Tumbling oil prices is the biggest energy story in the world right now as global oil prices are in free fall over the past seven months. In the mid of 2014 oil prices were around $115 per barrel but since than the prices have fallen below $50 per barrel for the first time since May 2009. Steep fall in oil prices leads to significant revenue shortfalls in many energy-exporting nations, while many importing countries are likely to pay less for their requirements.

By the second half of 2014, world oil supply was on track to rise much higher than actual demand and, in September, prices started falling sharply. The oil price is partly determined by actual supply and demand, and partly by expectations of the market participants. Demand for energy is closely related to economic activity. It also spikes in the winter in the northern hemisphere, and during summers in countries that use energy to cool the internal temperature with air conditioning. Supply can be affected by weather (which prevents tankers loading) and by geopolitical upsets. If producers think the price is staying high, they invest more on technology and exploration, which after a lag boosts supply. Similarly, low prices lead to an investment drought. As per the International Energy Agency (IEA) Oil Market Report for November 2014, the production of oil in November stood at 94.1 mbpd and demand estimates stood at 92.4 mbpd.

Reasons behind the oil price nosedive
To understand this story, we first have to go back to the late 2000s. World oil prices experienced a sustained upward movement. By far the most important reason for this long-term trend is the rising demand for these products stemming from rapid economic growth in China and other emerging-market economies including India. That led to large price spikes, and oil hovered around $100 per barrel between 2011 and 2014. This robust growth in oil demand encouraged companies in US to step up for exploration, developing higher cost sources, and making some major technological breakthroughs to start drilling for new, hard-to-extract crude in shale formations in North Dakota and oil sands in Alberta. This slowly led to a glut in oil production. Here are some main reasons of big drop in oil prices.

US Shale oil production
America’s oil boom is well documented. Shale oil production has grown by roughly 9 million barrels per day (mbpd), that is just 1m b/d short of Saudi Arabia’s output. Imports from OPEC have been cut in half and for the first time in 30 years, the U.S. has stopped importing crude from Nigeria. Bursting US oil production has transformed one of the world’s leading oil consumers into one of its leading producers. Innovative drilling that has unlocked oil and natural gas deposits trapped in shale rock. Their manic drilling—they have completed perhaps 20,000 new wells since 2010, more than ten times Saudi Arabia’s tally which boosted US oil production by a third after Russia & Saudi. The International Energy Agency has predicted that U.S. oil output will overtake Saudi Arabia’s by 2020.

Price war
The pace of the slide accelerated in November when the Organization of Petroleum Exporting Countries (OPEC) decided to maintain production at 30 million barrels per day on big meeting of their members in Vienna. Some members like, Venezuela and Iran, wanted the cartel (mainly Saudi Arabia) to cut back on production in order to prop up the price. These countries need high prices in order to “break even” on their budgets and pay for all the government spending they’ve racked up. But on the other hand Saudi Arabia opposed to cutting production and willing to let prices keep dropping because it don’t want to sacrifice its own market share to restore the price. Saudi Arabia has taken a lesson from what happened in the 1980s, when prices fell and the country tried to cut back on production to prop them up. The result was that prices kept declining anyway and Saudi Arabia simply lost market share.

OPEC’s refusal to cut production seemed like the boldest evidence yet that the oil price drop was really an oil price war between Saudi Arabia and the US. It is relatively cheap to pump oil out of places like Saudi Arabia and Kuwait. But it’s more expensive to extract oil from shale formations in places like Texas and North Dakota. Saudi Arabia can tolerate lower oil prices quite easily. It has over $700 billion in foreign currency reserves. Its own oil costs very little (around $5-6 per barrel) to get out of the ground. So as the price of oil keeps falling, some US producers may become unprofitable and go out of business. And the price of oil will stabilize. At least that’s what OPEC members hope.

Libya and Iraq are back
Till the mid 2014 oil prices are rising, the US Shale boom had little effect on oil prices because at the same time geopolitical conflicts were flaring up in key oil regions, There was a civil war in Libya and Syria, Russia’s annexation of the Crimea and broad advances by Sunni insurgents across northern Iraq. Turmoil in Iraq and Libya, two big oil producers with nearly 4m barrels a day combine, has not affected their output at a time when demand is low.

