T.C.A. Srinivasa-Raghavan: Is India heading for bankruptcy?

OKONOMOS

Back in the 1930s, a fight broke out between the two Iyengar sects. It was about the control over the rich, main Kanjeevaram temple. The shape of the tilak on the temple elephant became the proxy over which the battle was fought.

Eventually, the matter went to the Privy Council in London, which actually admitted the case. The winners were jubilant but, alas, the elephant was in the control of the losers.

These fellows had their revenge when the elephant was paraded for the first time after the judgement. As it had not specified where the tilak had to be placed, they painted it on the elephant's backside.

The ongoing debate over the fiscal deficit resembles the above story, which is true, by the way. That the fiscal deficit needs to be reduced is a given, but to what level is a matter of control and discretion.

This paper* by Brian Pinto and Farah Zahir is an important and highly informative addition to the growing literature on India's fiscal deficit. It states the problem and delivers its judgement as succinctly as the Privy Council did in the temple elephant case.

But like it, it fails to mention the all-important detail: what is a safe level for the fiscal deficit? Would 10 per cent of GDP be all right if 80 per cent of it was capital spending?

The authors say, rightly, that since 1998 deficits have hovered around 10 per cent of GDP. But that is a long time and, by now, there should surely have been some sort of crisis. The fact that there hasn't, has led to two lines of argument.

The minority view, like mine, argues that it is silly and futile to fret so much over the fiscal deficit and that it will sort itself out with the return of stable governments, not to mention the sale of government assets and expansion of the service tax.

India has a larger proportion of both compared to Latin America "" the touchstone of the Fund-Bank weltanschauung and is, thus, really quite safe. Indeed, the process "" both of stability and sale "" has already begun.

The other argument, like Pinto and Zahir's, says watch out, you are in for serious trouble. They have, I must concede, done a splendid job in painting the gloom-doom scenario. Their paper presents "evidence that, in the absence of a fiscal adjustment, low inflation and high reserves may have been pursued at the expense of long-run growth."

Boldly, they posit a new "trilemma" "" inflation, external vulnerability and growth. Bold, because they overlook a small detail: inflation and external vulnerability have an overwhelming political content. Be that is it may, the resolution of this trilemma requires rapid fiscal adjustment.

To prove their point they show that "without a fiscal adjustment, the debt burden is likely to reach unmanageable levels by the end of the Tenth Plan period".

Contrary to popular belief, "record lows in interest rates have not softened this deterioration because of slowing growth and also because public debt dynamics are driven by the average cost of the whole stock of debt, not just the marginal cost...."

So while it is all very well to blame the Fifth Pay Commission, "the elimination of financial repression and incomplete tax reforms have 'cost' the exchequer a minimum of 2.5 percentage points of GDP over the 1990s" because fiscal adjustment has been achieved by cutting investment spending.

Combine this with the not un-natural desire to "crisis-proof by building up reserves and keep inflation low by targeting base money" rather than cut bad expenditure, and what you get is a "loose fiscal-tight money" policy mix after 1997/98. Under it, banks are happy to lend safely to the government at high rates and interest rates stay higher than they would if the government did some expenditure pruning.

The authors also say that "the decline in interest rates over the past 18 months or so is unlikely to survive a recovery in the global economy." So even the gains at the margin now in evidence could be wiped out. The paper thus says that India may not grow out of its debt problem merely by cutting interest rates.

It also presents alternative debt projections with and without reform. In the former, debt and interest burdens become unmanageable by the end of the Tenth Plan period. With reform, deficits drop and the composition of spending greatly improves.

Everyone, presumably, lives happily ever after.

*World Bank Policy Research Working Paper No. 3230, March 2004