THE ECONOMY IN OCTOBER 2002

Suman Bery began a quarterly survey of the Indian economy in National Council of Applied Economic Research and invited me to a discussion on it; it made me think macro.

1    The meaning of reserve accumulation

National Council of Applied Economic Research has for long made periodic reviews of the economy, ending in forecasts of a few key figures based on a model. Their competence has been recognized. Though meant for a limited audience of buyers, the reviews have always leaked out and made headlines in the financial newspapers. But they have seldom said anything surprising or unknown. They have not shaped the way we look at the economy, conveyed an idea of the broad forces shaping its course, or forecast the turning points. Anyone can project a trend. An economist’s skill lies in forecasting the unexpected; and one does not look to the NCAER reviews for that.

With the coming of Suman Bery as NCAER’s Director General, however, the macroeconomic backbone of the forecasts looks likely to be strengthened. By this I do not mean that more equations will be added to the NCAER model or that the equations will become longer; I mean that the macroeconomic rationale of what is happening is more likely to be explained, discussed and questioned. The first signs of this happening are to be found in the review Suman Bery presented at the India International Centre on 26 October.

Bery thinks that India is in its first conventional business cycle. Does this mean that there were no cycles before, or that they were unconventional? I think he would say that there were fluctuations in the growth rate before, but that they were driven, not by autonomous overshooting of variables – principally investment – but by payments crises, which cut short every boom. The 1996 boom was the first one not to end that way; it was accompanied by industrial overinvestment which is being slowly unwound. In my view, the ubiquity of payments crises in the past does not mean that they invariably ended booms, or that there were no booms that did not end in payments crises. Past cycles would repay study and might tell us something about the present one as well – if we approached them as cycles. But Bery is clearly right to say that we are in the middle of a cycle and that it is worth analyzing the present problems in such a theoretical framework.

If we do so, then we are faced with an intriguing problem. The last boom was very short-lived – roughly from 1993 till 1996. The slump, on the other hand, is very prolonged; since 1996 we have not really seen a prolonged boom. Surely it should not take an economy six years to digest overinvestment? One would have to bring in some extraneous, noncyclical factors to explain the prolonged sluggishness.

I think Bery would like to make Reserve Bank’s exchange rate policy the villain of the piece. Briefly, the idea is as follows. If Reserve Bank had not been so obsessed with accumulating reserves, the Rupee would have appreciated, imports would have been cheaper, and cheaper imports would have closed down inefficient producers and restructured the economy faster. Instead, Reserve Bank has sterilized capital inflows by buying and amassing dollars. It invests these in low-yield securities of industrial countries (we do not know which, but knowing Reserve Bank’s incurable conventionality, most of the money is probably in US securities).

An important element of Bery’s thinking is that the exchange rate policy cannot affect relative prices or terms of trade. If Reserve Bank buys up dollars, it will be selling Rupees in exchange, money supply will be that much greater, and it will raise domestic prices: the ratio of prices at home and abroad, converted at the exchange rate, will be the same whether Reserve Bank accumulates dollars or not – and indeed even if it runs out of dollars and lets the Rupee collapse. That, however, is true only of prices of tradable goods. There are non-tradables as well; their prices cannot be affected by their imports and exports. Hence exchange rate policy can affect the relative prices at home of tradables and non-tradables. If Reserve Bank had allowed the Rupee to appreciate, Rupee prices of exports and imports would have been lower, the prices of tradables would have been lower relatively to those of non-tradables, the demand for tradables would have been greater, and so would have been their production. The prolonged slowdown is thus due to Reserve Bank’s policy of pushing the Rupee artificially down.

I am not sure this follows. If the Rupee had been stronger, imports would have been greater – the cheaper imports would have reduced relative domestic prices of tradables. Hence whilst domestic demand for tradables would have been higher, how it would have been divided between imports and domestic production is still uncertain: it cannot be asserted that domestic production of tradables would have been definitely higher. Conversely, a lower exchange rate, induced by reserve accumulation, would raise relative prices of tradables at home and reduce their domestic demand. But it would also lower imports, and no unequivocal prediction can be made about its impact on domestic production.

