Tuesday, 30 July 2013

Back to the Basics: What is CAD and why does it matter?

By now we have all read or heard from one source or the other that India is suffering a huge Current Account Deficit (CAD). This post is for those who are wondering what this is and why does it make a difference.

A lesson in Economics

Let us forget the individual companies and corporate houses for a minute and view India as a single entity. When we purchase things from another country we have to pay them in return. Similarly, when other countries buy things from us, they pay us. A simple understanding of budgeting tells us that if we do not sell as much, if not more, than the amount we buy, we are sooner or later going to run out of money. This is what we call a current account deficit. Effectively we, as a nation, are borrowing from other countries to fund our consumption. One way to sustain such a situation is to offset the Current Account Deficit with a Capital Account Surplus.

Capital account is the measure of money that enters and leaves our country in terms of investments. There are three main forms that this can take:

  1. Foreign Direct Investment (FDI): When foreign investors pick up a large stake in an Indian company or set-up their own operations in India. This is usually a longer term investment as compared to FII (below). For example, when Etihad will buy a stake in Jetairways, they will be paying Indian shareholders with capital from their country.
  2. Foreign Institutional Investment (FII): When foreign institutional investors trade in the Indian stock exchange they bring capital from their economy into our market.
  3. External Commercial Borrowing (ECB): When Indian companies borrow from foreign entities which are able to provide capital at a lower rate of interest.
If the cumulative of such investments into the country is greater than such investments out of the country we achieve a capital account surplus. Thus while overall we are running a deficit on our current account (i.e. money is leaving the economy) we are able to sustain it because of the capital account surplus (i.e. money is entering the economy).


Why we are a mess

India has historically managed to run a CAD of around 2% of GDP without stress as the capital inflow was easily able to offset it. However, with the rising uncertainty for investors in India, capital inflow is no longer as reliable as it once was. To add to this, there is threat of capital flocking back to the US where the interest rates might be on the rise soon. The situation is further worsened as our CAD has risen from 2.7% (2011) to 4.8% (2013) of GDP making us ever more reliant on the capital inflow.

So what happens if due to macroeconomic instability, capital inflow decreases and we reach a stage where the capital account surplus cannot offset the current account deficit?

International transactions happen in the US Dollars (USD). Hence, if overall more money were to leave the economy than enter it, the demand for the USD viz a viz Indian Rupee (INR) would be greater, causing the dollar to gain value relative to INR (i.e. INR would depreciate). What does this lead to? Say a year back a good produced in India was priced at $1 in the international market and Rs 50 in the domestic one. At that exchange rate the producer was effectively receiving Rs 50 for his product and he would be indifferent between selling it on the domestic market and the foreign market. However, a year later with the new rates, the foreign consumer is now able to pay Rs 60 to the producer with no extra cost to him. The producer will thus divert his goods to the foreign market till the scarcity in the domestic market raises its price to Rs 60 at which point he will once again be indifferent.

The example above has been simplified considerably to get the basic point across: Devaluation of our currency will cause further inflation. Inflation which is already in its double digits (CPI) and is the worst enemy of the poor which the Government swears to protect.

To make things worse the government has dug us another pit fall due to lack of timely reforms. Of the $502 billion worth of imports in the financial year 2013, $170 billion was spent on oil. Oil which the government provides at a bench-marked price no matter what the price they buy it at. Thus as the currency depreciates faster than the rate at which the government is increasing the price of oil (and related products) the government is in fact forced to provide more subsidy than it previously did. Hence not only is the rise in prices causing inflation but is also increasing the government's fiscal deficit which reached 4.8 at the end of FY 2013 - another threat to our macroeconomic stability.

And so the cycle continues.

Monday, 22 July 2013

Vote for No One

In the run down to the 2014 general elections there is a huge outcry imploring the people to exercise their right to vote. I, myself, have been part of this persuading movement. But the more I attempt to decide who to vote for the more uncertain I get. More than an economic bankruptcy, India is suffering a leadership one.

Your vote demonstrates who you think deserves to lead this country. It is a tool to demonstrate your confidence in a Party (in all practical terms an individual) to govern us for five years. But what if you do not think any of them are up for the task? What if you are so completely indifferent between candidates that voting becomes a matter of a lucky draw?

The way I see it, come 2014 I have the following options: Congress, BJP, AAP and the 3rd Front. The way I see it, none of them deserve my vote.

A recently trending article by Pratap Bhanu Mehta, illustrates what Congress has done to our country in their back-to-back reign for 10 years. A better job cannot be done by any and I urge you to read the article yourself. It explains how under Congress' rule almost every sector of the economy has been destroyed and is being destroyed further in their final attempt to consolidate certain vote banks using populous policy. The economy is in a bad shape, worse than we realise, while Congress seems to be on a suicide mission with laws such as the Food Security Act. It is almost like they realize they will lose and are setting up the economy to collapse post the 2014 elections.

No, Congress definitely does not deserve our vote. Not only because of their pathetic performance and their scandal filled reign but also because the kind of precedent we as a nation want to set: Do we allow terrible performance to be rewarded by once again giving them power? If so, how will we ever hold our leaders accountable? Our leaders, who already think of us as idiots, will have more reasons to mistreat us. No, Congress back in power would be a national shame.

