Suman Bery: The public and the private

It is hard to back both the public and private sectors in infrastructure

In his address to Assocham on August 24, the Prime Minister addressed the general issue of improving the climate for private investment in the economy.

Within this larger framework his particular focus was on the need to revolutionise India's infrastructure, by encouraging both public and private investment.

This priority was signalled by the announcement that he would personally chair a high-level committee on infrastructure, with the Planning Commission functioning as its executive arm.

The Planning Commission is also charged to prepare a paper on the regulatory reforms needed to create a regulatory framework in individual infrastructure sectors that is independent of government so as to be impartial as between public and private providers of infrastructure services in the various sectors.

Stress on infrastructure is nothing new, of course, nor is the desire to go beyond the traditional public sector provision model so as to involve the private sector.

However, as the experience of the last decade in India has revealed, achieving this blend is extremely difficult, with only telecom showing much success.

As before, fiscal and political limitations continue to constrain public investment in the area, while private provision is constrained by regulatory uncertainty.

It is accordingly appropriate to reflect on both the fiscal and the regulatory dimensions of this renewed push towards infrastructure, and the important challenges that lie ahead for the authorities.

Let me start with the fiscal side, to ask what scope exists for a big push on public investment in infrastructure. As many readers would be aware, a few days before the July Budget the finance minister notified the rules of the Fiscal Responsibility and Budget Management Act, 2003.

These rules were then amended in the Budget itself, so that the central government has now committed itself to eliminate the revenue deficit by the end of its term, in fiscal year 2008-09.

In addition, the FRBM rules require a minimum annual reduction in the revenue deficit by 0.5 per cent of GDP. In the case of the fiscal deficit, the rules specify a target of 3 per cent of GDP for FY 07-08, with a minimum annual gain of 0.3 per cent of GDP.

Additional constraints specified in the rules include a limitation on the issuance of guarantees of 0.5 per cent of GDP per year, and a rather generous limit in the growth of central government liabilities, starting with 9 per cent of GDP in the first year.

The rolling targets specified in the Medium-Term Fiscal Policy Statement that from now on will accompany the Budget are in fact more ambitious than the minima specified in the rules, as they project the revenue deficit declining from 3.6 per cent in 03-04 (revised estimates) to 1.1 per cent in 06-07, while the fiscal deficit declines from 4.8 per cent to 3.6 per cent over the same period.

As the finance minister expressed it in his Budget speech, "The elimination of revenue deficit will open up fiscal space up to 3 per cent of GDP for enhanced public investment without undermining fiscal prudence" (para 7).

This concept of "fiscal space" has been receiving a good deal of attention internationally. The debate began in connection with the stability and growth pact (SGP) in Europe.

It has now been carried to the portals of the World Bank and the International Monetary Fund (IMF), in connection with the fiscal conditionality included in IMF-supported adjustment programmes in developing countries.

In principle, government solvency should, like a company balance sheet, be an intertemporal concept, relating to the present value of revenues and expenditures and encompassing both assets and liabilities.

An excessive focus on the fiscal deficit (which is a flow, rather than a stock concept) can create a bias against investment expenditures, where cash-flows are initially negative.

The editors of a recent book on the subject* compare the situation to a government that chooses to repay debt at 9 per cent (the marginal cost of borrowing) with debt at 20 per cent (the likely marginal return on much public infrastructure investment and maintenance expenditure).

Given these concerns, public finance economists have been searching for alternative indicators of responsible fiscal policy over the medium term.

One such alternative is the so-called "golden rule," where debt accumulation is allowed only to finance investment spending.

This is in fact the doctrine underlying the FRBM. This too contains both conceptual and implementation difficulties.

On the one hand, it may excessively penalise very high-return maintenance expenditure; on the other it may legitimise unproductive "white elephant" or "pork barrel" public investments.

By itself, the golden rule does not cap the growth of government debt, since the shelf of productive public investment projects may be very full. It is for this reason that the FRBM includes a ceiling on the growth of debt, over and above its deficit targets.

A further complex set of issues is raised when resort is made to public-private partnerships. Such partnerships can often contain substantial future risk for the public finances, through guarantees and contractual obligations.

As I had noted in an earlier column, renegotiations of infrastructure contracts are more the norm than the exception, making a proper assessment of fiscal exposure difficult. The Dabhol project is a continuing reminder of some of these perils.

The Report of the Task Force on the Implementation of the Fiscal Responsibility and Budget Management Act, 2003 (the so-called Kelkar-II report) is fully mindful of these issues.

In its discussion on capital expenditures (Section 4.3.2) it notes that while the FRBM does leave the government with flexibility in capital expenditure, a rigorous screening process is needed, particularly if such investments are to be financed through issues of debt.

It is obvious that issues of cost recovery are critical if such projects are to be financially sustainable; it need scarcely be said that this has not traditionally been the strong point of Indian public investment.

Turning next to the regulatory challenge, the Prime Minister is completely correct in identifying this as a key area for action. In most if not all sectors (again, telecom may be now be the exception) regulatory institutions are relatively weak when compared to the power of government ministries, and their wards, the public sector incumbents.

Given the reluctance of governments, both past and present, to privatise public sector incumbents, ministries remain much more concerned to defend the interests of these incumbents than to foster competition in their sectors, which ought to be their public policy goal.

In turn, this appearance of favouritism inhibits significant private sector entry. A big push to strengthen public investment in areas that could potentially interest private players will only exacerbate these concerns.

The Planning Commission therefore has its work cut out for it. It needs to revive, and enforce, a disciplined system of project appraisal to ensure that public investment in infrastructure exceeds the opportunity cost of funds, while ensuring that the regulatory system is not tilted in favour of the public sector.

Achieving these goals in the context of a coalition government will be particularly hard. One possible way of reconciling these disparate objectives could be to restrict the areas where public investment will be permitted, so that the private sector would be clear that it was not betting against the government.

Just as important will be to frame clear rules on public-private partnerships, so that the government is not taken for a ride.

*"The Limits of Stabilization: Infrastructure, Public Deficits and Growth in Latin America," Edited by William Easterly and Luis Servén, The World Bank, Washington D.C. and Stanford University Press, Palo Alto, CA. 2003.

(The author is Director-General, NCAER. The views expressed here are personal)