In July, Libyan rebels opened two key export terminals, Es Sider and Ras Lanuf, that had been shut down for a year. Libyan exports rose unexpectedly. Initially, it had been assumed that Libya’s output would hover around 150,000-250,000 thousand barrels per day but it turns out that Libya has sorted out their disruptions much quicker than anticipated, producing 810,000 barrels per day in September and expecting 1.2 million barrels a day by early this year.

European Economic Slowdown
Oil prices are falling because of changes in world supply and world demand. Demand has slowed because Europe is an economic wreck. European economies, meanwhile, are weak. Combined with the weak euro, which is near its all-time low, that means Europeans are less inclined to use energy. One of the reasons for an extension in the decline was the disappointing German output that reinforced worries that global oil demand will falter, it’s exports were down 5.8 percent in August, stoking the fears of anxious investors that the EU’s largest economy had double dipped into recession last quarter. Across the Eurozone, the IMF again lowered its growth forecast to 0.8 percent in 2014 and 1.3 percent in 2015. Austerity measures and decreased consumption across Europe are curbing oil demand.

Weak Asian Demand
The remarkable fall in global oil prices is continuing because of a mismatch in demand and supply. Demand is down because of Eurozone’s economic stagnation, Japan’s slipping into recession and China’s slowdown. Output, on the other hand, is rising on account of the U.S. shale boom. A global economic slowdown has left Asian demand weaker than expected and number of Asian countries have begun cutting energy subsidies, resulting in higher fuel costs despite a drop in global oil prices. In India between 2008-2012, diesel demand grew between 6 percent and 11 percent annually. In January 2013, the country started cutting the subsidies of diesel. Since then, diesel consumption has stablised. The US is producing record amounts of oil, and there’s plenty of supply out of OPEC and Russia. But there’s not enough demand from China and India, to consume all the oil that’s being supplied.

Impact of Oil Price Plummet: Winners & Losers
Oil prices affect almost everyone, for better or for worse. Petroleum products are a big slice of families’ budgets and a significant cost of production for a myriad of industries. It is no surprise that lower oil prices benefit consumers and hurt producers. For the users of oil, a lower price is like a tax cut. The positive effect will work its way through the economy via two channels: first, it will give consumers more disposable income, which they can spend on goods and services; second, it will reduce input costs and encourage production in sectors other than oil, especially energy-intensive sectors.

The dramatic drop in oil prices over the past few months to lowest since 2009 is leading to significant revenue shortfalls in many energy exporting nations. Meanwhile other economies that are large net importers of oil, such as China, Japan and Europe, will also get a boost to their economic growth.

The Losers:
The decline in oil prices has clear adverse effects, however, on oil-exporting emerging economies. Some of these countries, which have relied on high oil prices to balance their budgets, could face financial stress. Some examples are:

Russia
The Russian currency plunged against the dollar on the back of a decline in the price of crude oil, the country’s main revenue earner. Russia’s currency has lost some 16 percent against the dollar since the start of the year after dropping by around 41 percent in 2014. Russia is one of the world’s largest producers and its oil & gas exports accounts 70% of total export revenues. Russia’s central bank has been struggling to deal with this crisis. On December 15, the country suddenly hiked interest rates from 10.5 percent to 17 percent in an attempt to stop people from selling off rubles.

The economy is slowing sharply as Western sanctions over the Ukraine crisis deter foreign investment and spur capital flight, and as a slump in oil prices severely reduces Russia’s export revenues and pummels the ruble. The slump in oil prices has clouded Russia’s economic outlook, as the country relies heavily on revenues generated by exporting oil and gas to finance its budget. Russia loses about $2bn in revenues for every dollar fall in the oil price, and the World Bank has warned that Russia’s economy will shrink 2.9 percent in 2015 if oil prices do not recover. Russian Finance Minister Anton Siluanov said the budget faces a shortfall of up to $240 billion in revenue, most of it, about $180 billion is due to the oil-price collapse.

Venezuela
Venezuela is among the world’s largest oil exporters and is also tens of billions of dollars in debt, so their economy was struggling even before the oil prices dropped. Venezuela’s economy, which is heavily dependent on oil for 95 percent of its export revenue, has been crippled by the fall in oil prices and set to shrink some 3 percent this year and inflation is rampant.

