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Deadly Taxes

The high ‘sin tax’ on liquor drives people to look for cheaper and unfortunately, fatal alternatives

It is that time of the year again where another hooch tragedy has occurred, the dead are counted, state compensation is given to the kin, few are arrested, political blame game ensues with no real consequences, and we move on till the next time the cycle repeats itself. The death toll this time has gone up to 97 and the opposition is demanding Maharastra Chief Minister Mr. Fadnavis’ resignation. An inquiry has been set up, the police claim that they have caught the main culprits and that justice will be meted out. Those caught will be tried and prisoned and within no time, others will take their place. The makers of hooch are suppliers of a commodity that is high in demand. This high demand for the illicit liquor makes it a profitable venture to produce the commodity. So long as the demand is high, the supply will exist.

The real question to ask then is regarding the cause behind the high demand for illicit liquor. One of the main reasons why the poor decide to drink illicit liquor is because they cannot afford to buy packaged, manufactured and regulated alcohol. There are different categories of alcohol available in India: the most expensive are the imported ones, which attract heavy import duty and other taxes, then, there is the Indian Made Foreign Liquor (IMFL), country liquor and finally, illicit liquor.

The customary police raid and destruction of illicit liquor bottles after the tragedy.

The customary police raid and destruction of illicit liquor bottles after the tragedy.

While the imported liquor and IMFL are firmly out of reach of the daily labourer’s budget, he often cannot afford even country liquor and it might not be easily available. Country liquor is produced in cottage industry type of setting and was recently brought into the regulatory fold. Many southern states have completely banned country liquor and others are beginning to impose strict regulation and taxing it heavily.

Like a typical patronizing welfare state, heavy taxes are levied on alcohol to prevent people from over-consuming the substance and thereby, prevent health hazards and societal evils. While the intention might be good, the outcome, as is the case more often than not, has not been desirable. A look at the Maharastra tax structure on liquor reveals the extremely high rate of tax levied on regulated alcohol. The excise duty on IMFL is 300% of manufacturing cost and on country liquor, the excise duty is upto 250% of manufacturing costs. It is these high tax rates that explains why large factories which enjoy significant economies of scale produce liquor which is more expensive than home-made liquor produced in small quantities.

The high rates of tax is levied by the government in order to make the relative price of alcohol higher than other products, which, in theoretical economics, should reduce the product’s demand. However, it is a known fact that high taxation on alcohol and tobacco products does not deter people from its consumption. Instead, they move to cheaper alternatives. Of course, the other reason for high taxation is that it continues to be a strong revenue earner for the various state governments. Nearly 10-15% of state government revenue comes from excise duty on liquor and another huge chunk from the tax on tobacco products.

While the government might feel that it is its moral obligation to levy a ‘sin tax’ on harmful products to prevent its use, it might not realize that its morality is driving people to illicit liquor and consequently, death.

P.S: For an excellent discussion regarding the ineffectiveness of using taxation to influence public consumption behaviour, read Catalyst’s post on “Taxing our way to better health“.

Anupam Manur is a Policy Analyst at Takshashila Institution. He sporadically tweets @anupammanur

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The Economic Consequences of Debt Repayment

If either the troika or the Greek government does not blink, a Greek default on its loans and exit from the Euro (Grexit) is a very real possibility.

With about €320 billion involved, the standoff between the left wing Syriza Government in Greece on one side and the IMF, ECB and the European Union (collectively known as the Troika) on the other makes it the most glorified and high risk game of chicken played. Monday, the 22nd June, presents one of the last opportunities for a deal to be brokered between the two sides and neither side is willing to back down and give in to the other’s requests.

In short, the situation reads thus: Greece has an outstanding debt of about €320 billion to various creditors. Recognising its inability to pay the amount, in 2010 and again in 2012, the IMF, the EU and the ECB decided to formulate a bailout package totally amounting to €240 billion. However, this money would be given to Greece only on the condition that it makes wide sweeping reforms and introduces a severe austerity drive. Further, 9 out 10 Euros from this bailout package will be used to pay back the creditors and not for Greek citizens. In June, Greece owes about €6.74 billion as part of its monthly debt repayment schedule (about €1.5bn to the IMF) and it does not have the resources to pay for that, while the last tranche of the bailout package worth €7.2 billion is also due to be given to Greece. While this situation is complicated enough, throw in a bit of political economy to the mix and there exists a true conundrum for everyone involved. The present government came into power in the last election in 2014 on a strict anti-austerity platform. It refused to prioritize repaying the creditors by cutting back on government expenses towards citizens’ welfare.

