Heed the warning
Prem Shankar Jha
Dawn
2/16/2002
 http://www.frontierpost.com.pk/articles.asp?id=7&date1=2/16/2002

Moody’s has warned the world to stay away from India because it was headed into a debt trap.

A similar warning, couched in far more professional language had been delivered to the Vajpayee government by India’s central bank, the Reserve Bank of India.

In its currency and finance report for 2000-2001 it shed bureaucratic restraint and exposed the utter hollowness of the excuses the government has been putting up for its inaction.

First on the growth rate: Finance Minister Yashwant Sinha’s favourite justification for inaction used to be that India was among the fastest growing economies in the world.

The RBI report quashed this conceit by drawing pointed attention to the steep decline in GDP growth over the past three years (1998-99 to 2000-2001).

But it was written before the Central Statistical Office drastically revised its estimate for 2000-2001 downwards from 5.2 per cent to 4 per cent.

This revision occurred because the earlier figure had assumed that the growth in non-banking finance, i.e. mutual funds and so on, had paralleled the growth of bank deposits, when in fact it had collapsed.

The correction exposed the unreliability of GDP estimates for the service sector as a whole.

Yet that is where all of the growth of the last five years has taken place.

The truth is that in these years India has been among the slowest growing economies in the world.

Second, Sinha has confidently predicted an automatic revival in the second half of the year in every year of his ministership, including 2001-2002.

The implied assumption is that the slowdown is only cyclical and is awaiting a boost in consumer demand to turn the corner.

Based on this assumption he first adopted a do nothing policy, then tied unsuccessfully to make the ministries speed up infrastructural spending, and finally announced that since the economy was experiencing recessionary trends, there was no point in cutting the fiscal deficit.

The government would instead spend its way out of recession.

This is the hypothesis that has brought down the RBI’s severest censure.

With painstaking thoroughness the report has proved that the slowdown is not part of the downward phase of a trade cycle, but is structural.

In short its causes lie buried in deep structural imbalances that have been allowed to develop in the economy.

The most important by far, among these is the imbalance between expenditure and saving, and within expenditure, between consumption and investment.

To put it simply the government is spending more than it is earning, by an increasing amount every year.

That is the rising fiscal deficit.

Of its spending less and less, in proportionate terms is going into investment and more and more into consumption.

The lack of investment has brought the growth of the producer goods industries to a halt, forced them to shave profit margins till there is nothing less to shave, and pushed more and more of them into the red.

This underlies the slump in the share prices of the ‘old economy’.

The government’s need to borrow to cover its rising fiscal deficit has crowded private borrowing out by raising interest rates.

High interest rates have combined with low share prices to raise the cost of new investment by the private sector to prohibitive levels.

As a result, there is next to no new investment, other than for maintenance, taking place in the economy.

The lack of new investment is behind the slump in consumer demand.

This has brought down the inflation rate (as was predicted in this column several months earlier) to below 1.5 per cent.

Low inflation has pushed up the real rate of interest on new borrowing to the astronomical level of ten to twelve per cent.

At that level even existing producers do not want to buy and stock more than they absolutely need.

So demand has flattened out even further.

The self-reinforcing nature of the above chain of causation is obvious.

The RBI has therefore warned the government that the current slowdown will only worsen if nothing is done to correct the basic two imbalances described above.

Understandably therefore, it has been deservedly harsh with various economists who have, from time to time, put forward quick fix solutions.

Not deigning to notice the votaries of the new economy, who want the old economy to be consigned to history’s wastebasket, it has first examined the proposal to lower the interest rate still further.

And concluded that there are limits to which a developing country can do this, and those limits have been reached.

In India and other similar economies most people hold their savings in postal savings and provident funds that yield interest and not in mutual funds that play the stock market.

To lower the real rate of interest it is the rate of inflation that needs to be raised.

That happens automatically when there is a healthy rate of investment in the economy.

For investment increases purchasing power without immediately increasing the supply of consumer goods.

But the RBI has also advised against pump priming even when it is used to finance public sector investment in infrastructure projects.

For an increase in public investment without a simultaneous cut in public consumption will further crowd out private investment.

That will only rob Peter to pay Paul.

The only course open to revive the economy is to increase public sector infrastructure investment by cutting consumption.

This means cutting subsidies and administrative waste.

Every rupee transferred from a peon to a power station will improve the chances of the Indians yet to be born.

There is no sign as yet that the Vajpayee government intends to do anything of the sort.

Today, as the failure of interest rate cuts in the last two years has shown, this will not be sufficient to revive investment and self-sustaining growth.

Only the third option can increase investment and revive the core sector of industry without triggering inflation and an outflow of foreign exchange.

Proposals on how this can be done have been presented more than once in these columns.

In brief they amount to pressing ahead with the fiscal reforms that the Finance Minister Yashwant Sinha had outlined in his budget speech this February, with a few modifications designed to make them more politically acceptable.

Chief among these is the replacement of physical food procurement and distribution with a system of food stamps over a period of three years.

A second, already mooted by the finance and petroleum ministers, is the decontrol of oil product prices.

The first will shave almost $ 4 billion from the consolidated fiscal deficit while the second will reduce it by another $ 6 billion at crude oil prices ranging from $ 28 to $ 30 a barrel.

A third is to bring down the subsidy on domestic fertilisers to the same level as that on imported ones - a measure that could save the government $ 1.5 billion.

Together these measures could reduce the fiscal deficit by three per cent of the GDP, more than enough to finance all the infrastructure projects that remain incomplete for want of funds, to maintain existing assets, step up power generation and modernise transport.

The next few weeks will show whether Vajpayee meant what he said in his broadcast to the nation after the attack on America.

 http://www.frontierpost.com.pk/articles.asp?id=7&date1=2/16/2002