Crowding out

Textbook macroeconomics defines "crowding out" as a situation in which high fiscal deficits, financed by borrowing, raise interest rates, which, in turn, deter private investment. In these days of booming retail finance, higher interest rates will hurt consumption spending as well, increasing the negative impact of fiscal profligacy. However, in the Indian context, even as the fiscal deficit was touching its peak levels in the early part of this decade, there didn't seem to be much evidence of crowding out. In fact, interest rates were steadily falling even as deficits remained high. A major reason for this paradox, as it turned out, was the cumulative impact of financial sector reforms. The sheer force of competition among an increasing number of entrants into the sector was a major contributor. Coupled with more liberal entry, the government progressively removed controls over various interest rates. The combined effect of these moves more than offset the impact of the deficit.

In recent months, however, the spectre of crowding out has raised its head again. After having bottomed out a couple of years ago, fuelling both a consumption and investment boom, interest rates have been steadily rising, aided by the Reserve Bank of India's generally anti-inflationary policy stance during the period. Yields on 10-year government securities, having fallen below 5 per cent at the bottom of the cycle, are now well over 8 per cent. Most forecasters, including the Prime Minister's Economic Advisory Council, see this trend persisting as a result of overall economic buoyancy. This rise is mirrored in lending rates across the board, whether to the corporate sector or to individuals for financing housing and automobiles. The benefits of the financial sector reform done so far appear to have been fully realised, at least for the moment. There are no immediate structural changes in sight that would impact interest rates in the same way as the two factors mentioned above. As a consequence, the economy is back to a more traditional textbook situation in which widening fiscal deficits could put further pressure on interest rates that are already upward bound, threatening the growth momentum being generated by private expenditure.

Higher interest rates are, in fact, a double whammy for government finances. To the extent that they crowd out private expenditure, slower growth will result in lower revenue collections. But, beyond that, they increase the government's cost of borrowing, which adds to an already stressed fiscal situation. This is of particular concern this year because, as the fiscal numbers for the first quarter revealed, the fiscal deficit is already above 50 per cent of the full year's estimate. This is the consequence of both a shortfall in revenues and overshooting on expenditure. Simple projections based on this pattern would suggest an increase in government borrowing requirements for the year, driving up interest rates and cementing concerns about possible crowding- out effects. Of course, this is not inevitable. The finance ministry is quite capable of controlling the deficit by capping expenditure for the rest of the year. But the unavoidable fact is that, as interest rates increase, the double whammy on government finances will be felt, making it that much more difficult for the finance minister to comply with the mandated commitment to eliminate the revenue deficit by 2009. High interest rates could well crowd out, among other things, fiscal responsibility itself.