Sudhir Mulji: Montek's forex dilemma

Although most economists and readers have not fully understood what precisely Montek Ahluwalia means by using foreign exchange reserves for infrastructural development, there may be more to his argument than meets the eye.

As I pointed out in my review of the "Approach to the Mid-term appraisal of the Plan", the Planning Commission is caught in the dilemma of finding more resources and yet remaining within the constraints of the Fiscal Responsibility Act.

In escaping from this predicament, Montek is trying to distinguish between capital expenditure and revenue expenditure, and that is fair enough. But the overall problem is not actually the type of expenditure but rather the high level of the fiscal deficit of 10 and 12 per cent of GDP that most observers consider inappropriate and unsustainable.

For those who do not consider the size of the fiscal deficit to be relevant there is no particular problem. But that will not appeal to the majority. However, if there is ever a time when a larger deficit can be suitably accommodated it is perhaps now. We have ample foreign reserves and some depletion by use would be welcome.

In fact by purchasing foreign exchange inflows and then sterilising them by selling bonds, the Reserve Bank has depleted its own stock of Indian bonds; it must therefore be the case that the RBI's present stock of Indian bonds is less than it would like.

An exchange with the government, or whatever infrastructural organisation the Planning Commission may devise, of foreign bonds for a fresh supply of rupee bonds will not be unwelcome for the RBI.

If the government were to make a straight exchange between foreign bonds and Indian bonds, the impact on the government and the Reserve Bank's budget would be negligible; indeed taken together the net effect would be zero; but once the government comes to use the foreign exchange for expenditure the cost would have to be accounted for in their books and that would add to the fiscal deficit.

Unlike the private sector the government does not keep a balance sheet showing assets created by its expenditure perhaps because it is not necessarily expected to yield future revenue.

Thus, expenditure on highways or public health may be an asset to society but may not yield future revenue to the government. The essential distinction between social assets and private assets is precisely that.

The former is once-and-for-all expenditure and unlike private capital expenditure yields no accountable income. Private companies also do spend money for the benefit of their employees or for further training, which do not necessarily yield revenue but the proportion of these outflows is relatively small, almost inconspicuous, in their balance sheet and accounts. These costs are often written off in the year they are incurred.

Both these forms of expenditure are very large in the government's books and add to government costs so considerably that they lead to fiscal imbalances. This leads to considerable dispute both within the government and among the voters even though they benefit from such expenditure.

The trouble with large fiscal deficit is not that the money spent is usually borrowed both domestically and internationally, which affects foreign investors who assess the liabilities without valuing the assets.

On this aspect the IMF has played, what Thirlwall, the Economics Professor at Kent University, describes as "... the dismal role in developing countries which through the pursuit of inappropriate policies based on misleading economic theory has exerted a depressive effect on economic activity in these countries."

Broadly the Fund has advocated a standard package of devaluation and deflation to these countries to meet their foreign and domestic liabilities.

It may therefore prove difficult for even Montek to sell his notions of a higher fiscal deficit, albeit limited, to the capital account. Further, the domestic inflationary impact of government expenditure on infrastructure cannot be ruled out.

Keynesians like myself are convinced that with the sort of manpower surplus within India, inflationary pressures should not be of such severity or of such importance as not to be easily countered; but knowing myself to be in a minority on such opinions, Montek may need to make a more convincing tale to satisfy potential critics.

In his address to the CII, Montek did express concern about inflationary pressures, which he proposed could be mitigated by increasing imports through reductions in tariffs and a revaluation of the rupee.

The former would certainly be welcomed by economists who generally consider Indian tariffs still absurdly high, but the political question is: "Are Indian tariffs imposed primarily for balance of payments considerations or for protecting domestic industries?"

At least, one economic argument that Montek would be confronted with is that reducing tariffs will damage the employment potential of using domestic labour and unused capacity. That, combined with higher fiscal deficits, has often proved to be the political death knell of ambitious development schemes.

It is this confrontational predicament that has sadly been crystallised in the Fiscal Responsibility Act. Montek has tried to suggest that if social asset building cannot be included in the balance sheet nor should such social liabilities as infrastructural development.

Logically he should be allowed to get away with that; but unfortunately, liabilities incurred with borrowings are calculated and suffer a recurring cost by way of interest payments. Private companies get away with such costs because they are small in proportion to their overall expenses.

For governments, however, these costs are large and lend credence to the charge that bureaucrats mismanage public funds.

Montek would like to circumvent this by using the government's monopoly power to create money. He has proposed using some foreign assets for infrastructural development with rupee bonds that the RBI could purchase presumably by effectively selling some of its foreign assets directly to the government. This could have an inflationary impact, which Montek would hope to mitigate by lower tariffs and revaluing the rupee.

For myself I entirely support his objectives but not necessarily his methods. No one could disagree with lower tariffs""that proposal would improve competition and should be pursued regardless of infrastructure finance.

Montek wants to finance infrastructure with bonds but there is no indication that he would allow money supply to grow. So eventually the government would neutralise the position by financing the deficit through taxes or further borrowings from the public.

The better route is to increase money supply in the hands of the public in the hope that inflation would be prevented by greater use of domestic manpower and idle resources.

By increasing money supply, one could ensure that there is no crowding out of private investment, and if, as a consequence of excess money supply, the rupee gets devalued, it would help Indian exporters to sell more competitively in the world markets.

The fear is of course that an increased money supply could have a sharper inflation effect, but there is no evidence, or at least as little evidence as any other economic proposition, that an increase in domestic money supply would necessarily raise prices.

After all, the foreign exchange inflow did not do that if we accept the RBI claim that it followed a passive sterilisation policy. An increase in money supply is risky but it has the merit of reducing the burden on the budget.

sjmulji@aol.com