The country already has some of the world’s cheapest petrol prices, fuel subsidies cost Caracas about $12.5bn a year, but President Maduro has ruled out subsidy cuts and higher petrol prices. The country’s needs an oil price of $118 per barrel to balance its external accounts, but oil is falling rapidly towards $40 per barrel and so far, Venezuela has failed to persuade other oil producers to reduce production in order to support the price. Venezuela’s foreign exchange outflows now substantially exceed its inflows, not least because it is supporting a complex and unhelpful exchange rate system: its US $ reserves are down to $22bn and falling fast.

Iran
Iran may be in the most trouble as it’s economy had recently started recovering after the geopolitical conflicts. IMF projected that the country will grow 2.3 percent next year, but now it is precarious situation to country after the oil price plummets. One big problem for Iran is that it also needs oil prices at $100 per barrel to balance its budget, especially since Western sanctions have made it much harder to export crude. If oil prices keep falling, the Iranian government may need to make up revenues elsewhere, it could by paring back domestic fuel subsidies. It spent 25% ($100 billion) of its GDP on consumer subsidies last year. As oil makes up about 80 %of total export earnings and 50 to 60% of government revenues, the economy could grow substantially under this scenario. With no deal, cheap oil could mean a 60% drop in fiscal revenues, down to $23.7 billion in 2015 from its peak of $120 billion in 2011/12. According to world bank report under this scenario, a loss of about 20% of GDP would be expected, bringing GDP growth down to zero (from the previous year’s 1.5%), and the economy would continue to shrink. This will put tremendous pressure on inflation, unemployment, the fiscal deficit and the currency.

Saudi Arabia
Saudi Arabia leads this pack and is now forecasting the biggest fiscal deficit in its history. The deficit for 2015 is expected to amount to $38.6 billion, announced by government. The Saudis can ride through this because they have a huge amount of foreign exchange reserves amounting to over $700 billion, which is why they remain steady in letting prices fall, mainly to ensure the production of U.S. shale oil does not increase and take some of their share of the market.

The Winners
Globally the big winner is the world economy. Tom Helblin of the IMF says that a 10% change in oil prices is associated with around 0.2% change in a global GDP. This essentially shifts the resources from the producers to consumers who are more likely to put that money back into the market.
Slumping oil prices could prove to be a boon for the many Asian economies that depend on crude imports as oil prices breaks the 5.6 years low. Falling oil prices should help lift emerging Asia’s gross-domestic-product growth this year to 4.7% from an estimated 4.3% in 2014.

China
China is the one of the largest net importers of oil, and fortunately most of its manufactured exports have not dropped in price, so its economy should benefit greatly from this plunge in oil prices. Oil prices have a big impact on the trade position of China, it has registered a record trade surplus for 2014 of $382bn, up by 47% from 2013, so nearly doubling its surplus from the previous year. Yet, trade growth has been weaker than targeted. China’s oil imports grew by nearly 10 percent last year, to nearly 2.3 billion barrels (308 million tons). As prices have fallen from around $115 a barrel in June to less than $50, importers are saving tens of billions of dollars.
Among the Asian economies, none is more dependent on oil imports than China. The country spent $234.4 billion to import oil in 2013. According to IEA December oil market report notes a sharp slowdown in Chinese oil demand growth, estimation of total Chinese demand growth is just 2.5 percent in 2014 and 2015. Despite recent falls in oil prices, Chinese government move in late November to hike consumption taxes for oil products has resulted in small price change to Chinese consumers, negating an expected economic benefit that would have come from lower prices.

Tumbling oil prices are still seen as a net benefit for the Chinese economy. Bank of America Merrill Lynch estimates China’s GDP increases by about 0.15 percent for every 10 percent drop in the oil price, with its current account balance growing by 0.2 percent of GDP and consumer inflation declining by 0.25 percentage point.
International Monetary Fund researchers have estimated that falling oil prices could boost China’s GDP by 0.4 to 0.7 percent 2015 and by 0.5 to 0.9 percent in 2016.