The IMF refuses to hand out the last €7.2 billion of the bailout package unless Greece undertakes severe austerity measures and also pays back the €6.74 billion that is due by the end of the month. The Greek government, with tremendous support from the citizens, refuses to take either action.

If one of the sides does not blink – the IMF extending the deadline for Greece to pursue fiscal consolidation and debt repayment or the Greek government undertaking reforms and paying part of the bailout money to its creditors – a Greek default on its loans and exit from the Euro (Grexit) is a very real possibility.

The IMF and Germany would do well to revisit Keynes’ classic work “The Economic Consequences of Peace” (1919), where he hinted at the possible consequences of the Allied countries extracting huge sums of money as reparations for the war (WWI) damages from Germany. He had rightfully explained that Germany will have no means to pay back the sums demanded by the Allied countries, especially given the economic downturn they were facing, except by resorting to the printing press. The predictions came true later on as Germany printed large sums of money in an expansionary monetary policy, which later resulted in hyperinflation, political upheaval, economic chaos, etc. The consequences of this are well known.

In this game of who blinks first, if neither of them blink by the looming deadline, everybody loses.

 

There is a chilling parallel here. If Greece defaults and exits the Euro, there will firstly be a bank run, where depositors will rush to withdraw their savings from the banks. This will result in a loss of liquidity. In the past few days, hundreds of Greeks are queuing up outside the cash points, in order to withdraw their money, in anticipation of a financial crisis. This will only worsen as the deadline approaches. Further, there will be a new, deep and prolonged recession. It would also be forced to go back to printing its own currency, the Drachma, or some other variant of it. Its financial system will collapse in the wake of a liquidity crunch and loss of access to the ECB. The Independent explains: “To prevent these institutions collapsing Athens would have impose controls on the movement of money out of the country. The international value of the new Greek currency would inevitably be much lower than the euro. That would mean an instant drop in living standards for Greeks as import prices spike. And if Greeks have foreign debts which they have to pay back in euros they will also be instantly worse off. There could be a cascade of defaults”.

This will obviously have a contagion effect, where banks, financial institutions and governments who are over exposed to Greek debt will lose their principal amount. The Euro currency and Euro stocks will crash, which can have renewed negative consequences for a world economy just recovering from the previous recession.

Thus, in this game of who blinks first, there is a unique scenario, where if neither of them blink by the looming deadline, everybody loses.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

 

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Demonetising a currency

Adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by massive corrections in the macroeconomic fundamentals.

 The Central Bank of Zimbabwe announced that it would officially demonetise the Zimbabwean dollar with effect from 15th June 2015. Any bank account in the country which holds between zero and 175 quadrillion Zimbabwean dollars will get a flat amount of US $5. This, in effect sets the exchange rate at US$1 = Z$ 35,000,000,000,000,000

Demonetisation is the process whereby a currency of a country officially loses its status as legal tender. The Zimbabwean dollar’s usage was effectively abandoned in April 2009 itself, but was still recognised as legal tender. Legal tender or fiat money is the official status given to a currency by the central bank, whereby all citizens of that country are obliged to accept it as a means of exchange.

Demonetisation has often happened in the past. Germany has demonetised at least thrice in recent history – from Papiermark to RentenMark; from Reichsmark to Deutchemark to finally from Deutchemark to the Euro.

The process of demonetisation was seen when several European countries abandoned their national currencies to be replaced by the Euro. The other big event of demonetisation process happened with regard to gold, when the US officially closed the gold window in 1973, thereby ending the decades long gold exchange standard/Bretton Woods system.

Apart from these one-off occurrences, the process of demonetisation usually happens after a country goes through a process of hyperinflation and the currency becomes worthless. Zimbabwe’s episode of hyperinflation in 2008, where inflation rates were as high as 231 million percent, caused the Zimbabwean dollar to collapse in value. It was impossible for normal trade to occur with the national currency, as a loaf of bread cost Z$1.6 trillion at one point. As a result, currencies such as the US dollar, the South African rand and the euro were widely circulated and used in Zimbabwe.

HundredTrillionDollar

A hundred trillion Zimbabwean dollar note

 

Demonetistion is usually the last step in the fight against hyperinflation. It is the official acceptance from the central bank and the government that its currency is of little or no value and acknowledgements of its failure. Thus, demonetisation is undertaken only at severely extenuating circumstances. Countries usually try to redenominate the currency first. Redenomination is the fixing of a new value for the existing currency. Operationally, it is the equivalent of knocking of a few zeroes from the value of the currency. For example, Zimbabwe tried redenomination four times since 2006. In the first redenomination Zimbabwe removed three zeroes from the value, 13 zeroes in the second redenomination and a further 12 zeroes in the third redenomination. However, bad macroeconomic fundamentals and a bad fiscal and monetary policy framework ensured Zimbabwe’s journey further into hyperinflation.

