The Indian bailout

Prime minister Manmohan Singh’s diagnosis of, and remedy for, the economic slowdown isn’t too off-the-mark. “I think we are in a typical Keynesian situation where there is a lack of demand—private sector demand is very weak—but, strong government demand, both for social services and for physical infrastructure, will provide the essential stabilisers that our country needs at a time like this,” he had declared on October 25. Yet, the antidote has few buyers.

It’s easy to see why. Even as Singh spoke, Finance Minister P. Chidambaram was preparing to beseech Parliament for funds over and above budgetary allocations to pay salaries and bills. He wanted—and got—additional sums that add up to a third of the total Budget he had piloted through Parliament only in May this year. Government spending has overshot Chidambaram’s estimates mainly on subsidies and rural wage programmes (see Budget Busters). Such largesse to the aam aadmi has dominated the UPA government’s spending agenda since it took office in May 2004. So far this year, the Centre has pumped in more than Rs 1,340,000 crore into rural development (about half of resident Indians’ bank deposits), inflating its fiscal deficit by 26 per cent over its last year’s level. “It can be taken for granted that the fiscal deficit this year will miss the target,” says Suresh Tendulkar, Chairman of the Economic Advisory Council to the Prime Minister.

The global economic crisis is the Government’s excuse for overshooting the deficit target. “So what if our deficit settles at 3.2 per cent instead of 3 per cent? If the target is breached by a few decimal points, so be it, because there is a global financial crisis and we are suffering the ripple effects of this crisis,” Chidambaram told the Rajya Sabha on October 29. He employed this year’s Nobel winner for economics, Paul Krugman’s tip, “this is no time to talk about the deficit”, in the Government’s defence, following a scathing attack from former Finance Minister Yashwant Sinha on the demand for supplementary funds.

The Finance Minister’s defence will be credible if he can turn the deficit into an antidote for the current economic downturn. Investment, the key driver of economic growth, is slowing down after an average rate of growth of 18 per cent in the past five years due to which the Reserve Bank of India (RBI) has forecast GDP growth at 7.5-8 per cent this year. The volatile cost and non-availability of credit is further slowing down projects. In such a scenario, public expenditure—the one that boosts productive spending—will pump prime the economy.

Injecting money Six major heads of government spending and their likely impact. Rs 25,000 crore on Farm Loans Waiver Has offset the dampening effect on rural consumption by cushioning agricultural incomes with waivers amounting to Rs 72,000 crore Rs 38,863 crore on Fertiliser Subsidies Has protected farm incomes; the huge fuel subsidies, which the government doesn’t pay in cash, are protecting urban, rural and middle class incomes and consumption Rs 1,274,474 crore on the NREGS Has boosted rural incomes and consumption and is creating demand for construction materials. Total funds available with states as on October 31 were: Rs 1,976,9890 crore; of which states have spent 65% or Rs 1,274,473 crore Including: 70% on wages: Rs 898,216 crore for 7.8 million households or 12.5 million people 4% on semi-skilled and skilled wages: Rs 45,359 crore 23% on materials: Rs 287,615 crore 3% on administration: Rs 43,283 crore Rs 29,579 crore on Rural Development Has boosted village incomes and fuelled demand for construction materials Rs 3,862 crore on Road Infrastructure Is generating demand for construction materials

Government spending can help or hurt private investment. The best kind of government spending is one that aids both asset creation and income generation. Such spending, even if financed by higher than targeted deficit, encourages (crowds in) private investment. However, a deficit, especially that does not lead to asset creation, can also hamper (crowd out) private investment and therefore stoke inflation. Only government expenditures designed to boost productive investments to offset the slowdown will pump prime the economy and exonerate finance ministers around the globe for rising fiscal deficits.

It’s not that there are no large dollops of public expenditure taking place. The Rs 1,275,000-crore National Rural Employment Guarantee Scheme (NREGS), the Rs 25,000 crore on the farm loan waiver scheme and the Rs 25,000-crore largesse announced by the Sixth Pay Commission (SPC) for central government employees will all put significant sums of money into rural and urban consumer wallets. But all these spending programmes were well underway before the global financial crisis hit hard. “The spending, ranging from the farm loan waiver to the SPC, and its growth effects were factored in by the government in February, when it presented the Budget… just that the government had not included any of it in its accounting at that time and they were all referred to as ‘below the line’,” says Rohini Malkani, Economist, Citigroup India.