Japan
Japan imports almost all of its oil, Imported USD 150 bn in oil last year, so it should reap large benefits of cheaper prices. But the effects might also hurt the country’s economy. The higher energy prices have actually been pushing inflation higher and have been a part of the country’s economic growth strategy.

Japan has been suffering from a trade deficit, which stood at US $6.8bn in October, and was the highest on record last year at JPY11.5tn (US $120bn). An important driver has been the cost of oil and gas (34% of all imports), due to their shutting down all of their nuclear reactors Fukushima in 2011. Plummeting oil prices is a huge positive for them. The lower oil price will also be offset by the weaker yen, since the end of September, the yen has fallen by 8% against the dollar while crude oil prices have plunged by 60%.

The fall has became great challenge to the Bank of Japan due to the latest fall in inflation to 0.9%. The fall in the oil price will have a significant dis-inflationary impact, which is currently estimated at -0.4% on CPI.

India
India is one of the top oil importers, importing nearly 75% of its oil. Falling oil prices will will reduced India’s import bill, oil accounts for 37 per cent of its total imports. India, which is the fourth largest consumer of oil, is a big beneficiary of falling oil prices. The reduced prices will not only lower the import bill but also help save foreign exchange. As per Bank of America Merrill Lynch estimates, every $10 fall in crude could reduce the current account deficit by approximately 0.5% of GDP and the fiscal deficit by around 0.1% of GDP.

India had fuel subsidies of almost $22 billion for consumers, though much of that has gradually been cut, the cost of India’s fuel subsidies could fall by $2.5bn this year and the country is planning to deregulate fuel prices completely if oil continues its fall. The Indian government has increased the excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues.

Falling oil prices is not enough for Europe
Europe, meanwhile, is only partially benefiting from the decline in prices because the euro has been weakening, making it relatively more expensive for Europeans to purchase oil, which is priced in dollars. Falling oil prices has been welcomed by oil importing countries but European economy showed its mixed reaction on it. Lower oil prices will be welcomed by consumers who will see a rise in discretionary income, after years of a real wage squeeze this will help strengthen the economy. But the problem is that, looking at the wider economic situation it is hard to get too optimistic. The overwhelming impression is of a very weak European economy, which is struggling with a dangerous mix of austerity, deflation, weak growth and debt. Falling oil prices rather than helping increase spending is pushing down the headline inflation rate and making actual deflation a real possibility.

In the US
Most American consumers are delighted with the recent slide in the price of crude oil, which has lowered gasoline prices significantly,which have fallen to $2.47 per gallon, the lowest since 2009. Falling gas prices have an effect on consumer prices. The most recent CPI report was released on Jan.16 and consumer prices had fallen by 0.4% in Dec 2014. The core CPI, which excludes the volatile food and energy groups, rose by a mere 0.1%. The CPI rose 0.8 percent in 2014 after a 1.5 percent increase in 2013. This is the second-smallest December-December increase in the last 50 years, trailing only the 0.1 percent increase in 2008. It is considerably lower than the 2.1 percent average annual increase over the last ten years. The energy index, which rose slightly in both 2012 and 2013, declined sharply in 2014, falling 10.6 percent, the largest decline since 2008. According to Swiss investment bank UBS, US alone, boosts GDP by 0.1%, each $10-per-barrel drop in the price of oil. In US oil-producing states like Texas and North Dakota are likely to see a drop in revenues and economic activity. The falling price of oil is also putting severe pressure on Alaska’s state budget.

Crude Conspiracy: A Secret war on Russia and Iran
If we take it to other side, many believes that recent drop in the oil prices is the secret economic war on Russia and Iran by the US Saudi alliance. The US-Saudi oil price manipulation is aimed at destabilizing several strong opponents of US globalist policies. The alliance is trying to instill an economic collapse upon Moscow and Tehran, almost similar to what the US and Saudis did to the leaders of the Soviet Union in 1986. According to Article on WSJ , September meeting between US Secretary of State John Kerry and Saudi King Abdullah at his palace on the Red Sea arrived at a deal that the Saudis would support Syrian airstrikes against Islamic State (ISIS), in exchange for Washington backing the Saudis in toppling Assad.

