The rupee crisis macroeconomic causes and cures (Part 3 of 5)

Continuation of sub-topic – Second cause of INR Shortage: Divergence in Inflation

Suitability of relative weights can be judged from drinks and meat in the consumer basket. Beer gets 0.56% weight and fruit juice is given 0.64%. Domestic spirit, which is ubiquitously consumed, gets 0.65% light weight. Drinks seem to fare better in consumer price index than meat. Chicken is given 0.57% weight while pork is given 0.50% weight, but beef gets a higher 0.98% weight.  Potato, however, is mightier with 1.04% weight.

Indian inflation, as measured by consumer price index, should be much lower than that of Bhutan but due to the difference in weights and basket size, the inflation rate of Bhutan is implausibly close to that of India. Their comparison is deceptive. Wholesale price index of India, which includes some 600 items in the basket, is far less relevant for comparison though some offices such as RMA regularly print wholesale price index of India for comparison.

The fact however is that Bhutanese inflation has been so high that in the last 12 years the Nu has lost 45% of its value. Because of transport, trading and tax margins, price level of imported goods will be obviously higher in our country. But it cannot lead to sustained divergence in inflation between the two countries. A sustained divergence in inflation rates between India and Bhutan is primarily caused by either monetary and fiscal expansion1 or some combination of both. Such expansion has increased demand for traded goods, making the current account deficit worse due to increases in imported goods and imported labour. Current account deficit in 2011 was about 17.5 b2 when exports and imports of all countries with whom we trade are estimated. But current account deficit with India was about 12.7 b3 for the same year. Increases in demand for imports by Bhutan cannot increase the prices of those goods in India. But fiscal or monetary expansion4 has raised the prices of domestically produced non-traded goods because of poor supply response. Although it is not discussed here, it should be emphasized that the exponential fiscal expansion since 2000 has been caused by upward shifts in wage and entitlement bargaining in the public sector employment as well as the expansion in the size of the public sector employment.5 It should be noted that there is no wage or salary index in Bhutan. However consumer price index includes rental cost which has 15% weight.

Higher prices should stimulate higher production of non-traded goods. But in an open economy, demand shifts towards imported substitutes of such non-traded goods because of their lower prices. Think of the price of Tsirang-produced egg going up by 15% every year while an Assamese egg’s price is going up by 5% a year. Such divergence in prices induces a continuously deteriorating balance of payments and consequent running down of INR reserve. Under the fixed exchange rate between the two countries, this cannot go on forever; foreign exchange reserves will be depleted.

As the GDP of Bhutan increases so has its propensity to spend on imports. Spending, as measured by GDP, on domestic goods rises but it rises less than GDP because part of GDP is saved and an overwhelming part of it is spent on imports. Import price increase does not exert expenditure switching effect in favour of domestic goods. The government often considers increasing import taxes as people’s income rises so that the price of imports rises relative to exports and import volume and value is lowered. Relative increase of prices of imports, whether it is Assamese eggs or Taza milk, by imposing additional taxes could improve trade balance only if the sum of import plus export elasticity exceeds unity. This so-called Marshall Lerner condition6 is most likely not satisfied in our economy. Rising import taxes will have limited effect on improving trade balance under such circumstance. Further research with better data should reveal whether it is true or false. In any case, whether import tax increase improves trade balance also depends on how the government uses the revenue accrued from increased import taxes. If the government is able to use the revenue thus accrued to switch its expenditure to domestic goods more than the households sector, trade balance can improve. Short of this, restricting imports by imposing higher taxes will not meet the objective of improving trade balance fully though it will obviously improve revenue for the government.

Divergence of costs of goods produced in India and Bhutan and its effect on INR was discussed so far. Higher wages (wage-costs inflation) in Bhutan is another contributory factor to the INR crisis, because it has led to import of cheaper labour for constructions especially in the urban sector. The growth of private housing in urban Bhutan relative to rural areas can be explained by two basic factors. The first is the allocation of credit to construction sector which happens mostly in urban areas. The second factor for the growth of urban Bhutan and its construction is ease of importing labour into urban areas relative to urban areas. In fact, there is no clear regulation allowing for importing labour for rural house construction.