So if not Congress, then BJP? That does seem to be the popular track as of now. Modi has proved himself as an able administrator. True, there are plenty of reports, with good grounds, that say he is more hype than action. But still, he has done good for Gujarat. With our current economy, Modi maybe our best option. But now I ask you to pause, breath, and picture this:

You are at work and are suddenly informed that riots are imminent and you should probably head home to your family. In the age of fewer mobile phones you find it difficult to get in touch and rush home to make sure your family is safe. You reach home to find general panic among your neighbors. No one seems to know what may happen and no one seems to know what to do. Suddenly some one shoots the idea that the neighboring Gulbarg Society which houses a Congress MP would be a safe bet. People pounce on this first rational suggestion and rush towards what they believe will be a safe retreat.

You are now with 30 other families in the MPs house when you see a mob appearing at gate of your society. The hooligans are armed with swords and guns. They are screaming slogans of an alien religion and lusting for the blood of you and your family. You reassure your children by telling them there is a 20 feet wall around the colony which will keep them safe. But when you hear the gas cylinders blowing up you begin to avoid their eyes. The helpless feeling of not being able to assure the people who rely on you is shattering your spirit. Watching the MP, with all his power, making calls after calls begging for help and being repeatedly turned down is washing away that little confidence you had left.

As a last resort your leader is trying to offer a bribe. No one believes it will work, but you have run out of options. You watch the MP reluctantly open the door and throw the money just to rush back in. But just before he could, arms grab him from behind and you watch him, in horror, being cut into pieces and burnt alive right in front of you. You know the same fate now awaits you and your family and there is absolutely nothing you can do...

The above narration was based on the in-depth research conducted by Tehelka on this topic. Their reports also comprehensively prove Modi's involvement (or lack of) in this episode (here and here to list a few). Such atrocities happened under the rule of this man. This man refused to help such people. Help he could have given with a mere phone call. Does such a man deserve the top job of this country? What is the precedent we are setting here? I shudder to think.

Chankya is credited with the quote: "If the king is pious, the subjects become so; but if the king is vicious, the subjects become the same. If he be indifferent to both (virtue and vice), then they too bear the same character. In short, as is the king so are his subjects." How can we, with a clean conscious, vote ourselves into this direction?

So no to Congress and no to BJP. We seem to be running out of options. Aam Aadmi Party (AAP) is not really feasible either as they are still a nascent party and do not have the experience. They have also periodically made a few statements that suggests they may not understand the economy very well. The 3rd Front on the other hand have all the experience in doing all the wrong things. With potential leaders like Banerjee, Mayawati or the Yadavs, this would be India's nightmare come true. Fortunately, it seems highly unlikely.

So who is left? No one. I am a young Indian very eager to exercise his right to vote. I had to wait 5 years after turning 18 to do so. If given the option I would have gone through the entire registration + voting process just to show how I think none of them deserve my vote. Alas, that is not an option. I am truly stuck between a rock and a hard place.

Correction: A friend has just brought to my attention Rule 49-O of the Conduct of Election Rules (1961) which provides you the ability to abstain (using form 17 A) and have the presiding officer make a note of this decision. I apologize for my ignorance. I guess I will be voting this elections after all!

PS - If you do agree with me, I urge you all to exercise this option even if it makes life a little difficult for you and the election commission.

Friday, 19 July 2013

Back to the Basics: The Game of Elections

The election is a game for the politicians. It is a competition for them which they have to win. But lets not get mistaken, it is a game for us too: We have to use our one vote to ensure the best possible outcome according to our perspective. This responsibility does not end at choosing who you want the winner to be and voting for him, but requires you to generate a ranking of the candidates in order of preference and calculate who your vote should go to backwards.

Those familiar with economics will recognize my attempt at explaining the basics of Game Theory. But to understand the need for this we must first understand how elections take place in India and what are the implications.

I am sure all of us are aware of the absolute basics: The country is divided into 543 constituencies which are suppose to be roughly equal in terms of their population. Each of these constituencies elects a representative. This representative need not even achieve a simple majority (i.e. 50%); as long as he has more votes than any other single candidate he will be given the seat in the Parliament. For example, if there are 3 people running from a constituency and the vote share is divided in the ratio 25%, 35% and 40%, the candidate with 40% will be declared the winner. This is called First-past-the-post voting (FPTP).

What does such a mechanism imply? It can result in skewed representation. For example in the 2012 UP state elections SP (Samajwadi Party) received 29.3% of vote share and were allocated 226 seats in the assembly out of 403, where as BSP (Bahujan Samay Party), who received 25.9% of the vote share were allocated only 80 seats. This happened because the SP won several seats against the BSP over a very small margin. Thus while BSP received considerable votes overall, they were thwarted in individual battles and thus annihilated in the war in the world of FPTP.

This may seem like an unfair mechanism, specially when compared to the proportional representation method. But that is a debate for another blog post. What I would like to discuss is what the voter should do.

Let us imagine that the people who voted for BJP would rather have BSP if their only other option was SP. Their strategy should be obvious: Instead of voting for BJP, who anyway did not have a chance of coming to power, they should have voted for their next best choice which was BSP. If we assume that in each constituencies the vote share was identical to the state level data, then with the transfer of BJPs 15% to BSP, the party would be propelled to number one status with almost 41% of the vote share. Thus the BJP supporters might not get their first choice, but at least they would not be stuck with their 3rd or 4th one.

This example is obviously simplified using several assumptions, but the principle remains the same. At the central election level this effect can be observed with Modi being portrayed as the PM candidate for BJP. While Congress' abysmal performance has lost them support, voters who fear Modi more will fall back to Congress which is the only credible force to stop BJP. The same applies to people who fear another five-year reign of Congress: Recognizing this possibility they will leave their regional parties and flock to Modi (also discussed in Back to the Basics: Polarising Mr Modi).

The FPTP system often has the effect of bringing the war down to two parties. Understanding the system is important or your vote may actually count for nothing.