Much of the pump priming impact of these programmes has already been absorbed by the economy. And given the rising deficit, the government has little additional money to fund a “New Deal”-kind of project. Of course, government can simply borrow more to fund new programmes, but given the shortage of funds in the financial system, a stepped-up government borrowing will dry up funds (or raise the cost) for private sector—a situation government is trying to avert. It’s not that government spending hasn’t helped create demand. The question is whether the demand creation is adequate and more importantly, if the demand and asset creation is proportional to the money spent on these programmes. The sporadic effects of government-led demand creation are evident.

Hyundai, which usually sells 1,000 cars in a month to government employees, sold 3,000 cars to this segment in October. The Centre and state governments are disbursing 40 per cent of the Sixth Pay Commission Award arrears this year, which is beginning to boost white goods and automobile demand— mostly urban consumption. “The SPC should have a larger impact on consumption as most beneficiaries are middle class people,” says Dushyant Singh, Director, Strategic and Commercial Intelligence, KMPG. The effect of this expected increase in consumption will show up in the third quarter of 2008-09. And, even this too, will be counteracted by the demand-dampening impact of the across-the-board wealth erosion, increasing job insecurity and expectation of slower income growth.

Besides, the consuming classes can only marginally offset the effects of an economic slowdown. The poor, the largest chunk of the target group for government programmes, spend mostly on food, though they account for the largest number of votes. "Even if the entire Government spend on the flagship poverty alleviation programme, the NREGS, were to be directed into household consumption, it would account for less than 1 per cent of annual rural consumption of goods and services," says Singh. "It would go largely into higher consumption of food, and investment expenditure on building materials." The bulk of the UPA's social spending is via the NREGS, which has derailed the fiscal deficit over unexpectedly high demand for jobs even during the agricultural season. This points to the rampant leakages and mismanagement. While the government's social spree has protected farm incomes, preventing the bloody food riots of the sort seen in several African and Asian countries earlier this year, including Thailand and Egypt, it is also fueling some village consumption.

These spends cannot pump prime the economy. Increased spending by the government can stimulate a slowing economy only if the money spent generates incremental demand for goods and services. "The old Keynesian theory of getting people to dig the earth and fill it up again is not sustainable," says Arvind Virmani, Chief Economic Advisor in the Ministry of Finance. "The more the fiscal deficit encourages private investment, or economic growth, the more sustainable it is," he adds (see Interview with Arvind Virmani). Despite the Prime Minister's advocacy of public investment on infrastructure, the Government has spent Rs 3,862 crore on road construction this year from the Rs 7,180 crore it has collected as cess from diesel and petrol. "Unfortunately, the government has frittered away the tax bonanza of the past few years on populist expenditure instead of using it for the removal of critical infrastructure and governance bottlenecks," says Ashima Goyal, Professor of Economics in the Indira Gandhi Institute for Development Research.

To be sure the NREGA's expenditure of Rs 2,87,615 crore during April-September 2008 (equivalent to the annual market of the construction industry in India) on construction materials is an exception that is propping up some industries. "The total demand for steel and cement from all sources is growing at a faster rate than that is coming from the private sector with the additional demand coming from the government schemes," says Amir Ullah Khan, Director, India Development Foundation, a Delhi-based economic research foundation.

The question then, is, not over funding the pump priming of the economy, which is unconstrained, assures Virmani, but the efficacy of the government machinery. "The worry is the government's record in implementing projects," says Tendulkar. The bloated fiscal deficit so stoutly defended by Chidambaram is, therefore, unlikely to kick start the economy by itself.

Aware that the nature of his expenditure programme.no matter the size.won't suffice to revive the economy, the Finance Minister is resorting to other means. Chidambaram's first rescue package for airline companies comprised tax cuts. Then, he has goaded public sector banks to lower interest rates and increase lending to home buyers. Next, he is expected to trim duties for the jobs-and-export oriented textiles industry. These measures, though beneficial, given the situation, do not amount to pump priming.

What is needed is a comprehensive booster dose of steroids to resuscitate the economy; what is being offered are incremental shots of pain killers that address only those symptoms that become unbearable. Even as these medicines are being prescribed and purchased, little attempt is being made to ensure that they reach the right patient in the right dose. Doctor Singh's diagnosis is not off the mark, but the delivery is.