Once a currency is demonetized, the country has two options left: 1) Dollarization/Adoption of a foreign currency – This is when the country adopts the currency of another country as its own, which effectively translates into abandoning independence in monetary policy. The monetary policy of the adopted currency become applicable and binding on the country adopting it. Usually, the dollar is adopted, but not necessarily so always. 2) Introduction of a new currency – Eventually, the country might choose to introduce another of its own currency and have a preset exchange rate with the old currency/dollars. This is done to regain independence in monetary policy.

In the final analysis, adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by large scale corrections in the macroeconomic fundamentals.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Narendra Modi’s One Year – A review of reviews

By Anupam Manur and Devika Kher

In one year, the PM has made incremental changes to the economy, government structure, and foreign policy but the lack of the game-changing reforms expected of him renders the year marginally above average.

One year on, Prime Minister Narendra Modi’s performance has been under severe scrutiny and though the assessment has been mostly positive and hopeful of the coming four years, there is an underlying recognition that much more needs to be done in order to justify the overwhelming mandate.

Economic Performance under Modi

As per New York Times’s article by Ellen Barry, “India is now seen as a bright spot, expected to pass China this year to become the world’s fastest-growing large economy.” Prime Minister Modi entered the office at one of the most exciting time that the Indian economy has seen till date.

To begin with, almost all the dailies commonly acknowledged Prime Minister’s ‘luck’ with the oil price fall and discounted his contribution to the financial condition of the country. The Live Mint’s editorial article remarked on lower commodity prices bringing down inflation, fiscal deficit and the current account deficit. However, Raghuram Rajan is quoted by Barry as appreciating the government’s steps to create an environment for investment.

India also saw liberalisation of sectors untouched for a long time; limits on foreign investment in defence and insurance were both raised to 49 percent. The PM also deregulated the prices for diesel, petroleum and cooking gas. Live Mint also appreciated the PM’s move to avoid lavish increases in minimum support prices and the successful auction of coal blocks and telecom spectrums.

The improvement in economic performance has largely been attributed to positive global factors rather than the present government’s interventions. There have been no revolutionary game-changing reforms and the government is struggling to implement its Goods and Services Tax and Land Acquisition Bill, even in a diluted form. Surjit Bhalla, in his Financial Express column, is particularly critical of the confused tax policy. The retrospective Minimum Alternate Tax (MAT) has led to Foreign Institutional Investment outflow and a loss of confidence in the Indian economy. The data on FDI for the popular ‘Make in India’ campaign does not match the brouhaha. The Urbanization agenda also scores rather poorly, with no real activity on the ‘100 smart cities’ project. The government’s track record on education and health is not impressive either, as argued by Tavleen Singh. Another article in the Hindustan Times also severely attacked the government for reducing the budget in areas like food subsidies, health, education, etc.

Social Policies

Subir Gokarn’s one year report card in Business Standard positively assessed the progress on three critical structural challenges: food, infrastructure and employment.

The PM has, however, been applauded for the announcement of various social schemes such as the Pradhan Mantri Jan-Dhan Yojana and the Atal Pension Yojana that will improve the financial inclusion of the people. However, G. Sampath has dubbed these financial inclusion schemes as Modi’s war on welfare as they have come at the cost of poverty alleviating ones. While the MGNREGA and the Food Security Act were rights-based social provisions, the Pradhan Mantri Yojanas “put the onus of social security on those who lack it the most — the poor themselves”.

PM Narendra Modi and President Obama

Foreign Policy 

An Open magazine article by Brahma Chellaney commented that pragmatism, zeal and showmanship were the trademarks of the PM’s foreign policy. He describes the PM as a ‘a realist who loves to play on the grand chessboard of geopolitics’ and postulates that the foreign policy strategy is to revitalise India’s economic and military security. He does appreciate the PM’s “non-doctrinaire foreign-policy approach powered by ideas”. In a Hindu article, Chellaney states that “for a politician who came to office with virtually no foreign-policy experience, Mr. Modi has demonstrated impressive diplomatic acumen”.

The Diplomat’s two part review of the PM’s one year by Rohan Joshi complimented the PM on his efforts ‘to correct the faltering trajectory of India’s relationship’ with the United States and China and described them as “a positive departure from the past”. Joshi also acknowledged the PM’s attempt to strengthen relations with “Asian Sates that share India’s anxieties over China’s aggressiveness in its neighbourhood.” He goes on to commend the PM’s indifference to Pakistan and his work to build relations with Bangladesh.

It is generally agreed that Narendra Modi has been the most active PM in India’s recent history with regard to foreign policy. However, critics have questioned the timing and number of Modi’s foreign visits as it has left Modi with little time for domestic affairs. Chellaney points out that the Sri Lanka visit could have been extended till after their domestic elections and that his visit to China within 8 months of Xi’s visit to India can be considered too soon.

The Autocratic ruler

The PM’s micro-managerial style has come under intense scrutiny. The Economist ran a cover story on “India’s one man band” where the PM was appreciated for his move to devolve powers to the states. According to The Economist, this would help in creating a manufacturing boom in the country. However, the magazine contends that Modi’s biggest mistake is to believe that he alone can transform India.

The PM is however, having an impact on the bureaucratic culture in India. One of his first reforms was to push for the self attestation of documents. The fastidious whip of the PM has made the bureaucratic staff more efficient and punctual. According to the New York Times article, the PM has ensured that all business deals by ministries are routed through his office to remove the “informal meetings that business leaders used to hold with ministry officials.” This opinion was also backed by Mint, which dubbed the PM an effective administrator.

Brahma Chellany also supported this view by pointing out that the PM has realised the negative impact that corruption would have on internal security and foreign- policy options, and is seeking to bring it under control.

However, not everyone is happy with Modi’s style of governance. The biggest criticism against Modi and his government is that it is hard to distinguish between the two. Santosh Tiwari, in his Financial Express column, contends that the fallout from PM Modi projecting himself as the sole panacea to all of India’s woes is that there is a genuine lack of second rung leadership in the party and the government. The result is that the PM is the final authority on all matters, which hampers the ability of other ministers/leaders to act competently and independently.

Mihir S Sharma, in his acutely critical article “Wasting 282” in the Business Standard, argues that Modi has wasted the enormous mandate presented to him in his first year and attributes this to the lack of direction of top officials.  Ministers and bureaucrats are confused and pulled in different directions because there are no clear set of guiding principles from the PM. The PM insists that “hands-on, case-by-case action such as he delivered in Gujarat, is enough”. This explains the piece meal reforms and lack of big sweeping reforms.

The final word:

Given the nature and enormity of expectations, PM Modi’s government was bound to fall short. As Rajiv Kumar puts it “surprisingly, thus, at the end of one year, Modi finds himself facing disquietude and impatience from the middle, neo-middle and business classes who were his star supporters during the campaign”.  In one year, the PM has made incremental changes to the economy, government structure, and foreign policy but the lack of the game-changing reforms expected of him renders the year marginally above average.

Anupam Manur is a policy analyst at Takshashila Institute and tweets @anupammanur

Devika Kher is a Research Associate at Takshashila Institution. Her twitter handle is @DevikaKher

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Potential Output – Importance and Estimation

Potential output is of vital importance in macroeconomic policy making, despite imperfections in its estimation.

In order to have an effective monetary and fiscal policy, policy makers need to gauge the level of economic activity in the economy and whether this level is consistent with the potential level. In economic terms, policy makers look at the real output and its deviation from potential output, called the output gap. Potential output – the trend growth in the productive capacity of an economy – is an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use.  This is not a technical ceiling on the maximum level of output attainable. Rather, it is an estimate of maximum sustainable output – output that can be sustained in the long run without leading to macroeconomic instability.

While this may seem like a purely academic and statistical exercise, in reality, understanding and proper estimation of potential output has grave consequences for the economy. If actual output is lower than potential output, that is, if the output gap is negative, then the economy is performing below its potential – resources and capacity are underutilized and unemployment is higher than what it should be. On the other hand if the output gap is positive (actual output is higher than potential output), the economy is overheated, demand exceeds supply and inflationary pressures on the economy is high. As is self-evident, neither state is desirable. The manifestation of the output gap is usually through inflation in the economy. A positive output gap results in higher inflation and a negative output gap results in deflation.

For policy makers, therefore, understanding potential output and the output gap is of crucial importance. Negative output gap should ideally be followed by an expansionary fiscal and monetary policy, so as to increase spending and demand in the economy, which will result in actual output converging towards potential output. A contractionary monetary and fiscal policy is required in the case of a positive output gap to reduce the demand in the economy and to provide liquidity to the suppliers to increase their production.

Many central bankers around the world indeed use the concept of potential output in determining the rate of interest. In deciding the policy rate, central bankers use a popular rule of thumb called the Taylor rule, which reduces the complexities in choosing the interest rate to a formula that incorporates the difference between the actual and targeted inflation rate and the difference between the actual and potential GDP[1].

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

As can be seen from the graph, real GDP has exceeded potential GDP during the boom years in the late 1990s and has significantly fallen below the potential GDP after the recession off 2007. It can also be seen that inflation reacts to the output gap. Inflation is above the targeted rate of 2% when output gap is positive and vice versa.

Estimating Potential Output

Despite its overwhelming importance to policy making, there seems to be no consensus amongst economists regarding the best method to estimate potential output. Different countries and organizations use different methods based on country specific circumstances. However, no method has been able to provide consistently robust estimates and each method has its own set of lacunae.

The various methods of estimating potential GDP can be broadly classified into two categories: the production function approach and the statistical approach. The first approach, followed by the Congressional Budget Office, USA, relates the level of output to level of technology and factor inputs, namely capital and labour. Potential Output, thus, would be the output if both labour and capital are fully utilized in an efficient manner. This manner would also require certain assumptions regarding the specific form of the production to be made. Usually, a constant returns to scale production function, such as the Cobb-Douglas production function, is used.

However, for emerging market economies, where reliable data on labour and capital is unavailable, time-series statistical techniques have become quite popular. A widely used approach in the Indian context is the Hodrick-Prescott filter, which decomposes the actual real GDP into two components – a trend and a cyclical component – and potential output is proxied by the trend component.  In other words, the GDP growth rate has an underlying structural component (trend) and another component that is seemingly random due to natural variations in the business cycles and external demand and supply shocks (cyclical). The purpose of the statistical tools is to remove the cyclical part and project the long run potential GDP based on the trend growth rate.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

The graph below shows the estimates of output gap for India using various statistical techniques. While there are differences between the different techniques, broad generalizations can be derived: the economy was overheated for a prolonged period between 2005 and 2012 and has been in slack ever since.

Irrespective of which method is used, it is important to understand the shortcomings in these approaches. However, the presence of short-comings should not be a reason to undermine the immense importance of the concept of potential output in determining macroeconomic policies.

Anupam Manur is a policy analyst at Takshashila Institution. He can be found on twitter @anupammanur

 

[1] Specifically, it is: it = i* + α (πt – π*) + β (yt – y*), where it is the policy rate; πt and π* are the actual and targeted inflation rates, respectively; yt and yt* are actual and potential output, respectively; and i* is the federal funds rate consistent with on-target inflation and output.

 

 

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The Pritchett Test for Evaluating Policy Programs

Lant Pritchett urges analysts to ask four basic questions when evaluating policies

There is a growing practice of conducting intense policy impact assessments in OECD countries, one which developing countries are trying to emulate. For example, in the EU, every department that wants to propose a policy has to conduct a policy Impact Analysis (IA). This usually involves the setting up of committees, boards, consultations between departments, evaluations of the IA, etc – a complex bureaucratic process. International organizations like the World Bank are notorious for their IA tomes. These are thorough and meticulous documents covering all possible micro aspects of the policy. However, in the pursuit of the tiny details, sometimes the macro picture can get lost. The danger of this is that micro policies that can be easily evaluated tend to get preferred over other policy initiatives that might pose bigger challenges for evaluation.

Lant Pritchett, Senior Fellow at Center for Global Development and ex-World Bank man, had written a blog post in June 2014 on whether these detailed impact evaluations are asking the right questions for economic growth and development. He proceeds to develop a simple test containing four simple criteria for impact assessment. These are the questions analysts must ask even before undertaking an IA. If the policy proposal meets all or most of these criteria, the nuances and complications can be addressed later. While this test might not entirely apply to issues such as institutions, human development, approaches to trade, intellectual property, etc, it is extremely relevant to most issues relating to economic growth.

To judge whether a policy/program (let us call it X) is an important determinant of development or economic growth, it must respond in the affirmative to these questions:

Question 1: Is X done more in developed countries than developing countries?

Countries differ in their level of development by an order of magnitude. Countries that are developed should have more of X than countries that are developing. If UK and France don’t have more of X than Mali or Eritrea, X needs to be revisited.

Question 2: Is X done more today in developed countries than it was before?

The magnitude of development changes significantly with time. So, developed countries will be significantly more developed than they were a hundred years ago. Thus, there should be more of thing X now than a hundred years ago. If Germany and Japan didn’t have more of thing X now than they did in 1915, X needs to be reassessed.

Question 3: Is X done more in rapidly growing country than stagnant ones?

Apart from magnitude, countries also differ in their pace of growth. Naturally, X should be present more in the rapid growth countries than development failures. If Korea and Singapore don’t have more of X than Haiti and Nigeria, X should probably be dumped.

Question 4: Does a country’s growth accelerate/decelerate when a country does more/less of X?

Countries don’t grow at a uniform pace all the time. They differ, sometimes dramatically, in their rate of development and growth from time to time. Therefore, X should be present in the country during a rapid growth phase rather than a slow/stagnant phase. If more of X is not present in China after 1978 than before or in India after 1991 than before, then X needs to be revaluated.   If we look for countries that switch from a regime of slow economic development to a regime of rapid development, do we see a parallel shift in the rate of growth of change in X?

Urbanization as the policy Variable (X)

Paul Romer, noted American economist, took Urbanization as the policy variable (X) and put it through the Pritchett test with fascinatingly clear results. Using cross-sectional and time series data for urban share of population and per capita GDP growth (levels and growth rates), Romer concludes that Urbanization as a macro policy variable passes criteria number one, three and four of the Pritchett test.  He does not examine the second criteria reasoning that it requires a separate treatment.

 

Urbanization and GDP per capita.

Urbanization and GDP per capita. 

Source: Paul Romer’s post “Urbanization Passes the Pritchett Test

In brief, urbanization is positively correlated with GDP per-capita. Those countries with higher GDP per capita also have a larger share of their population living in urban areas. This answers the question of whether X is done more in developed countries than developing ones.

Romer then shows that a 1% increase in the urban population share is associated with a 2.7% increase in GDP per capita. He then goes on to show that countries that have a bigger increase in GDP per capita also tend to have a bigger increase in the urban population share. This is an affirmation to the second question of whether X is done more in rapidly growing country than in stagnant ones.

Finally, to answer Pritchett’s fourth question of whether a country’s growth accelerate/decelerate when a country does more/less of X, Romer uses China as the example country and 1980 as the break point between low and high growth.  Before 1980, the urban share increased at the rate of 0.2% per year and GDP per capita grew at 1.0% per year. The corresponding values for after 1980 are 2.5% and 6% per year respectively.

After undertaking a primary analysis such as this, other complexities can be studied and policy conclusion drawn. Romer’s study of urbanization and GDP per capita is a brilliant application of Pritchett’s simple yet powerful tool of analysis. It is a breath of fresh air from the complex and verbose policy impact assessments coming from bureaucrats.

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur

 

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Why is the Dollar the World’s Reserve Currency?

By Anupam Manur and Varun Ramachandra

Strength, stability, universal acceptability, and a lack of a viable alternative to the dollar makes it the global reserve currency. 

Global trade and businesses function best when there is a currency that is widely accepted. This doesn’t imply a common currency, instead, it refers to the usage of a widely acceptable currency for international transactions. Such a currency reduces the transaction costs of converting one currency to another and enables easy invoicing of traded goods and services. This common currency is referred to as the reserve currency.

The brief history of reserve currencies:

Historically, a reserve currency implied a currency that was in wide circulation even outside the issuing state’s borders. Currently, the US dollar is the world’s reserve currency but this hasn’t been the case forever. The silver Drachma issued by the ancient Athens was probably the first reserve currency. The Roman Aureus and Denarious coins, the Byzantine Solidius coins, the Arabian Dinar, the Florence Fiorino, and the Dutch Gulden have at various points had the status of being the world’s reserve currency.

History of money

 

In 1717, Britain adopted the gold standard – a system where central banks had to back each paper currency note they printed with an equal or proportional amount of gold — and simultaneously built a vast empire. At the height of its power, more than 60% of world trade was invoiced in pounds and this led to the pound sterling becoming the world’s reserve currency. At around the end of the 19th century, America’s economic significance rose and this resulted in the US dollar toppling the pound as the most sought-after currency. Today, more than two-thirds of foreign exchange reserves held by central banks around the world are in US dollars (see figure).

COFER

 

Why do central banks maintain reserves?

Two important reasons for holding reserves are as follows:

First, safety. Reserves act as savings, and central banks can benefit from this in hours of need. When a country faces a balance of payments crisis or some other form of financial crisis, the central bank can use its reserves to alleviate the situation. Typically, central banks manage enough reserves to cover for three months’ worth of imports to maintain continuity of trade in times of crises. Reserves also act as positive assurance to debtors.

Second, reserves are maintained to manage a country’s exchange rate policy (the previous post explored this aspect). Whenever a country’s currency appreciates or depreciates, and moves away from the target exchange rate set, the central bank steps in and uses its reserves to maintain exchange rate stability. The Reserve Bank of India has done this on numerous occasions when the rupee has appreciated or depreciated.

Why is the US dollar the reserve currency?

Since the United States boasts of the world’s largest economy (around $18 trillion) and has a stable political environment, most international trade is invoiced in dollars and about 50-60% of US dollars circulate outside US borders. Since there has been no default or major devaluation of the dollar in the past few decades, the USD and the US government’s treasury bonds are thought of as the safest assets in the world; this inherent stability and risk-free nature of the dollar is attractive to investors and has therefore ensured that the US dollar is the world’s reserve currency.

According to economist Ewe-Ghee Lim, there are five factors that facilitate international currency’s status: a large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features for currencies that assume reserve status are large-scale current account and financial account convertibility, an independent central bank, a high degree of capital mobility, surveillance of economic policies, and cooperation of monetary policymaking at regional and multilateral levels. The dollar checks almost all of these boxes.

The rise of China since the 80s has made the Chinese Yuan an important world currency, but since the Yuan has been deliberately undervalued to aid exports, the real exchange rate of Yuan is unknown. Japan and Britain are waning economic powers, the emerging markets are too volatile, the Euro has many internal problems, and gold is too static a commodity to be held as the reserve currency. This leaves the dollar as the only viable option for the time being, and probably for some more time to come.

Anupam Manur is a Policy Analyst at Takshashila Institution  and tweets @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and tweets   @_quale

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The Murky Connections between Trade and Exchange Rate

A positive trade balance should result in appreciation of the currency. However, it is in the interest of countries that export large volumes of goods to have a weaker currency.

By Shobitha Cherian and Anupam Manur

The relationship between the strength of an economy and the strength of the currency was discussed in a previous post. The aim of this post is to discuss the conditions under which economies would want to have a weaker currency. Generally, it is in the interest of countries that export large volumes of goods to have a weaker currency.

The exchange rate of a particular currency is determined mainly by the demand and supply of the said currency. By this logic, countries which export large volumes of goods, or which have higher international demand for their goods, would have stronger currencies, or would have a higher value when compared to the reserve currency or the U.S Dollar. This is due to the fact that since their goods are high in demand, so will be their currency. However, in actual practice, one can see that it is favourable for certain countries to have weaker currencies.

Table showing the relationship between trade balance and exchange rates

Table showing the relationship between trade balance and exchange rates

Source: Calculations based on data from World trade organisation and the International monetary fund database.  Note: Since the countries belonging to the Euro zone use a common currency, they have been eliminated from this analysis.

The above set of countries shows the volume of exports as a percentage share of total world exports, the current account balance (difference between exports and imports) and their exchange rate with respect to the US$. The chosen countries are amongst the top 20 exporters.

From the above data set, it is apparent that countries with a significant share of the world export market have currencies that are weaker than the dollar, i.e., more of that currency is required to buy one dollar. The Korean Won and more so the Indonesia rupiah stand out; around 12800 rupiah is required to buy 1US$.

However, merely looking at export data and the exchange rate gives an incomplete picture. Since the exchange rate is determined by a country’s exports and imports, the relevant data to look at is the trade balance (second column). Further, the strength of a currency has to be looked at in terms of changes. The third column gives the percentage change in the value of the currency since 2010 (a positive number reflects appreciation and a negative number means that the currency has depreciated/weakened).

The table above shows the rather murky lines between economic principles and reality. As explained above, a positive trade balance should result in a currency appreciation and vice versa. Only five of ten countries (highlighted in green) follow this rule. Saudi Arabia and the UAE have fixed exchange rate regimes and thus, show no change in the five years despite having a positive trade balance. Japan, Russia and South Korea have very strong trade surpluses, yet their currencies have depreciated during this period. The Russian rouble has depreciated by over 175%.

Why is this so?

The regulatory authorities of a country may actively keep their currency weak in order to boost exports; if the currency is weaker, the goods produced domestically for export become cheaper for the rest of the world, and by the simple principle of demand and supply, the demand for its goods increases.

Monetary authorities achieve this using a variety of instruments at their disposal. It can impose foreign exchange controls – artificially restrict the movement of the currency. The central banks also participate in the foreign exchange markets to keep the currency at the desired level. For example, if the rupee begins to appreciate against the dollar, RBI steps in, sells rupees and buy dollars, which will devalue the rupee.

