingredients there. Important to note that the dosa is primarily made from urad dal, after all.

The statement from the Guv created quite a furore. The RBI has issued a new guideline saying that all future governors should necessarily be good cooks and have to know all ingredients going into major food dishes. The Bhumata Ranragini Brigade is now actively considering marching into the inner sanctum of the RBI saying they always knew that women would make better governors.

The RBI has launched a new Big Dosa Index to counter the very popular Big Mac Index as the Indian contribution to quick-fix inflation gauges. The CSO, ruffled at being sidelined, cleverly pointed out that since dosas are only sold on retail, the BDI can only be seen to be a quick gauge of CPI movements and is hence, an incomplete index. The RBI reacted sharply by also announcing the creation of a Tawa-Index to understand wholesale price movements.

Startup India has announced a new VC funding line to whoever gets new technology for creating dosas. It’s expected that support to this line of credit will be declared in the upcoming Budget through the Tawa Hatao, Dosa Bachao Yojana.

Commercial banks now know what it takes to reduce their NPAs. Risk rating on the over-the-counter food service business units has gone down drastically since they are seen to be the only guys who can continue to charge high and make high profits, no matter what the inflation numbers. The new base rate or PLR will be termed the DLR, the Dosa Lending Rate.

On a more international front, Deutche Bank made headlines with its coco(a) bonds ratings taking a beating from S&P. “Their standard is very poor,” said an RBI spokesperson. “We always knew that this cocoa business is very risky. Had they listened properly to the Hon Governor, they would have issued Dosa bonds. That is the only way ahead.” The Chinese are also thinking of replacing Dim Sum Bonds, which have in letter and spirit become Dim Sum since the devaluation, with Dosa bonds.

In the meanwhile, the FM was fairly terrorised when he was asked to host the halwa ceremony. Despite the fact that no student interaction was allowed at all, he made sure that he knew the halwa recipe by heart before meeting the media. For good measure, he also learnt the prices of rawa, sugar and ghee, all by heart.

Rumour is that after getting to know the phenomenal prices of ghee and dry fruits, he wants to create a halwa cess to fund such colossal expense programmes. It is estimated that this single move will move the fiscal deficit from 3.9 per cent to the magic number 3.6 per cent. The RBI governor is happy. Dosas sure work!