The Rupee Crisis Macroeconomic causes and cures (Part 2 of 5)

Depending on the marginal propensity to import, Nu 2.9 may finally result in substantial INR equivalent requirement as a creditor converts her Nu holding into INR for import purposes. For example, if marginal propensity to import is 0.63, as my rough estimation show, an increase in gross national disposable income by Nu 1 will result in demand for INR by .63 paisa. In absolute terms, the amount spent on imports out of GDP will keep on going up as GDP does. But the estimate of marginal propensity to import is not reliable with a required level of confidence. Trade statistics on imports seem to be an underestimation by a substantial margin. The people living close to the border towns of India – perhaps constituting one fifth of the population – carry out their daily shopping across the border because they find it cheaper to do so.

To what extent licensing two more banks in early 2010 added to the credit creation boom requires further disaggregated data. Some accounts would have migrated to the new banks and would not count as new transactions. Together TB and DPNB lent 4.1 b out of a total of 40.6 b credit given by the banks in 2011. In 2012, TB and DPNB lent 5.7 b out of 51.3 b credit disbursed by the banks. It can be surmised that credit creation would have been slightly less if they did not come into existence in the same year.

Past hold lessons if it is heeded. Monthly data available from July 2011 to June 2012 on domestic credit and M2 show that domestic credit was almost equal to foreign reserves till December 2011 and then it exceeded foreign reserves.  Domestic credit is much higher than foreign reserves even now.This suggests that INR shortage which burst upon the financial sector early in 2012 lay in excessive domestic credit that has been fueling imports. For example, domestic credit in January 2012 was around 44.2 b whereas foreign reserves was only 36.8 b. Adding these two together, M2 in January 2012 was 55.1 b. Since then, domestic credit (loan) has continuously exceeded foreign reserves.

When six monthly disaggregated data is examined, loans given as a percentage of deposits were close to 100% at the beginning of 2012. Later, loan to deposit ratio crossed the 100% threshold sometimes in June 2012 when pronounced INR shortage became so evident. For the first time in the financial history of Bhutan, banks as a whole had given more loans than they had deposits to support them. The banks have been lending in amounts that exceeded deposits with them, indicating in general low liquidity. Looking back at the loan-deposit ratio, in January 2006 it was about 45%. By January 2012, loan deposit ratio exceeded 100% and in April 2013 reached 116%. Such simple indicator suggests that aggressive lending and aggressive borrowing resulted in financial instability.

Despite the difficulties faced by the economy, profit maximisation has been the goal of the financial institutions but it can be often false achievement when seen from a higher integrated perspective. Their financial over performance can emerge as problems at another level, in this case as over active money multiplier and consequent INR problem that led to borrowing by RMA at commercial rates of interest. Between 2011 and 2012, Bhutan National Bank (BNB) profit grew by 37% (697 m), Tashi Bank (TB) by 71% (37 m), and Druk Punjab National Bank (DPNB) by 90% (86 m). Bank of Bhutan (BOB) made a hefty profit of 660 m in 2012.  The dividends of government owned bank and taxes on profits comes to the government but such revenue collected from financial institutions due to their performance can be offset by interest payment on INR borrowing by RMA.

The experience of the past five years should be heeded, if we are not to buck lessons from the past. A few major investments drew away most of the credit. Top five borrowers in 2012 were Tashi, DCP, Lhaki, Druk Iron and Steel, Royal Thimphu College and Royal Insurance Corporation of Bhutan taking a total of 5.4 b out of a total of 51 b lending: 5.4 b is 10% of total credit. An official report available on the web says that “Tashi InfoComm, Druk Ferro Alloys, Druk Deothjung Resorts, Bhutan Concast and Drukwang Ferro Alloys, and several others contributed to the domestic credit growth and increased the Rupee demand. It also highlights that constructions of Dungsam Cement and Dagachhu hydropower projects contributed to the credit growth as part of the projects are financed through domestic credit.” 1 Spacing of major investments over time, as opposed crowding them over a same period, will be prudent. Repeating the experience will worsen liquidity situation and INR shortage. At the same time due to the advantageous electricity tariff granted to some of these industries compared to export price of electricity, their operation can lower electricity revenue in INR.

