Balance of risks

Healthy industrial growth and a resurgent corporate sector are signs of a strong fiscal climate

What a difference a year makes! As 2002 wound down, the Indian economy was reeling from the failure of the monsoons, a sluggish industrial sector and the uncertainty of escalating conflict in Iraq.

Fifty two weeks later, those factors seem like a distant dream. Everything has changed, mostly, it appears, for the better. The industrial recovery that actually began in July 2002 has consolidated itself and the corporate sector, particularly the old economy, which had faded into the background during the IT boom, has seen an unbelievable resurgence in profitability and valuations.

All of this is happening in a domestic macroeconomic environment of extreme comfort. More so, the global economy, which performed indifferently for the last year or two, is also showing signs of recovery.

The obvious question is: if things turned around so dramatically during the course of just a year, can the same thing happen again? At the end of 2004, will we be back to the gloom and depression of 2002? Or are we now just beginning an upward climb that will last well into the future?

What is going to significantly ratchet up the industrial growth rate from its currently steady, but unspectacular level, is a broad-based revival in investment spending of the magnitude that we last saw in the mid-1990s.

Already, the media is full of reports that this is likely to happen in the coming year. Having lived through a virtual investment drought for some years now, what has changed? One way to look at the motivations, and therefore the likelihood of investment is to look at the totality of risks confronting the investor. The more favourable the picture on a larger number of risk factors, the greater the likelihood of people making significant new investments.

Over the last year, there have been critical changes in the risk characteristics of the macroeconomic environment. These relate both to the behaviour of specific variables and to the flexibility that this gives to the government in managing macroeconomic stability. From the monetary perspective, this is seen in the unprecedented combination of low inflation (by our standards) and low interest rates.

The reasons for this outcome are complex. Many factors "" productivity improvements in both the real and financial sectors, changes in the demand patterns for funds, changes in the nature of inflationary expectations (the forex and food reserves play a role here) and so on have all contributed to the way in which the economy has achieved this new equilibrium.

However, the precipitating factor was the significant reduction in administered interest rates over a two-year period. What this has done for monetary management is to give it the room to manage liquidity without worrying too much about inflationary consequences. In other words, interest rates can remain relatively low for long periods of time.

But, there has also been a significant change in the fiscal scenario as well. A direct consequence of lower interest rates is some easing of pressure on committed payments by government. But, perhaps more importantly, starting last year, a trend that had begun in the early 1990s was reversed.

The share of capital spending by government started to increase. The roads programme was primarily responsible for this, but the important thing here is the mode by which it is being financed. Locking in the fuel cess to finance road development has ensured that the resources for the programme are not vulnerable to annual budgetary compulsions.

Of course, there is nothing legally binding about this commitment, but with such obvious benefits flowing from it, a government would have to be really desperate to dismantle the arrangement. Having a predictable flow of resources into this activity will make a lot of producers of goods and services feel a lot more comfortable about the prospects for their businesses.

The expenditure pattern is only one aspect of the changing macroeconomic risk profile on the fiscal front. A point I have made often in this column relates to the high dependence of revenue collection on industrial performance.

As long as industrial growth is healthy, revenue collection will also be so. Increasing corporate profitability, to which lower interest payments also contribute, mean more corporate taxes. All of this means less uncertainty about the fate of the fiscal deficit and more room for the government to put resources where they matter.

I am not for a moment downplaying the problems of inefficiency and misallocation of government resources. Structural reforms are absolutely necessary. But, given an increase in revenue buoyancy and an easing of pressure on the expenditure front, the ability to carry out these reforms without worrying too much about destabilising the fiscal situation also increases.

But, as conducive to new investment as the prevailing macroeconomic environment is, it is clearly not the only source of risk. Microeconomic factors also contribute to risk. Can these neutralise the macroeconomic advantage that India currently has and dilute the likelihood of an investment resurgence?

The main source of microeconomic risk is the degree of control that a player in a competitive marketplace has over his costs. When we compare the costs of major inputs now with the situation prevailing during the last investment boom, there clearly have been many favourable movements.

Interest costs have probably seen the most dramatic change, but many service inputs as well as a greater degree of assimilation of IT have also contributed to a significant change in the typical cost structure.

Tariffs have come down since the mid 1990s, but the rupee has depreciated since then; the net impact on the competitiveness of imports probably varies across sectors. Of course, cheaper imports may reduce costs, but they also make the marketplace that much more competitive.

The two most significant components of cost that have not seen a comparable increase in controlability are labour and electricity. There is no progress on reforms that might favourably affect the labour cost scenario as yet.

There is progress on the electricity front, but its benefits are still some way off. In terms of the argument being advanced here, both of these factors will work to deter, or at least delay investment until their control is within grasp.

Is the balance of risks favourable or not? Does the reduction of risks on the macroeconomic as well as some microeconomic dimensions outweigh the obduracy of risks on other fronts? As things stand today, "yes" is the clearly more appropriate answer.

(The writer is chief economist, Crisil. The views expressed are personal)