India's decade but what about the fisc?

Beyond Logic

The problem is not the fiscal deficit "" the culprit is interest in scam small savings

As the Indian economy emerges from a trough, there are several legitimate queries "" how much of the recovery from the below 5 percent growth last year is cyclical? How much of the soon to be found growth of 7+ per cent sustainable?

It is fair to state that the forecasting reputation of a large number of domestic and international economists is tied to a correct answer.

Not just reputation "" the pocketbooks of a lot of individuals, and money managers, are also involved. And perhaps even the fortunes of incumbents up for state and general elections.

The intellectual, and noise level of those in favour of the cyclical story is high. The drum-beating is contagious "" World Bank, IMF, Moody's, S&P, Crisil, NCAER, NIPFP, all echo the same analysis and concern.

It's the rains, stupid. And if it hadn't been the rains, what would the growth rate be? Around 5.5 "" 6.0 per cent, almost exactly the same as not just the last 10 years average, but the last twenty years as well! Rather than tempt the gods again, the traditional gurus argue, the concern today should start and end with the fiscal deficit.

The level is dangerously high "" the consolidated (centre plus states) deficit has hovered around 9-10 per cent for the last six years. This level is not sustainable, and it hinders growth. So, higher growth is impossible.

When asked about how the fiscal deficit can or should be cut, the analysts shrug their shoulders and mouth the usual "" implement tax reforms, reduce subsidies, reorient expenditure and improve its composition, etc.

Then the mandatory oxymoron "" more productive expenditures, less wasteful expenditures, etc. If you have heard even sociologists and political scientists utter these learned remedies, you are not alone.

Apart from the cookie-cutter recommendations, the traditionalists seem to make a lot of sense, don't they? Especially if one ignores the facts, the fiscally correct experts make sure you do not know.

For example, that the (consolidated) fiscal deficit in India has stayed in the 8-10 per cent range for the last twenty years. The first six years of the eighties (1980 to 1985), the deficit averaged 9.7 per cent; the next six years, 11.1 per cent; the next six years, 8.8 per cent; the last six years (1997-98 to 2002-03) 9.2 per cent.

Surely, the fundamentalists cannot see a pattern here, except for the constancy. So what is the new problem? I completely agree that deficits in India should be brought down, that subsidies, especially those 'in the name of the poor' should end.

But I don't believe there is evidence to suggest that with our traditional deficits, India is constrained to grow at no more than 5.5-6 per cent.

What the learned men also fail to tell you is that for a non-crisis economy, India has had the highest fall in interest rates over the last three years.

In 1999-00, overnight interest rates were 9 per cent, the prime lending rate 12.5 per cent, and inflation (WPI) around 3.3 per cent. Today, the rates are 4.5, 5.0 and 10 per cent respectively.

Inflation today is somewhat higher than trend, and the prime lending rate somewhat lower in 'effective' terms ie. few borrowers at the stated rate of 10 per cent. Thus, no matter how one slices the data, real rates are down by about 400-600 basis points.

In the West, a level one-tenth this amount is considered a precursor to a revolution "" yet the fiscal aristocrats do not think this decline in interest rates will have an effect on investment and therefore growth.

This fundamentalist belief is not based on economic logic. This disease is particularly prevalent among Indian economists, but it is so contagious, that anybody working on India is afflicted with it faster than you can say Mibor (Mumbai interbank interest rate).

So what does affect investment if not its price? Why, animal spirits, government investment, infrastructure investment, privatisation, sun spots "" everything but the price of investment.

When asked to explain as to why the demand curve is not downward sloping (cheaper the good, the more you purchase), the economists answer "" woman does not live by demand alone, the spirit is crucial.

This error on the part of the fiscal fundamentalists is the major reason for the optimism that the world is not flat, and that Indian future growth (starting now) is considerably higher than 5.5-6 per cent.

There are several other reasons. For starters, the fiscal deficit will reduce somewhat on its own. Lower interest rates today mean less payments for the next eight years.

In four years time, lower interest payments will lead to a lower interest burden "" about 1.5 percent of GDP. This is the 'direct' effect of the impact of reduction in interest rates.

Indirectly, the lower deficit should add some downward pressure on domestic interest rates, though in the open-economy world to which we belong, the level of interest rates is given by forces (thankfully) beyond our control.

More importantly, a lower deficit will mean less wasteful expenditures, less losses due to inefficiency and therefore higher growth. A decline of 1.5 per cent of GDP in the fiscal deficit is expected to add about 0.5 per cent to the growth rate.

The second round effect is via the extra growth that will materialise with lower interest rates. Each 1 percentage point decline in real interest rates adds about 0.25 to the GDP growth rate. So a 5 per cent decline will mean extra growth of 1.25 per cent.

Add these two effects and the expected Indian growth rate moves up from 5.75 per cent per annum to 7.5 per cent. How did we get to the magic 7 figure? With no assumptions except that the demand curve for investment goods is downward sloping and that international (and domestic) interest rates are not likely to significantly move up anytime soon.

What is the downside to this seemingly optimistic forecast? If the international situation remains benign, India's growth is in the 'sweet spot'. The question is "" what possible reforms will make the growth rate of 7+ a near certainty and an even higher 8+ distinctly attainable? While the traditionalists talk about the fisc, the real impact, not surprisingly, will be felt through interest rates.

The hugest distortion anywhere in the world is today present in India. The reason little research is needed to make this assertion is because nobody can be as stupid as the Indian government has been on the issue of scam savings "" also known in socialist India as 'small savings'.

These savings are insured and have a tax-free 8 per cent yield. The rich world is subsidised by poor India via scam savings "" and the accumulation of reserves and a strong rupee. How small is small? About Rs 100,000 crore or equal to about 40 per cent of the entire financial savings in the system. Simple point "" small is HUGE.

Dr Reddy is the author of a GoI report recommending that interest rates on scam savings be tied to market rates on government securities. He is now the governor of the RBI and is scheduled to give his first policy statement on Monday.

There is no monetary policy more important than eliminating the small savings scam ie. implementing his own report. The real policy issue is not the fisc "" it is the scam. Let us hope that this huge reverse Robin Hood policy is arrested. There is no law against dreaming.

ssbhalla@oxusresearch.com