Home > Uncategorized > Piggy Banks and Political Pork – II

Piggy Banks and Political Pork – II

An honest currency, positive real interest rates and liberalization of import of gold were at the heart of reforms unleashed by Dr Manmohan Singh in the 1990s. Under his very watch as PM, first two elements of reforms have reversed by his current Finance Minister and it is moot how long it will be before gold imports too screech to a halt. On the currency front India’s economic reforms are firmly in the reverse gear.

 

When an economy runs with negative real rates of interest it basically transfers wealth from savers, who are mainly middle class households, to large borrowers who comprise the Government, businesses & large farmers. As we saw in Part I of this article, the total value lost by households through negative real rates was as much as 40% of the total direct taxes collected by the Govt. On the other hand, for a typical household, the concealed tax so paid by it on savings can rage from 9% to 36% of annual income even in the 0 tax bracket, depending on the level of savings of the household. These are humongous amounts of taxation that really should be made obvious and transparent.

 

Three things should be noted about this hidden taxation. Firstly, it is grossly invidious as it taxes accumulated savings and not income. The more you save, the more tax you pay; annually but also over time. The inequity of this is unbelievable. If you save money you are taxed on it over & over again, year after year, until you die! What can be possibly be more cruel?  You are punishing thrift and rewarding profligacy; punishing virtue and rewarding vice. On this ground alone this evil practice needs to be proscribed.

 

Secondly, if you profile people who save in bank deposits, these turn out to be lower middle class, financially unsophisticated savers who save for a rainy day or to meet bulk expenses like college or marriages etc. What they are looking for is simplicity, safety, convenience and no hassles. These are voiceless people, the sort who unknowingly pay the bills for others. So the tax falls disproportionately on precisely those households least able to pay such onerous taxes which makes the tax highly regressive. This is socially disruptive as well.

 

Thirdly, there is a huge element of repeated taxation of the same income simply because it is saved. Consider some money you saved in year one say R1000. If you hold on to the saving, you pay 3% hidden tax every year on the saving. By year 33 when you retire it is all gone! You saved nothing of the R1000 you had 33 years ago. How much more ridiculous can taxation get.  The point to note is that your average household may not be able to articulate what we have analyzed here but its real impact on their savings is not lost on them! They actively seek to offset this taxation and that leads to further complications in our system.

 

Why is this taxation by stealth important from public policy point of view? Prolonged negative real interest rates drive people away from holding wealth in financial assets into other assets such as land, housing, gold, silver, not for use, but as a store of wealth. Paradoxically, over time, negative real interest rates drive up cost of finance for legitimate business activity by reducing total savings in financial assets. Negative real returns over time kill off the bond markets choking off finance to infrastructure projects and industry. Practically no market for bonds existed in India prior to the reforms precisely for this reason. So negative real interest rates are inherently harmful to economic growth.

 

In India, negative real interest rates have traditionally driven households to gold. From a personal point of view, it is absolutely rational to switch from fixed deposits that yield negative real returns to gold. Gold is basically a hedge against malfeasance  imbedded in a fiat currency issued by an unreliable Government. But from the point of view of the economy as a whole, investment in gold is a wholly wasteful activity. It takes away money from creation of real assets such as infrastructure, plant and machinery, schools and colleges, hospitals that better the lives of people.

 

Indian households currently buy about 800 MT of gold annually valued at $40 billion.  That is a mind boggling figure. What would be India’s total stock of gold? A conservative estimate would put that figure at 50 times the annual consumption – about $2 trillion. That wealth is lying idle in our country with households because of the politician’s propensity to cheat us out of our honest money. Why not think of using this horde productively?  And why not stop adding to it through positive real interest rates? Note $40 billion is 2 times the value of all FII and FDI investment in India in any given year. But our politician’s penchant for dishonest currency, we would not need any external funding at all to sustain growth.

 

Cleverly masked from public view is the fact that India runs a huge current account deficit that averages about 3% of GDP. We just don’t export enough to pay for all the oil, gold and other imports. Gold is the largest component of our imports after oil and the two together make up nearly half of our total annual imports. This current account deficit, roughly $40 billion, is met by selling shares in our businesses to foreigners, through borrowings and FDI. So at the margin what are we doing? Here is the vicious circle. Negative real interest rates drive households away from saving in financial assets into gold. Government is forced to import gold because we hardly produce any. To pay for the import of gold Government sells or induces others to sell shares in profitable businesses to foreigners. So people here is the deal – you sell productive assets to buy jewelry and trinkets.  Would you ever to do that in real life?  Yet as a nation we are doing precisely that because the Government cheats us out of our savings if we don’t.

 

This reversal of currency reforms, very pronounced since the beginning of 2008, is now slowing down economic growth, adversely impacting fresh flows of FDI and portfolio inflows and in fact encouraging capital flight out of the country. A return to the bad old days of dishonest currency will quickly undo the remainder of the reforms. It is therefore high time to pressure the Government & RBI to return to a regime of positive real rates of interest.  This is not difficult to achieve if the Government cuts off its entitlements bonanza to modest proportions that can be sustained by honestly collected taxes. If not individuals acting privately to prevent erosion of their hard earned savings will force us back to stagnation and eventual bankruptcy once again.

 

Advertisements
Categories: Uncategorized
  1. Lakshmi
    October 25, 2011 at 11:53 am

    thanks for this article. it is very educative for people like me who have no background in finance/economics.

  2. Adwait
    October 26, 2011 at 9:27 am

    Thanks a lot for this article!!!

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: