Is Subsidies are Bad?

We all come across the term subsidies more often. I would like to pen down here about the basic things about subsidies.

1.  What is Subsidy? What are the main Objectives of Subsidies?

Answer: The most general definition – It is an assistance to an economic sector or any business for producers. Subsidies lead to changes in demand/ supply decisions by means of creating a wedge between consumer prices and producer costs.

Many of these subsides are set in place by the Government for producers or distributed as subventions in an industry in order to prevent decline of that particular industry or for an increase in prices of its products or simply to encourage it to hire more labour (as in the case of wage subsidy)

These are often aimed at:

1. Inducing higher consumption/ production
2. Offsetting market imperfections including internalisation of externalities;
3. Achievement of social policy objectives including redistribution of income, population control, etc.

2.  What are the Economics effects of Subsidies?

Answer:  Economic effects of subsidies can be broadly grouped into

1. Allocative effects: these relate to the sectoral allocation of resources. Subsidies help draw more resources towards the subsidised sector
2. Redistributive effects: these generally depend upon the elasticities of demands of the relevant groups for the subsidised good as well as the elasticity of supply of the same good and the mode of administering the subsidy.
3. Fiscal effects: subsidies have obvious fiscal effects since a large part of subsidies emanate from the budget. They directly increase fiscal deficits. Subsidies may also indirectly affect the budget adversely by drawing resources away from tax-yielding sectors towards sectors that may have a low tax-revenue potential.
4. Trade effects: a regulated price, which is substantially lower than the market clearing price, may reduce domestic supply and lead to an increase in imports. On the other hand, subsidies to domestic producers may enable them to offer internationally competitive prices, reducing imports or raising exports.

            Source: Wikipedia

Now comes one of the important question

3. Whether Subsidies are really bad? 

Answer: If you ask an economist then he would answer Yes Subsidies are bad. I would like to quote here from an article by Kenneth P. Green on energy policy. It explains why subsidy in any form is bad policy.

First, subsidies breed corruption. They don’t create incentives for honest people that already have a market-worthy product — such people can already sell their goods into the market easily.

Rather, subsidies create a fertile garden for rent seekers who are unable to sell their goods competitively in a free-market, and prefer to tap the coercive and redistributionist force of government to lever their uncompetitive good into the market at the public’s expense.

Rather than contribute to overall social welfare by giving consumers the best goods at the least cost, or even maximizing the efficient use of people’s taxes, rent-seekers undermine social welfare by foisting inferior or over-priced goods onto the market while taking money from people that could be used for other important purposes.

This is a particular problem in countries with relatively weak property rights regimes, and countries with legal institutions insufficient to prevent it.

He further states that,

Subsidies subvert the efficient functioning of the market, which is our only effective mechanism for matching supply with demand. Free trade of a given good is, as economics tells us, the only way to determine efficiently how much of that good is desirable at a given price.

                    Source: http://www.american.com/archive/2012/august/subsidy-powered-vehicles

In 2011, Delivering the P N Haksar Memorial lecture here, Subbarao, Governor of RBI, said, "In charting a roadmap for fiscal consolidation, we need to be mindful of the quality of fiscal adjustment-- which is to weed out unproductive expenditure and protect growth promoting expenditure," he said.

Sharing his thoughts on subsidies in his address on 'rejigging the Elephant Dance: Challenges to Sustaining the India Growth Story, Subbarao said, "There are bad subsidies and there are good subsidies".

"Bad subsidies like fuel subsidy, subsidy on LPG may be Rs 300 but every time you buy LPG you are getting subsidy to the extent of Rs 300. Not only you, Mr Birla, Mr Ambani, every time they buy a cylinder, they will also get subsidy," he said.

"Then there is fertiliser subsidy...soil degradation happens because of fertiliser subsidy and thereafter irrigation subsidy," he said.

Subbarao said there were good subsidies as well, like giving cycles to girls to come to school and constructing toilets for girls in schools located in villages. "These are good subsidies," he asserted.

Source: http://ww.inwdianexpress.com/news/subsidies-are-bad-d-subbarao/880519

So there are few subsidies which are good, but, most of the subsidies are bad may be due to ineffective management and political reasons.

Currency War – A Small Note

If any one who is following the Exchange Market news closely then those people would have come across this term “Currency War”.  Many news targets on China while US, Japan, UK themselves are also involved in the war silently.  I would like to put few links here which talks about the present currency wars:

1. Why China fears currency wars

2. Central Banks Pause, but 'Currency War' Not Over

3. Currency Wars 2013: China Takes Aggressive Stance On Currency Tension With Japan, As Yen Sinks To New Low Against The US Dollar

4. Currency Wars Have Begun: Central Banks in Denial or Worse

5. China warns over fresh currency tensions

Now back to the topic. Here I am going to start with the basics and then going to give some historical facts

What is currency War?