Bery’s neoclassical view involves looking at two equilibrium positions of a two-good economy. Such a simplification can be illuminating. But the economy is never in equilibrium; it is always in transition. The transition may be different from what the two end-positions would predict. In particular, Bery assumes instantaneous adjustment of relative prices. If price adjustments are sluggish, the real effects may be very different from those predicted by a two-good model.

Just how sluggish prices will be – how much output will be affected during a certain change in relative prices – will depend on surplus capacity in the case of expansion, and stickiness of prices in the case of contraction. It is remarkable that Bery, who would like to look at the Indian economy in cyclical terms, adopts a model that rules out the essence of cycles, namely changes in capacity utilization and stickiness of prices and wages.

In the specific context of the Indian economy, it is doubtful whether the depreciation of the Rupee on account of reserve accumulation raised relative prices of tradables. So much surplus capacity was built up in tradables in the boom of the early 1990s that domestic competition kept down inflation in them. Instead, it is possible that depreciation raised exports, restrained imports and improved capacity utilization in tradables, – that the slowdown would have been even worse without depreciation.

That said, I greatly welcome Bery’s raising of the issue. Debate on the Indian economy would only benefit if it were informed by economic theory; and if we look at longer-term trends, we are likely to see more clearly where the economy is going.

SAVINGS AND INVESTMENT RATIOS (TO GDP, PER CENT)
			1990-91	1995-96	2000-01	C   h   a   n   g   e
			(p  e  r     c  e  n  t     o  f     G  D  P)			91-96	96-01	91-01
Savings			26.3	26.9	24.0	0.6	-2.9	-2.3
Foreign			3.2	1.8	0.6	-1.4	-1.2	-2.6
Domestic			23.1	25.1	23.4	2.0	-1.7	0.3
Government			1.1	2.0	-1.7	0.9	-3.7	-2.8
Companies			2.7	4.9	4.2	2.2	-0.7	1.5
Others			19.3	18.2	20.9	-1.1	2.7	1.6
Investment (domestic)			26.3	26.9	24.0	0.6	-2.9	-2.3
Government			10.6	7.7	7.1	-2.9	-0.6	-3.5
Companies			4.1	9.6	5.9	5.5	-3.7	1.8
Others			11.6	9.7	11.0	-1.9	1.3	-0.6
Difference			0.0	0.0	0.0	0.0	0.0	0.0
Foreign			3.2	1.8	0.6	-1.4	-1.2	-2.6
Domestic			-3.2	-1.8	-0.6	1.4	1.2	2.6
Government			-9.5	-5.7	-8.8	3.8	-3.1	0.7
Companies			-1.4	-4.7	-1.7	-3.3	3.0	-0.3
Others			7.7	8.5	9.9	0.8	1.4	2.2
Source: CSO.

II    Indict the government, not RBI

Last week I reviewed Suman Bery’s diagnosis of what ails the Indian economy. Let me now give mine. The ratios of savings and investment to gross domestic product show considerable changes over the decade to 2000-01. The inflow of foreign savings – also known as current account deficit – has fallen by 2.6 per cent of GDP. The fall was roughly equal in the years before 1995-96 and after. This improvement must be attributed to some extent to the progressive devaluation of the Rupee – unless one assumes that domestic and international prices are identical all the time, a demonstrably false assumption.

Since total savings and investment are identical, the improvement in the current account must be matched by a fall in domestic dissavings – in the excess of domestic investment over savings. Other sectors than government and companies (which the Central Statistical Office misleadingly calls households) increased their net savings in both periods. But there was a huge difference in the performance of the other two sectors. In the first half, the government (which includes the central and state governments as well as local authorities) reduced its net dissavings by 3.8 per cent, and companies increased theirs by 3.3 per cent; in the latter half, the government increased its net dissavings by 3.1 per cent, and companies reduced theirs by 3 per cent. In other words, the improvement in the balance of payments in the first half was more than matched by a fall in government dissavings in the first half, which in turn was largely due to a fall in investment by the government. In the second half, it was more than matched by a rise in net private savings, which in turn was due to a fall in corporate investment and a rise in others’ savings. This is the cycle Bery had in mind – the investment boom of the first half followed by the investment bust.

But in the first half the governments helped the boom by reducing its dissavings; remember that inflation was high, Manmohan Singh was very sensitive to it, and followed strong policies to restrain it, of which fiscal prudence was a part. One could equally argue that the governments followed a countercyclical policy in the second half and increased its deficit as private investment declined (as a proportion of GDP). But that stimulus was achieved entirely by reducing the government’s gross savings; it did not raise its investment to counteract the effect of falling corporate investment. Total investment fell by a full 2.9 percentage points because the government replaced private investment with its own consumption. It could do so because of its privileged access, through the banks and financial institutions it continued to own, to private financial savings. If it had not had that access, interest rates would have been driven down faster. Its deficit too would have been smaller, and hence its direct stimulus to demand. The two effects conflict, so we cannot say growth would have been faster. But the government would certainly have spent less on interest payments, and more on investment and services.

The current account deficit is financed by foreign capital inflows; they constitute foreign savings. The inflows have been larger than the current account deficit; the excess has added to foreign exchange reserves. The inflows are in foreign currencies, which Reserve Bank buys in return for Rupees. It then invests the foreign exchange in low-yield securities of foreign governments. The result for the country is that foreign funds are used to buy and set up productive facilities in India, and Reserve Bank at the same time invests its foreign exchange reserves abroad in low-yield securities of foreign governments. The Rupees sold by Reserve Bank for foreign exchange add to money supply. Then, to reduce the cash with public, Reserve Bank sells domestic government securities to the public. The net result is that foreign investors earn high returns on their investment in India, while the government pays out net interest equal to what it pays on its securities less what Reserve Bank earns on its foreign currency assets. Bery considers this bad business. He would like Reserve Bank to stop sterilizing the reserves – in other words, to stop mopping up cash by issuing securities – and he would like it to stop accumulating reserves and let the Rupee appreciate.

Actually, the policy motivation of the bad business is quite different. Reserve Bank does not first sell Rupees for dollars and then mop them up for government bonds: the government keeps spending more than it receives from revenue and issues securities to finance it. Reserve Bank buys dollars and sells Rupees, which the banks receive in deposit and then use to buy securities. The government borrows; Reserve Bank creates demand for the borrowings by adjusting bank liquidity. The inflow of foreign exchange has released liquidity into the economy and made it easier for RBI to find a market for government securities, and enabled the governments to sell them to the banks at a lower rate of interest. This is how excess capital imports have helped the government.

In the circumstances, should Reserve Bank stop buying foreign currencies and let the Rupee appreciate? The idea will appeal to Ram Naik. The only way he can justify his ministerial post, now that overt price control on oil products has gone, is by worrying about prices, not letting government oil companies raise them without asking him, and trying to keep prices down at somebody’s cost. He would simply love a higher exchange rate; he is the prime buyer of Bery’s theory. The defence ministry is another prolific importer; so George Fernandes would also lend a willing ear. In general, the government is a net importer, and has a bias in favour of a strong Rupee. But as I argued last week, its effect on growth is disputable. As long as domestic prices of tradables are sticky and do not immediately follow import costs, a lower exchange rate must improve the balance of payments. An improving current account has provided an important stimulus to a sagging economy in the past five years; to dispense with it while the economy continues to sag would be unwise.

What is, however, worth trying instead is a reduction in import duties. It will have the same effect as appreciation of the Rupee. In addition, it would bring down domestic prices of protected goods to international levels. Insofar as these goods are used in making exports (hot-rolled coils are an obvious example), it would reduce the cost of exports and stimulate them. Yashwant Sinha’s regime saw considerable increases in duties, including agricultural tariffs and anti-dumping duties. Now is a good time to reverse his protectionism.

III    Two policy problems

Having painted the background in the last two articles, let me come to the immediate policy implications.