Some economists have suggested that the aggressive lending and borrowing in the private sector has happened because of the lack of opportunities for buying short-term government instruments like bonds or treasury bills. A closer look at data disproves this observation. Amount off treasury bills sold by RMA on behalf of the government for 2012-2013 budget year in order to maintain cash flow is quite astonishing. To maintain cash flow of the government, in the past budget year nearly 13 b was borrowed and repaid. Revenue collection can be redesigned so that cash flow over the year is less erratic. The stock of domestic debt measured at the end of year is misleading. In the total credit market volume of 53 b2 or so in 2012 and 2013, a turnover of 13 b in the treasury bills itself can rock the financial system.  A more analytic appraisal of treasury bills’ impact as well as a more fine-grained appraisal of the budget deficit would be desirable in future, given the precise knowledge of the total deposit available for such purpose. Budget deficit as a percentage of GDP, though used as an indicator around the world, seems to be a blunt and misleading instrument in the case of Bhutan. Such large amount of fiscal deficit should entail financial crowding out either through increases in interest rate for treasury bills and by price increases, especially for non-tradable goods and services.

An interesting question about excessive seigniorage profit and inflation tax3 imposed by RMA has not been raised before by anybody so far except by UN-DESA economist Hamid Rashid. The basic idea of seigniorage is simple. The cost of printing paper currency compared to face value of currency is almost negligible. Cost of printing currency of high denomination above Nu 50 could be as low as 3 chetrum per Nu. Thus, the authority which circulates currency collects seigniorage4 or revenue, and excessive issuance of currency relative to the size of economy can result in inflation and undermine one-to-peg with INR. Hamid has provisionally estimated that seigniorage was as high as 4.6% of GDP, and when inflation tax is included, even higher at 7.26% of GDP in 2010/115. Hamid has remarked that “This is extremely high by international standards, which typically ranges between 3% and 4% of GDP. Standard economic theory suggests that a small open economy with a pegged exchange rate should not expect to collect a large seigniorage.” Seigniorage issue is relevant because it contributes to money supply and undermines currency peg. My re-estimation shows substantial seigniorage made by RMA but it is lower than Hamid’s findings. But the let me leave aside this issue here by merely noting that it is an important one for future monetary policy.

Another enormously important question that we should ask is why M2 which is composed predominantly since December 2011 by domestic credit accelerated. M2 is now hovering between 55-60 b. Within M2, the amount of currency circulating outside banks has been fluctuating little bit above 5 billion since 2010. Currency circulating outside the banks is about 5.43 b in 2013, which means each of 6, 13,000 Bhutanese has Nu 8,716 in cash in his or her pocket. Or it means that among 1, 27,000 households, each household have Nu 42,070 in cash. Most of the people in lower quintiles would not have; so its distribution is skewed.

Time deposit is now (April 2013) about 21 b out of some 51 b M2. An important thing to note is that the level of time deposit got lower than demand deposit after 2009. Time deposits were higher than demand deposits before that point in time. Demand deposits short term liquidity – have seen spectacular growth from 2 b in 1997 to 8 b in 2005 to 25 b in April 2013. Demand deposit is half of M2. Burgeoning demand deposits of ministries and Druk Holding Investment are could be responsible for this acceleration of demand deposits. Distribution in holdings of demand deposits suggests that about 10% of it on average belongs to government corporations. At any given time, government corporations hold about 4.5 b in demand deposits. I would assume that government offices hold about 2.5 b in demand deposits at any given point in time. Current and capital accounts of the government sector maintained in demand deposits contribute to growing level of M2.

As part of the explanation of growing level of domestic credit, it should be noted that the volume of money maintained as time deposit was higher than demand deposit before 2009. This is an important change in the behavior of money supply. It seems that this could be explained by a combination of two factors. The first factor could be the higher rate of expected inflation that has had a real balance effect, i.e., people did not want to hold time deposits because the acceleration of inflation that has been undermining its value. An indirect evidence of real balance effect is the velocity of money (V=PY=real GDP/M2). Velocity of money is influenced by changing psychology of the people about their demand for money.6 It is inversely related to inflation and it often goes down when inflation goes up. Velocity of money slows down as people do not want to hold money. It has slowed down since 2007. It was 1.7 in 2008/9 and 1.4 in 2010/11 according to RMA.7 However, my estimation shows that the income velocity fell gradually over the years from 1.9 in 2003 to 1.0 in 2012. It reached the lowest point, 0.9 in 2010. The second factor could be that the volume of demand deposits in the bank’s increased due to a rise in government sector revenue as well as increasing government sector expenditure which, importantly, included hydropower investments.

INR crisis is attributed by some economists to a change in the composition of foreign currencies reserves between INR and dollars. INR reserves as a % of total reserves has declined severely since 2006. INR reserves became less than dollar reserves of RMA since 2006. But I do not agree with this particular diagnosis as a cause. This is not a diagnosis of cause but of symptom. It is descriptive and it simply means that outflow of INR has been greater than inflow. People have suggested that half of reserves should be held in INR. But if outflow exceeds inflow, changing the composition of foreign reserves in favour of INR will not resolve the problem, just as selling dollar reserves from time to time when the Rs is at its lowest point cannot remove the root cause. Only if the INR or dollar reserves inflow is greater than outflow can the reserves get replenished and get cumulatively higher. For the moment, however, it is important note that when one looks at monthly record of the INR and dollar reserves held by RMA, they are almost mirror image of each other. When dollar reserves goes up, INR reserves comes down (See chart below). This happened simply due to the fact that as dollar is converted in Nu, the Nu holding is quickly reconverted into INR for import purposes. So the round tripping of dollar into Nu and back into INR seems to have taken place with very little time lag. In fact the time lag of completing a round trip seems to be less than a year.



Second Cause of INR Shortage: Divergence in Inflation

The second cause of the INR crisis is the higher inflation in our country compared to India. Usually in other countries, stable price is a goal of monetary policy along with full employment. Full employment is coupled with stable price because they are inversely related: inflation and full employment have trade off.

Though inflation is a major macroeconomic cause of INR shortage, paradoxically, INR shortage itself can lead to inflation.  The causal relationship can be multidirectional. For example, INR shortage clearly lead to rise of food prices in 2012 as supply of imported foods and vegetables became temporarily restricted due to scarcity and rationing of INR.

Let me focus my explanation here on inflation as a macroeconomic cause of INR crisis rather than INR crisis as cause of inflation. Bhutan’s inflation has been around 9% since 2010. It was 9.17% in 2010, 8.45% in 2011 and 9.54% in 2012. However, it can be argued that the current method and weights attached seems to underestimate core inflation in our country. This is due to weighted averaging across 438 items in the consumer price index. In contrast, consumer price index of the gigantic and diverse Indian economy is based on far less number of items.

The problem with Bhutan’s CPI may lie in two areas. First, it has too many items. We need to prune the basket to a more sensitive list instead of broadening it to all things bought over a year from exotic drinks and foods to consumer durables. Secondly, we need to reallocate weights among more representative but shorter lists. For example, bananas and chocolates have roughly the same weights of 0.24% and 0.22% in the current CPI. Their relative weights do not seem unreasonable. But the weights attached to the cost of tertiary education at 0.39%, the cost of pre-primary and primary at 0.36% and the cost of cinemas and theatres at 0.34% when compared with the weights attached to chocolate and bananas might be debatable. People spend far more on children’s primary education than on chocolates. Common sense leads us to propose that far greater weight should be attached to educational expenditure….

to be continued
By Dasho Karma Ura

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