The Currency war is nothing but Competitive Devaluation.   The Competitive devaluation is a situation in International Affairs where countries compete with each other in order to achieve relatively low exchange rate for their currency.

Who Coined the Term Currency War?

The term “Currency Wars” was coined by Brazils Finance Minister Guido Mantega in 2010 in order to describe how Federal Reserve’s Quantitative easing was pushing up other countries currencies. He also pointed out the effort made by the United States and China to keep their currencies at the lowest value.

What is devaluation? What is the difference between devaluation and Depreciation?

When a government or its central bank deliberately make downward adjustments to its currency in foreign exchange market then it is known as devaluation. This largely happens in fixed exchange rate regime. Depreciation occurs when a currency loses its value due to market forces.

Why one should care or worry about devaluation (or Currency War)

The Currency War will lead to instability. Nations who succeed in devaluation often experience inflation, especially, when they are dependent on imports. While those nations which do not involve in currency war will experience higher unemployment since their export sectors will lose competitiveness (read above article no. 5 for more info). 

Some Historical facts

When one look at the history then the popular method of devaluation was reducing the intrinsic value of precious metals content in minted coinage; example the Roman Empire faced constant threats from barbarians, but they lacked finance to defend themselves, so successive emperors reduced the silver and copper contents in coins.

When Fiat Money came into existence (where the value is purely based on laws rather than intrinsic value of the content) government started simply print bank notes in large quantities. After the First World War Wiemar Germany went to print huge volumes of German Mark in order to cover its expenses which resulted to hyperinflation on a massive scale.

This is a small note on Currency Wars which may lead to serious economic crisis across the globe. 

KAUTILYA's Principles of Taxation and ADAM SMITH's Canon of Taxation

Kautilya alias Vishnu Gupta (who is famously known as Chanakya) was an Indian politician, strategist and writer. He is well known for his text "ARTHASHASTRA". He lived during 350 BC-275 BC. 

Adam Smith, Father of Economics, is well known for his famous book "The Wealth of Nations". He  lived during 1723 AD–1790 AD. 

What's common between the Both or Why I am mentioning about both of them here now? Kindly read both Kautilya's Principle of Taxation and Adam Smith's Cannons of Taxation that are as follows:

KAUTILYA'S Principles of Taxation:

1. Taxation should be Such that it may not be felt by the Poor.

2. In raising taxes higher, it should be done little by little when the realms prosperity is increasing. It should be Mild.

3. Taxes should be levied on Proper Places at proper time in a proper form.

4. It should be reasonable and equitable.

ADAM SMITHS Cannons of Taxation:

1.Cannon of Equality :- Ability to pay principle.

2.Cannon of Certainity:- The amount of tax should be Paid.

3.Cannon of Convenience:- Less burdensome to tax payer.

4.Cannon of Economy:- tax should be collected to minimum Possible Level.

This is just a small comparison between Kautilya's Principles of taxation and Adam Smiths cannon of taxation.  I am leaving this post open  to you.

Some Freaknomics? - For a Change!!

As per our Constitution, Article 47 states that "Government shall endeavour to bring about the prohibition of the consumption (of alcohol) except for medicinal purposes of intoxicating drinks." In reality this completely fails.

Many of us know that, Alcohol consumption is steadily increasing in developing countries like India and decreasing in developed countries from 1980’s.  It was estimated that that are 62.5 Million alcohol users in India. A study shows that per capita consumption of alcohol increased by 105.7% between 1970 and 1996 (over the 15-year period) (Source: Alcohol related harm in India – a fact sheet by INDIAN ALCOHOL POLICY ALLIANCE)

India is generally regarded as a traditional ‘dry’ or ‘abstaining’ culture (Bennet et al, 1993). Yet, it has one of the largest alcohol beverage industries in the world. The UB Group, for example is the third largest spirits producer in the world after Diageo and Pernod Ricard (ICAP, 2006c). India is the dominant producer of alcohol in the South-East Asia region (65 percent) and contributes to about 7% of the total alcohol beverage imports into the region. More than two thirds of the total beverage alcohol consumption within the region is in India.

There has been a steady increase in the production of alcohol in the country, with the production doubling from 887.2 million litres in 1992-93 to 1,654 million litres in 1999-2000 and was expected to almost treble to 2300 million litres (estimated) by 2006-07 (The Planning Commission  of India, 2003).