Now, Saudi has used its oil weapon for proxy war against Iran to limit its nuclear energy expansion, and to make Russia change its position of support for the Assad Regime in Syria, Russia have provided the weapons and funding to keep Assad in power. While the US wants its Ukraine-related sanctions against Russia to have more bite. Sanctions imposed on Moscow over Ukraine and the low oil prices together will send the Russian economy into recession next year.

US Saudi alliance focusing to Squeeze them to the last drop and bankrupt them by bringing down the price of oil to levels below what is required for both Moscow and Tehran to finance their budgets with ease and control. Economy of both countries is highly reliable on revenue from oil exports, Iran need oil price to $140 to balance its budget favorable while Russia requires $100. The impact of lower prices strikes rouble badly as it already fallen over 14 percent since July against the US dollar, which puts Russian economy under more pressure as oil price quotes on US Dollar.

However, it is a conspiracy theory, use of oil weapon also hurts Saudi on its revenue in the longer term while in US, shale oil much expensive to extract surely it will hurts US producers as price are lower than the cost.

Through this article, we’ll discuss today the much debated mystery of inflation and will try to seek the possible solution.

Most of the debates revolve around the theory that there is a trade-off between growth and inflation. This theory has its roots in conventional economic ideologies.

On the other hand, now a days, there are people those are the proponent of the idea that there is no tradeoff between growth and inflation.

Let’s have a look on these thoughts one by one.

First we’ll delve into the thoughts of old school which says that there is a trade-off between growth and inflation. Here are some thoughts from the Executive Director, RBI, Mr. Deepak Mohanty:

The conventional view
India is a moderate inflation country. In the eight year period from 2000 to 2007, the world inflation averaged 3.9% per annum. Even the emerging and developing economies (EDEs) which traditionally had very high inflation showed an average annual inflation at 6.7%. India’s inflation performance was even better at 5.2 % as measured by WPI and 4.6% measured by the consumer price index (CPI-IW).

In 2008 the global financial crisis struck following which inflation rose sharply both in advanced countries and EDEs as commodity and oil prices rebounded ahead of a sharp “V” shaped recovery. Thereafter, inflation rate moderated both in advanced economies and EDEs. In India too the inflation rate rose from 4.7% in 2007-08 to 8.1% in 2008-09 and fell to 3.8% in 2009-10, however, it backed up and stayed in double digits during 2010-11 and 2011-12 before showing some moderation in 2012-13. Given India’s good track record of inflation management, the persistence of elevated inflation for over two years is apparently puzzling.

Deceleration of growth and emergence of a significant negative output gap has failed to contain inflation. It is understandable if inflation goes up in an environment of accelerating economic growth. There could be a situation when the real economy is growing above its potential growth that could trigger inflation what economists call an overheating situation.

During a boom, economic activity may for a time rise above this potential level and the output gap becomes positive. During economic slowdown, the economy drops below its potential level and the output gap is negative. Economic theory puts a lot of emphasis on understanding the relationship between output gap and inflation. A negative output gap implies a slack in the economy and hence a downward pressure on inflation. So, India’s current low growth-high inflation dynamics has been in contrast to this conventional economic theory. Real GDP growth has moderated significantly below its potential. Yet inflation did not cool off.

Reserve Bank raised its policy repo rate 13 times between March 2010 and October 2011 by a cumulative 375 basis points. The policy repo rate increased from a low of 4.75 % to 8.5 %. Still it did not help contain inflation. Interest rate is a blunt instrument. It first slows growth and then inflation. But the growth slowdown has not been commensurate with inflation control.

With the persistence of near double-digit inflation in 2010 and 2011, the medium to long-term inflation expectations in the economy have risen, underscoring the role of higher food prices in expectations formation. If inflation is expected to be persistently high, workers bargain for higher nominal wages to protect their real income. This creates a pressure on firms’ costs and they may in turn increase prices to maintain their profits.

Only in an environment of price stability, a step up in investment accompanied by productivity improvements could bolster potential growth. Even when the supply side factors dominate the inflationary pressures, given the risks of spillover into a wider inflationary process, there is need for policy response. While monetary policy action addresses the risk of unhinging of inflation expectations, attending to the structural supply constraints becomes important to ensure that these do not become a binding constraint in the long-run, making the task of inflation management more difficult. By ensuring a low and stable inflation, the Reserve Bank could best contribute to social welfare. (Excerpts from the speech delivered on January 31st 2013).