The vulnerability meter
A differentiated rather than a uniform approach to fiscal stimulus will work to mitigate the impact of the slowdown.

The Urban rich will cut down consumption of discretionary products and services due to lower incomes and dampened sentiments.
Fiscal push: From the Sixth Pay Commission Award and fuel subsidies. Financial bailouts for them will be politically and prudentially unsustainable.

The Urban Poor’s incomes will shrink on lower spending by the urban rich; will reduce food consumption since travel and other expenses tend to be inflexible.
Fiscal push: Is most needed for this group, which has no access to NREGS wages or farm loan waivers.

Rural Indians in the middle and rich income states could see declines in incomes depending on the Rabi crop.
Fiscal push: Incomes are cushioned by the NREGS, farm loan waiver and fertiliser subsidies and central spending.

Rural Indians in the five poorest states (40% of the population) could see their incomes fall depending on the Rabi crop; will cut down on food consumption.
Fiscal push: Limited benefit from the NREGS or farm loan waivers owing to states’ inability to implement the schemes efficiently.

Interview with Arvind Virmani
“The more the fiscal deficit encourages private investment,the more sustainable it is.”

Chief Economic Advisor in the Ministry of Finance Arvind Virmani spoke to Business Today’s Puja Mehra about India’s fiscal policy under the shadow of a global financial crisis and an economic slowdown at home. Excerpts:

Arvind Virmani

On the fiscal stimulus:
The intensifying global recession is slowing industrial growth (the growth in the index of industrial production is down to 1.3 per cent in August 2008) in the economy. Compared to six months ago, growth concerns are more important than inflation worries. In such a situation, fiscal stimulus, once an area of concern, is now correctly being cast the world over as a beneficial policy corrective.

On the fiscal deficit:
Oil price decline since August 2008 will lead to wide benefits from the October-December quarter onwards— improving the balance of trade, the current account deficit, inflation and the fiscal deficit— which will become visible when the data for these quarters is released. The fiscal deficit for the full year will be better than was thought six months ago, and drop lower in the second half of 2009 than in the first. No doubt, the full year’s fiscal deficit will be higher than last year’s, but this is not a problem. A higher fiscal deficit will offset the drop in investments resulting from the global recession. In the last five years, 60 per cent of GDP growth—at the rate of 8.9 per cent per annum—came from investments, which rose at an 18 per cent yearly rate. There is no need to worry if the rate of investment growth halves but a larger slowdown will be disturbing.

On sustainability of the fiscal deficit:
The old Keynesian theory of getting people to dig the earth and refill it is not sustainable. The more the fiscal deficit encourages private investment, or growth, the more sustainable it is. Infrastructure investment must be accelerated to the extent that it is physically feasible. Policy measures and reforms must also support private investment. Since we are becoming a middle income country, we need to reduce fiscal deficit in the long term. I recommend freeing up petrol and diesel prices over the next 12 months to prepare for an inevitable rise in oil prices once global growth recovers.

On the impact of higher government borrowings on private investments:
Twelve months ago, we were worried about excess demand. Now demand is likely to become too low. Borrowing to finance the fiscal deficit will not crowd out private borrowing because there isn’t enough demand, which is why a fiscal stimulus is needed.

On quality of fiscal stimulus:
It is useful to focus on the quality of expenditure. The objective should be to make expenditure accountable, transparent and empowering, whatever it be. When I worked at the Planning Commission, we had written a report on the multi-application smart card system based on a unique ID number for each resident. The smart card can empower the poor receiver of government programs, by making part of the service provider’s funding dependent on it. The smart card can become the poor man’s cash on the basis of which (s)he can demand proper service. If a smart card has been swiped, it would mean the service has actually been provided, and the government school or hospital can claim/get funds. The system would also generate information on what programs each person is actually getting the benefit of, and which people any given program is benefiting. The proposal is in the system. It was hoped to start implementation in June 2008 and finish disbursing ID numbers and smart cards countrywide by December.

On fiscal policy possibilities: The Prime Minister and the Planning Commission’s Deputy Chairman (Montek Singh Ahluwalia) have discussed infrastructure development, which must be accelerated by the Centre and the state government. Policy handicaps must be removed. During previous big shocks, governments of high-growth economies—like those in Asia— accelerated reforms and returned to a high growth path.