Though consumption is still low, patterns of alcohol consumption vary widely through the country. Punjab, Andhra Pradesh, Goa and the north-eastern states have a much higher proportion of male alcohol consumers than the rest of the country. Women tend to drink more in the states of Arunachal Pradesh, Assam and Sikkim in north-east; Madhya Pradesh, Chhattisgarh, Orissa and Andhra Pradesh in central and east India; and Goa in the west, compared to other states. 
(Source:F-Current Patterns and Trends – ALCOHOL ATLAS OF INDIA –WHO)

This is the trend shown in the recent study on Alcohol in India. Now, when it comes to revenue part there is large part of revenue come from Liquor. In 2006-07 the combined earnings of States from alcohol were estimated about Rs. 30,000 crore which was over 11.5% of tax revenues. In fact, liquour was the second largest contributor to the State’s aggregate revenue kitty after sales tax  which was Rs 1,20,709.15 crore.

The revenue generation from alcohol is a national phenomenon. Karnataka is leader with the excise collection of Rs. 4060 Crore while Uttar Pradesh is in second followed by Andhra Pradesh in third with Rs. 3650 Crore and Rs. 3250 Crore respectively. 

(Source: Can govt ignore alcohol's revenue earnings? - IBN)

My Reflection:

India is the one of the largest producer of Alcohol. This news may not be surprising to many of us; but, the thing is our constitution says one thing and the reality is totally different. The worried part is consumption of alcohol by youngsters has increased from 2 percent in 1990 to 14 percent in 2006 (below the age of 21) and among adults (between age group of 21-30) it is increased from 29 percent to 35 percent in the same timeline. One side the per capita consumption of alcohol is increasing on the other side Government revenue from alcohol is also increasing; whether the revenue from this is utilised for some development purpose or again it goes only to produce more alcohol that's a big question mark ?

Note: TASMAC (Liquour Company owned by Government of Tamil Nadu) revene for 2011-12 was Rs. 18, 081.16 Crore with increase of 20.82% and This year Kerala saw Rs. 70 Crore worth sale of alcohol during two onam days. The entire week revenue was approximately Rs .720 Crore. As per the recent study  Punjab tops the sale of alcohol followed by kerala.

RBI Second Quarter Review of Monetary Policy 2012-13

Today (i.e. 30.10.2012) RBI had announced “Second Quarter Review of Monetary Policy for 2012-13”. It had announced in his statement (click here for full statement) that: Based on an assessment of the current macroeconomic situation, we have decided to:

Ø   Cut the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 4.5 per cent to 4.25 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning November 3, 2012.

Ø   The reduction in the CRR, will inject around `175 billion of primary liquidity into the banking system.

Ø   There is no change in policy interest rate. Accordingly, the repo rate under the liquidity adjustment facility remains at 8.0 per cent.

Ø   Consequently, the reverse repo rate under the liquidity adjustment facility (LAF), determined with a spread of 100 basis points below the repo rate, will continue at 7.0 per cent, and the marginal standing facility (MSF) rate, determined with a spread of 100 bps above the repo rate, at 9.0 per cent.

It had the above mentioned following stands:

i. enable liquidity conditions to facilitate a turnaround in credit growth to productive sectors so as to support growth;

ii. reinforce the growth stimulus of the policy actions announced by the Government as inflation risks moderate; and

iii. anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation.

Within few hours of RBI Second Quarter Review Finance Minister made following statements to the media:

"Growth is as much a challenge as inflation. If government has to walk alone to face the challenge of growth, then we will walk alone," he said in his reaction to the RBI's second quarter policy review. 

He also stated that “Government is doing its best to send the clear message that we are on the path of fiscal consolidation. It is my hope that everyone will read and understand the government commitment to path of fiscal consolidation. I haven't read last few paragraphs of the statement but if it holds out hope for the future I look forward to that future”.

My Perspective:

The RBI stance on Monetary Policy had received many criticism and many economist/analyst are disappointed of its Second Quarter Review. I am not at all surprised by this move of RBI since the reputation of RBI is already at stake. RBI may not have surprised the economy in positive manner but definitely it did surprised the economy in its own ways (of course in negative manner) as it does in the recent past. If one reads the reasons for the policy stance, especially third point "anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation", then one will realise that RBI in its Mid-Quarter Review Statement (on 17th September, 2012) had reduced CRR by same 25 percent and injected Rs. 17, 000 Crore primary liquidity into the banking system. For this stance it had said that "As inflationary tendencies have persisted, the primary focus of monetary policy remains the containment of inflation and anchoring of inflation expectations. In this context, the Government’s recent actions have paved the way for a more favourable growth-inflation dynamic by initiating a shift in expenditure away from consumption (subsidies) and towards investment (including through FDI)."

Many may argue that it was the expectation of the outcome but since it was not achieved RBI had made the current stance. True, the expected outcome had not been Achieved, but, on what basis the current stance of RBI is expecting that it will anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation? The present market situation needs a boost in investments in order to stimulate the economy. No doubt, at the same time we need to have eye on inflation; when one notice the present scenario then one can realise that most of the inflation may be due to failure of supply side boost. Inflation even though most of the times monetary phenomenon, does not mean that only through Monetary Policy measures it can be controlled. RBI again fails to read the situation of the economy and provide appropriate policy measures.

CRR DEBATE – Whether CRR will survive?

During the past few weeks, in the newspapers and televisions, many would have read, saw, and heard that whether CRR is required or it should be abolished? In fact, the close follower of this news would have noticed that the debate was initiated by SBI chairman, Mr. Pratip Chaudhuri and in response to his comment (on abolishing the CRR) RBI Deputy Governor Mr. K. C. Chakrabarty said that CRR is the only and important tool with RBI and it cannot be abolished.

Before going further let us see what exactly CRR is and its purpose?  Cash Reserve Ratio (CRR) is ratio of reserves at which commercial banks must hold or deposit with the central Bank. In other words it is a central bank regulation that sets the minimum reserves that each commercial bank must hold physically in bank vaults or as deposits made with the central bank. This reserve can be maintained either in cash, gold or unencumbered government securities.

The reserve requirement, on one hand, helps the bankers to have enough cash to meet any crisis and on the other hand, they serve as tools for Central Bank to control the liquidity in the system in order to manage the Inflation. When CRR is altered then the interest rates will be changing as per availability of funds with the commercial banks.

Now coming back to the debate that SBI Chairman said Abolish Cash Reserve Ratio, he said that "CRR does not help anybody. It is locked up in the vault and not ploughed back into the economy. It is unfairly applied on banks. If CRR is a liquidity mop-up tool, why not apply it to insurance companies, NBFCs and debt mutual funds, who as well mobilize deposits from the public?" he asked.

After three days of SBI chairman commented the RBI Deputy governor K C Chakrabarty commented that “the banks must work within the frame work of the regulatory norms”. He also said that “If SBI is not protected, the risk may catch other banks leading to a systemic failure and SBI is too big to fail.” He further went on to say that “If the SBI Chairman is not able to do business as per our regulatory environment, he has to find some other place”

This row has become a big debate now. Recently, Reserve Bank of India Governor D. Subbarao made a prank up his sleeve at a banking summit in Mumbai. In serious tone he announced that central bank has set up a ‘committee’ to review the need to retain the much-debated cash reserve ratio (CRR)” But when the Governor revealed the names of the committee members and its conditions, people realised he was only joking.  He said that “The members of the committee, Subbarao said, would be Pratip Chaudhuri, Chairman, State Bank of India, and K.C. Chakrabarty, Deputy Governor, RBI. Both, with opposite views on CRR (the percentage of deposits that banks need to keep with RBI), have sparred over the issue.” He also went on to say further that “the two conditions for such a committee would be: First, the two members would be locked up in a room till they come to an amicable solution. And, second, the findings of the committee should not be made public until his own term as Governor comes to an end.”

So let us see the main reason why SBI chairman said CRR is not required. The main reason for it is that CRR has come down from its peak level of 15% in 1994 to 4.75% at present. Few years ago RBI had ceased to pay interest rate on CRR, which affects the commercial banks. This is one of the main reasons why SBI chairman wanted CRR to be abolished. SBI chairman had got some support for his view from Former RBI governor and present chairman of the Prime Minister's Economic Advisory Council (EAC) C Rangarajan; he said on that there is a need to bring down the cash reserve ratio as the instrument is no longer used in credit control and liquidity management. In his own words "We need to move towards a situation in which the level of CRR comes down and it is used as an instrument of credit control only in extraordinary circumstances," he also stated that "As OMO (open market operations) becomes increasingly a major instrument of credit control, the role of CRR as an instrument of credit control will come down,".
 
Here are 2 more articles on this debate 1.     CRR harsh on public sector banks
2.  CRR has outlived utility

My perspective with a Thank Note:

When one reads the debate then one may come to a quick conclusion that SBI governor is right and CRR should be abolished. If CRR is abolished then what are the other tools through which RBI can control credit and inflation? (Even though this is not the only tool to the do this, but one of the major tool for RBI). No doubt as EAC chairmen said that OMO becomes increasingly a major instrument of credit control, but at the same time we cannot ignore or doubt the credibility of CRR. The Problem with commercial banks is few years back RBI had stopped paying interest rates on the cash reserves; this affects the business of the commercial banks, because without any incentive when the cash is kept then it is no use for anybody. RBI need to find a amicable solution to stop this debate, either by paying some interest rates or through some other incentives. 

I wanted to end this big post with a THANK note to all the Visitors who had viewed, read, visited and commented on this blog. Today, with the help and support from all of you, this blog had crossed 4000 visitors (which you can see in the left side of the screen). I Thank  all of you again for giving your support and encouraging me to keep posting in this Blog. THANKS ALL