A major cause of loans or credit growth is obviously construction booms, inflationary costs of construction materials, and resultant trade deficit and finally INR shortage. This started with greater Thimphu town declaration in 2005 that began to suck credit into construction several years later. There are now some 60 declared urban sites7 and their development will require credit. In 2011, officially classified credit to construction went up from 5.7 b in 2008 to 14.5 b in December 2012,8  corresponding to 30% to 27% of the total credit. It went further up to 15 b in April 2013. Transport and construction loan together constituted 35% of the total credit in April 2013. Construction loan amount excludes credit given by National Pension and Provident Fund. The actual amount could be higher as other credits used for construction might be disguised. It might be better to control through slowing down of urban plans administratively. It would give space at the same time for aesthetic, architectural and functional dimensions of the urban planning to be improved. Administrative credit control by RMA for construction might lead to many distortions. Neither control of construction loan nor control of vehicle loan has actually led to significant decrease in credit to these sectors. Building and construction loan have increased while transport loan has remained the same in 2012 and 2013.9 Vehicle population increased from 62,697 in 2011 to 67,449 in 2012, with a disproportionate number of vehicles – 65% – being registered in Thimphu. Disaggregated vehicle population show that the number of light vehicle imported since 2011 have slowed down. Light vehicle imported decreased from 4921 in 2011 to 3104 in 2012.10

Foreign workers are mostly engaged in cconstruction sector. INR outflow on account of foreign workers is substantial. In the balance of payments accounting, it is part of the invisible trade which contributes to current account deficit. But in national accounts framework, it is called net income. INR outflow should not be considered with a value judgment as negative or undesirable. I wish to simply note that in 2011 about 4.8 b INR has been paid as remittances on account of wages and salaries of laborers and professionals from India. It is quite obvious that about Nu 5 b of INR that is incurred in current account deficit can be reduced if Bhutanese can work in similar tough working conditions as Indian workers, but this is very unlikely to happen for the foreseeable future. For Bhutanese people substitute effect of leisure seems to dominate income effect at the wage rate offered to Indian workers. On the other hand, adaptation to working conditions in the construction project could be made attractive to prospective workers by giving them training and better housing conditions. One part of solution to the current state of underemployment will lie in creatively and proactively organizing a substantial number of Bhutanese youth to work in the hydropower construction projects over the next decade. Their training has to precede hydropower investments.

Third Cause of INR Shortage: Terms of Trade Deterioration

The third cause of INR crisis is the deterioration in the terms of trade. Terms of trade are the ratio of the average price of exports to the average price of imports. Export price index and import price index are needed to estimate terms of trade improvement or deterioration. This can be done by selecting top 50 import and export items to create indices. The idea behind terms of trade is very elementary. Terms of trade measures how many units of export is needed to pay for a unit of import. An example can be given by comparing the growth rate of import price of diesel from India and the growth rate of export price of electricity from Bhutan. Import price of a litre of diesel has grown over the years much faster than the export price of a kilowatt hour of electricity. Electricity export price has lingered from INR 1.5 in 200211 to INR 1.99 in 2013, resulting in 32.6% rise over 11 years. In contrast, diesel price have risen 241% in the last 12 years.12 This means that to import a litre of fuel Bhutan needs to export increasing units of electricity. Even if the quantity of fuel imported remains constant, the balance of payments will continuously deteriorate. The fuel import has risen by a large amount every year. Value of diesel and petrol import amounted to nearly 5 b in 2011.


Exports and imports are not limited to electricity and fuel respectively. Food imports from India rose from 1.8 b in 2004, to nearly 7 b in 2012 when beverages is also included. For corresponding period, food exports increased from 675 m to 1.2 b. Food trade gap has widened sharply over the years.