Devaluation is sometimes used deliberately as a policy action in times of contraction, where the country would want to get back to the growth path through exports. However, continued devaluation can be seen as a manipulative path of action which seeks to keep a currency artificially weak and will usually face outrage by the international community. This might also result in a competitive devaluation amongst competitors, which can have grave consequences for global financial stability.

Shobitha Cherian is an intern at Takshashila Institution and studies B.Sc economics at Christ University

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur

 

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Using Price Discrimination to ensure Net Neutrality

The main reason that telecom companies are unable to ensure higher profits is essentially a pricing problem and the answer would lie in using price discrimination and charging higher for data.

Airtel claims that its revenues are falling due to free internet based services like Skype and Viber. It feels that it is missing out on its share of the pie as people can call each other for no charge using their data packages. To grab their ‘fair’ share, they want to charge the internet companies for allowing their service through their networks. This is a critical blow to net neutrality. However, if they are truly worried about their profits, they can instead resort to pricing their data services higher by using price discrimination.

The new plan proposed by the TRAI backed by Airtel and co. is trying to create a scenario where producers are given preferential treatment. The plan proposes that sellers can pay the internet service providers to ensure that their products get priority over other products. In essence, the data packets that come from their servers should be given precedence over the data packets coming from their competitors. It is this that has been driving the internet activists over the wall, as it breaks the quintessential property of the internet: that of being neutral. Lots of other writers have spoken about how the absence of net-neutrality will throttle small start ups. Others have addressed this issue in terms of the detrimental effects on our national interest. Most of them, though, take issue with the impingement on their personal liberty. If my service provider makes a deal with a company, agreeing to prioritize its data compared to its competitors, I am being robbed of my choice. The prioritization by the service provider is making a choice on my behalf.

The main reason that is given for pushing discriminatory internet services is that the revenues of the telcos are falling: they have previously invested a lot in buying spectrum, investing in infrastructure, etc, but are finding that their main voice and messaging services are being replaced by internet companies who offer the same services for free through the telcos’ infrastructure.

The numbers on the balance sheets of the telcos suggest that the revenues are far from falling. It has seen steady growth in the past few years and what’s more, there is ample scope for them to tap into the ever growing market of mobile internet users. Then, we can assume that they are normal companies wanting more profits through vertical collusion and cartelization. The reason they have not been able to profit as much as they want from the data services that they provide is essentially a pricing problem. If they felt that the internet services like Skype or Whatsapp were free riding on their data, they can easily increase the amount they charge for data. The reason that the telcos are not increasing their prices is perhaps because of the competition between themselves. Despite the market having few sellers, they face an elastic demand curve, where the slightest increase in prices will drive users to other competitors. This is basic market mechanics based on the Bertrand model of competition.

SECOND DEGREE PRICE DISCRIMINATION

The telcos can practice a form of reverse second degree price discrimination. Price discrimination is a concept in economics which refers to the act of charging different prices for similar or same goods to different consumers. There are various types of price discrimination that is followed in the market – based on geographical location, based on income elasticity of demand, based on the quantity bought and so on. When the price charged is based on the quantity bought, it is known as second degree price discrimination. It basically refers to the discount one gets with bulk purchases. However, the telcos can practice reverse second-degree price discrimination, where they charge lower prices for lesser usage and a progressively higher price for large data consumption.

This will ensure that VoIP services, which uses a lot more data is charged higher, as against text only messaging services. This scheme is still neutral in the sense that differential rates are being applied based on quantity and not on type of service. However, the solution of a blanket ban on prioritizing certain services might reduce economic freedom of the consumer. If service based discrimination has to be made, the choice has to be with the consumer. If a person runs his business solely based on international VoIP calls and doesn’t mind paying extra for ensuring reliability and speed, he should be able to access that privilege. Or, for that matter, a Facebook or Twitter addict who wants these apps to be quick such that they can post real time selfies, should be able to choose these apps over say, apps which give real time updates on political happening in Nicaragua. Thus, people can be given a choice as to which data packets have to be prioritized within their limited bandwidth. This will ensure that there is a high degree of net-neutrality, while ensuring economic freedom to the individual consumer.

Anupam Manur is a Policy Analyst at Takshashila Institution and can be reached on Twitter @anupammanur

 

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Does a strong currency mean a strong economy?

by Anupam Manur & Varun Ramachandra

Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.

The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.

The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP).  The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country[1]. The table below illustrates the metrics discussed thus far.

ExchangeRateGDP

Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com

Note on exchange rate rank:  It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.

Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.

It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.

EXCHANGE RATE DETERMINATION

According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:

First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.

Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.

Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.

The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.

Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.

In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

 

[1] For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.

Anupam Manur is a Policy Analyst at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

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