So, here is the fact that despite raising interest rates progressively RBI failed to put a check on inflation and moreover puzzled by intrigue behaviour of it being high contrary to the low growth rate. At last, Mr. Mohanty opined on the supply side constraints for it being the culprit behind current high inflation.

Now let’s have a look on the other side of the story and see the perspective of opponent of above-mentioned conventional theory, who says that there is no trade-off between growth and inflation. Here are the views of eminent economist Mr. Ajay Shah, Professor, National Institute for Public Finance and Policy:

The counter-view
All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-5% inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5%.

We also agree that there is something insidious when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Inflation messes up information processing
Essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

Impact upon relationship with banks
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, they tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

These may seem to be small things but they actually are fairly large effects.

But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:

Graph shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The proposition that there is a trade-off between inflation and unemployment was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

There is no tradeoff between inflation and growth. High inflation damages growth and one element of India’s growth crisis is India’s inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4-5% range.

So that we have seen both the perspectives, it is pretty much clear that high inflation is not a freebie rapped up only in the name of high growth rate. On the same note, the reason identified by Mr. Mohanty held its ground that supply side constraints are the key responsible factor behind this bout of high inflation.

And now, on the solution front, we can’t expect RBI to perform the duties of the Govt. and involve in the state affairs of distribution and supply of the resources. Government, rather than forcing and looking towards RBI to ease interest rates, should do their work sincerely.

All of us are aware of the wastage of the resources; be it rotten grains in the custody of FCI, unused frequency of bandwidth lying with BSNL and MTNL or for that matter line-loss percentage in power transmission. If they can only use these scarce resources effectively and devise a plan and implement the same to bring down the wastage gradually, our Finance Minister, Union of India, would need not to trade the path of growth alone, on the contrary RBI and entire nation would accompany him.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both, serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change and to maintain high ethical standards.

It now seems that those hopes were premature. The revolution in the stock market used to be one of the best success stories of economic reforms in India. It might have fallen apart in recent month and years. The more likely scenario could be one where India-linked finance will happen offshore, while our regulators and government squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance is suffering from one setback after another.

Business as usual, in India, is taking us to a destination where RBI, SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance is taking place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Money always follows the path of least resistance; therefore orders that used to come to India are easily being switched to other venues. An array of other venues has now come up:

• Nifty futures trade in Singapore on the SGX and in USA on the CME.
• An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market’).
• Derivatives on the rupee trade overseas on the exchange traded market and OTC market (linear contracts are termed `the NDF market’).
• Trading in individual stocks is taking place on the ADR and the GDR market.

Mistakes of domestic policy are giving a substantial shift in India-related finance to overseas locations. The two most important pillars of the Indian financial system are trading in the rupee and in the Nifty, and with both these, India is rapidly losing ground. If present policy mistakes continue, the role of the onshore market will continue to decline, for both the rupee and Nifty.

The plight of the Nifty

Let’s focus on Nifty – the most important financial product in India. The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy whereas the overseas markets offering India-linked financial products are already developed financial centres and face no such problems. In the baseline scenario, Indian policy-making will meander on clueless and unconcerned and NSE will continue to lose ground.

Things are neither that much simple nor only stop here. First, NRIs pioneered sending order flow to overseas venues, and made them liquid. Next are Indian MNCs, who run global treasuries, who easily patronize the overseas venues. And then there are HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul.

With these kinds of possibilities, Singapore’s appeal goes beyond just the type of markets it offers. For one, India demands new investors deal with a thicket of documentation. While opening a foreign institutional investment account in most countries takes a few days, in India it is up to six weeks. So the start itself is a hurdle.

And then, there is taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and is apprehensive about tomorrow (if GAAR is used to abrogate the Mauritius treaty).

The bigger hurdle is India’s more severe taxation. Singapore does not tax capital gains and its tax on interest income allows for certain exemptions, such as foreign-sourced dividends. Whereas, India has a 15% short-term capital gains tax on listed securities. Most domestic debt instruments carry a 20% tax on income earned, which according to many market experts is the “biggest showstopper”.