One reason could be slow increase in the price of export commodities. Prices of major export agricultural commodities like apple, orange and potato13 have risen very slowly for the last ten years. Export price of apple to Bangladesh in 1992 was Nu 10.7 per kg. In 2010 it was Nu 16.6 per kg. Averaging over 16 years, its export price rose only 6%. Export price of orange to Bangladesh was Nu 13.3 per kg in 1992 and Nu 14.8 per kg in 2010, rising by 2.1% in 16 years. Export price of potato to India was Nu 4.13 in 2000 and Nu 10.6 in 2010, but in certain years the export price (which I assumed to be auction price) had collapsed to Nu 2 per kg.14 The lessons from the trend in such agricultural commodity prices are three-fold. Firstly, value addition through agro-industry is vital if export revenue is to increase. Secondly, the distribution of the same commodities over the year and in the country should be improved to avoid importing them.  For example, in 2008 Bhutan exported potatoes worth Nu 119.7 m to India but it imported potatoes valued at Nu 17.7 m in the same year. This kind of trading can be avoided to improve trade balance.  Third and the most important lesson from agriculture commodity export, or in fact any major export item, is that demand for them should be price inelastic (price elasticity of export item should be below one) for the commodity to improve current account.

Minerals are a major export to India. Top ten exports to India are mostly mineral based. Export price of minerals also have not increased fast enough. Pit head price of gypsum, which is one top ten exports, was Nu 1000 per metric ton in 2000. Its pit head price was Nu 1600 in 2011, which is 60% over 10 years or 6% a year. On the other hand, those in coal mining business have thrived. Export price of coal have been rising at an annual rate of 10.8% per year. Export price of coal per MT was Nu 1700 in 2000; it rose to Nu 4400 per MT in 201115.

Estimation of terms of trade should include a wider range of goods exported and imported. The main point here is that changes in terms of trade affect current account, which in turn affect INR reserves level. Terms of trade’s impact on current account and on INR reserves depends on price elasticity of demand for exports and imports.

Many sectors of the economy unlike hydropower sector have been rendered uncompetitive by liberalizing too quickly. Prices of locally produced goods which are substitutes for imports are higher than prices of imported goods, as a result of opening up, combined with expansion of cheaper transport. One can illustrate this with respect to vegetables which were non-traded good (not imported).16 Vegetables from India were comparatively expensive before motor road transportation became widespread and rural people were self sufficient. Partly as a result of wage-costs push, cost of vegetable production in Bhutan has risen. Indian vegetables became comparatively cheaper even after haulage cost. Thus vegetables which were non-tradable goods became traded goods in urban Bhutan. In addition, lowering of transportation cost changed competitiveness of Indian vegetables which were earlier not imported. Cheaper imports creates consumer surplus for those who buy imported vegetables but those imports have to be paid for by selling something in return. But to be export competitive, labor productivity has to be high. Bhutanese labor productivity appears to be low in all sectors of the economy except hotel and hydropower sectors. Hours of work in a year should fall while the output in Nu per hour should rise due to the rise in the value of goods that is produced and sold. Consequently export price can rise and terms of trade can improve. If the labor productivity does not rise in sectors such as agriculture, labor will move out of agriculture further depressing production. This effect is, in my view, already evident.


Government can intervene to raise labor productivity in sectors like agriculture and services. But it will not effective if it continues to employ people in the public sector at relatively high wage or salary where productivity is in fact extremely low. Civil service is an example of low labour productivity. Civil service can become overmanned and a large proportion of it may not generate any efficient output.  It has drawn in all the bright people and gradually made them less innovative, while driving up the wage level and depriving other sectors of potential employees. Civil service size could be decreased gradually by discontinuing many irrelevant posts under a downsizing plan and winding up many redundant offices. It would reduce the pressure on fiscal expansion. At the same time, this move should not result in increase in unemployment. Employment generation outside the public sector employment can be found through two means while at the same time increasing production capacity and labour productivity. (1) Money must be saved instead of spending on public sector employment creation, to generate employment and enterprises elsewhere. (2) Plan should be launched to employ about thousands and thousands in new hydropower projects and elsewhere.

to be continued   

                                                                                                                          By Dasho Karma Ura

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