India's
damaging fiscal deficit
By Kunal Kumar Kundu
MUMBAI - Is the Indian economy capable of recording a sustainable double-digit
growth rate, as China has managed to do? Yes. Has India been able to record
such growth rates? Rarely.
If one were to list the factors that have hindered and prevented India from
reaching a higher growth plane, the growing fiscal deficit would appear at the
top. Theoretically, deficits are not necessarily bad, especially for a
developing economy, if its resources are employed in a productive manner.
However, if unchecked, they have the ability to ruin a nation's finances, thus
having the ultimate impact on its citizens.
Deficits are but one a feature of a developing economy given to the compulsions
of investing for future growth, especially in a situation of a savings
investment mismatch. However, in the case of India the composition of the
deficit is a major source of worry, as there is a clear lack of productive
focus.
To put things in perspective, the total fiscal deficit of India (ie combined
deficits of the central and state governments) is estimated to be more than 10%
for the financial year 2003-04. This is virtually at the same level it was in
1991, when India plunged into a crisis. Clearly the fiscal situation is getting
out of hand as the fiscal deficit gobbles up a tenth of India's gross domestic
product (GDP) and the structure of expenditure is increasingly skewed in favor
of the unproductive: administrative expenses, poorly designed subsidies and the
likes.
The revised estimate for the last financial year shows that total revenue
receipts of the central government totaled Rs2.63 trillion (US$56.5 billion).
On the other hand, the amount of central government debt that has fallen due to
repayment during 2003-04 and the total interest payment to be made stood at
Rs3.91 trillion. This is a clear case of an internal debt trap, as the Indian
central government is forced to borrow just to repay past loans rather
than using the same productively. The situation in the previous year was
similar.
Another gloomy picture emerges if one looks at the trend of revenue deficit
(the difference between revenue income and revenue expenditure) in India. For a
capital scarce country like India, it is criminal if the government fails to
manage its own expenses. But this is exactly what has been happening, resulting
in a continuously increasing revenue deficit. So much so that since the turn of
the century, revenue deficit as a percentage of fiscal deficit has been
increasing and touched an all-time high of 75.59% during 2003-04. What this
means is that the government spends more than three-quarters of its borrowing
just to meet housekeeping expenses, leaving very little for capital (read:
productive) expenses.
High fiscal deficits typically cause three problems: a balance of payments
crisis, high interest rates (because of private investment being crowded out)
and high inflation (with currency depreciation being a key contributor). India
suffered from all three of these problems in 1991. The question, however, is
how is India surviving such high levels of deficit at this time when fiscal
deficits of even 5% of the GDP have bankrupted countries, like Argentina?
The main reason is the flood of invisibles in the 1990s. That makes India
really different. The export of services, mainly software, has led to a deluge
of foreign exchange flowing into the country. Added to that is remittances from
non-resident Indians (NRIs). With a total recorded remittance of $10 billion,
NRIs are number one in the world in this category. As a result, India now has a
current account surplus situation. The influx has more than offset the impact
of a high fiscal deficit.
Next, consider the impact of the fiscal deficit on interest rates. A high
deficit should crowd out private investment and so raise interest rates. This
is exactly what happened in the investment boom of the mid-1990s, when
corporate bond rates soared to over 20%. This was unsustainable, led to
uncompetitive production, and was followed by an investment bust that cooled
interest rates. These were then pushed down even further by the flood of
invisibles. The flood greatly increased money supply, despite the Reserve Bank
of India's sterilization efforts. The foreign exchange reserves now exceed 100%
of currency. The inflow of invisibles has been augmented by foreign direct
investment (FDI) and foreign institutional investor investment. The net effect
is a much lower interest rate. In fact, it can be said that globalization has
forced down Indian interest rates via invisibles.
What has also helped India's cause is the conscious effort by the government to
reduce short-term foreign borrowings. One of the perpetrators of India's crisis
in 1991 was a high concentration of short-term external debt in the total
external debt basket. Since then the government has been constantly working at
reducing the extent of such short-term debt. So much so that now the short-term
external debt to total external debt is around 5%. India has also resorted to
pre-paying high-cost external debts.
Typically, high fiscal deficits drive down the real effective exchange rate.
Currency depreciation plus high interest rates typically cause high inflation.
But in India invisibles have kept the rupee steady, combined with steady import
prices, resulting in low inflation. As India opens up, domestic inflation is
increasingly determined by global inflation. Many people think the rupee was
weak in the late 1990s because it depreciated against the dollar. In fact,
other currencies depreciated even more, and India's real effective exchange
rate was pretty steady. Ever since the Asian financial crisis, global inflation
has been modest. So too has Indian inflation.
Nevertheless, there is no gainsaying the fact that the high level of fiscal
deficit is funneling precious resources (invisibles) to finance the fiscal
deficit instead of accelerating GDP growth.
Year after year, various economic surveys (released by the government of India
before the presentation of the annual budget), including the latest one, hold
forth about the challenge of fiscal consolidation and how it is crowding out
resources that the state may have otherwise used for infrastructural
investments.
Unless the fiscal situation is reined in, there is no way that the government
can internally fund capital expenditures to underpin the 7-8% growth objective
over the next five years, let alone double-digit growth rates.
Sustaining the growth momentum is all the more imperative as the employment
situation in the country has become much worse than eight years ago. About 41
million job seekers have registered with the 945-odd employment exchanges in
the country as on December 31, 2003. Unless there is growth of 7-8%, how can
the millions of job seekers from the countryside be absorbed in gainful work in
the towns and cities?
To quote Raghuram Rajan, chief economist of the International Monetary Fund,
"The beauty of India's fiscal deficit is that somehow, the consequences of the
lack of fiscal prudence are not showing up. But, that said, we would be making
the mistake not to deal with the fiscal issue on a priority basis."
Indeed there has been a marked slowdown of private investment in India. As the
available data show, real GFCF (gross fixed capital formation) for the industry
increased by a mere 3.1% since 1991, and has actually started declining since
1995-96. As a result there was no competition from the private sector for the
available resources, which allowed the government to raise finance without
raising interest rates. If India sees a surge in private investment, there will
be more competition for funds for the government. And if the government fails
to lower this deficit, the Indian economy will have to bear the consequences of
very high interest rates.
Kunal Kumar Kundu is a senior economist with a leading bilateral Chamber
of Commerce in India. He has a masters in economics with specialization in
econometrics from the University of Calcutta.
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