The obvious choice

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE’s. It is astonishing to see that for the biggest Indian product – Nifty – an overseas exchange has got superior open interest.

Things changed when SEBI banned Participatory Notes (P-notes) in October 2007. SGX’s share in the total open interest (outstanding positions) in the Nifty futures product rose to around 50% from as low as 6% before the ban. A year later, the market regulator lifted the P-note ban, which led to a fall in SGX’s share to around 25%. But since then, SGX’s share has been rising steadily again. SGX now enjoys a 68% share in the total open interest on Nifty futures contracts.

And the recent blunder that added to the misery is the GAAR fiasco that resulted in exodus of foreign investors’ from the Indian regulatory boundaries. And while the government has softened its stand on GAAR considerably, foreign investors now seem increasingly concerned about the uncertainties of Indian policymaking.

The predicament of Rupee

The Indian rupee has grown rapidly to becoming the 16^th most traded currency in the world. From less than 0.2% of the world forex turnover in 1998, it has grown rapidly to constitute about 0.9% of the world forex turnover in April 2010. It is one of the biggest emerging market currencies with the Korean Won, Russian Ruble, Chinese Renminbi and the Mexican Peso being its close competitors.

Trading in the rupee is composed of the following elements of the market:

The rupee-dollar is the most important price of the Indian economy. The overall market for the rupee is roughly $70 billion a day out of which roughly one-third is spot, and the rest is derivatives. The offshore market today is as big as the onshore market, as roughly half of rupee trading takes place in India.

In its 2010 triennial central bank survey on foreign exchange and derivatives market activity, Bank for International Settlements (BIS) also pointed out that about half of the dollar-rupee market was overseas.

Though the RBI has done away with many capital controls, access to the currency market onshore still has some restrictions giving rise to offshore currency trading. Having said that, it must also be noted that most emerging market currencies are traded heavily in prominent currency trading centres such as Singapore, Hong Kong, the UK and the US. This is an inherent feature of currency trading. Of course, countries which have capital controls tend to push a larger proportion of trading offshore.

The development in the Rupee market

InterContinental Exchange Inc. and CME Group Inc., among the world’s largest futures exchanges, have launched rupee-dollar futures contracts in the month of Jan 2013. This clearly shows the growing importance of the rupee in the global currency market.

Needless to say, large electronic exchanges will do their best to both capture market share and increase the size of the market. And given their advantage over domestic competitors of access to foreign market participants, as well as freedom with product design, the share of offshore trading could continue to rise.

Rupee trading on other markets does not necessarily mean that trading in local markets is shrinking. Though it may be the case that the cake is enlarging, but our slice isn’t.

As India internationalizes, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad considering the problems in the local financial system. NRIs do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to US (on ICE & CME), Dubai (on DGCX) or London.

The obvious implication

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. And as global interest in Indian derivatives surges, it is Singapore, not Mumbai that is reaping the benefits.

The swing shows how deeply a tax gaffe last year damaged foreign investor sentiment and the cost to an economy that has seen growth tumble to around 5.5% following the sharpest slowdown in a decade. India is now paying the price for poorly written rules last year aimed at ensnaring tax evaders, ironically including those routing investments through Singapore, which instead sparked outcry among foreign investors and an outflow of funds.

What worries India is that Singapore markets are now attracting flows in other derivatives, creating not only a missed opportunity for India, but also the risk of a parallel overseas market offering arbitrage opportunities that distort domestic prices.

Last but not the least, prospects of Bombay, emerging as an international financial centre will subside. If we can’t even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren’t India-linked?

Some steps in the right direction

Since all taxes are distortionary and a basic principle of public finance is that we should have a low rate that is spread across a large tax base; our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013-14 makes progress on two fronts (reducing STT from 1.7 to 1 basis point, and reducing distortions between equities and non-agricultural commodities).

One more announcement from the budget was in best of the spirits: FIIs are allowed to trade in currency futures. This will also give more liquidity and depth to currency futures and there are two reasons for expecting this, taxation of commodity futures and the entry of FII orders flow.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.