1.     The bulging reserves: Reserves have crossed $64 billion, and are rising rapidly. If they continue to rise at this rate, they may cross $75 billion by March, and $100 billion in a couple of years. They already exceed domestic money supply; they will far outstrip it. I am sure Bimal Jalan is under pressure from illiterate Hindutwists who ask, why does he keep the reserves in foreign currency? Why can’t he keep them in Bharatiya Rupees? Why does he not lend the reserves to the government, so that it can run even bigger deficits? Literate economists like Suman Bery add to his woes by asking: why does he need reserves at all? Why doesn’t he let the Rupee float up?

As Jalan said in his speech at the Bank of England last July, reserves are necessary because the whirlwinds of international instability are powerful and because a country must be able to withstand them on its own. They are the price of avoiding such disasters as Indonesia and Argentina have witnessed. But accumulating reserves also incidentally keeps the Rupee down. Keeping it down is a good idea; it improves the current account, and provides a welcome stimulus to the sagging economy. The problem lies elsewhere: that stimulus is dissipated because the expansion in the banks’ lending capacity arising from reserve accumulation is being used to expand government consumption. The answer to that lies in the fiscal field, to which I shall come later. But the reserves can be put to some good uses.

(a) Dismantle NRI deposit schemes: These deposits are a pure scam: anyone who can trump up an Indian-sounding name can borrow from a local bank abroad, go to the branch of an Indian bank abroad, place that money on deposit, and pocket the difference between the interest rates. This effortless game is a favourite of shady NRIs. But it is a racket, and the earlier it ends the better. Reserve Bank should prohibit the taking of all fresh NRI deposits and repay existing ones when they mature. That will reduce reserves by a third at least.

(b) No more Resurgence: The Resurgence Bonds of 1998 and Millennium Bonds of 1999 were similar scams: so-called NRIs borrowed money from sources abroad, earned high interest on it from the bonds, and took the difference. Millennium bonds got into trouble with the Federal Reserve, which ruled that they discriminated against non-Indian Americans. So State Bank collected money from them in Europe, and asked its NRI clients in America to siphon their money through London. Both  bonds should be repaid on maturity if not before. State Bank of India, which will lose the use of those funds, will lobby hard for issue of another Bombastic Bond. BJP politicians who depend on NRI money will lobby too. All such lobbying should be resisted; there should be no further issue of these bonds for racketeers.

(c) Remove import barriers: Reserve accumulation can be slowed down by encouraging imports. India had a golden opportunity of doing so when it finally abolished import licensing. It muffed the chance: it increased duties on agricultural goods, on so-called luxuries and miscellaneous other goods, began to monitor import of  “sensitive” goods and to impose anti-dumping duties and invented ingenious new import barriers. Sukumar Mukhopadhyay has shown how Yashwant Sinha, while announcing that he was reducing duties and the number of duty rates, was actually increasing both; the collection rates given in the Economic Survey themselves testify to the rise in duties. The new finance minister should accelerate duty reduction: he should abolish duties on all internationally competitive goods and all essential consumer goods, and reduce the peak on the rest to 15 per cent. He should go through anti-dumping duties with a toothcomb, and remove all duties on goods produced by local monopolies and cartels. Remember that changes in the exchange rate are equal to a combination of import duties and export subsidies (or their reduction). So higher reductions in duties can be made more tolerable by devaluation.

2.    Fiscal policy:  The fiscal deficit is the culprit; this is the cause of diversion of personal financial accretions into government consumption and for the fall in industrial investment. It is on the point of getting worse, for a number of states are close to financial collapse, and they will gang up to make the center bale them out. They have the political clout to force the center. In the Ahluwalia report on states’ indebtedness to the center, they have the precedent: it recommended a substantial write-off, which Sinha raised even further. There is no immediate solution, but the problem can be resolved in a few years if the direction is set.

(a) The first element is to introduce a hard budget constraint at the center: the expenditure during the year should not exceed the budget, there should be no supplementary grants, and any increase in the expenditure of a ministry should be accompanied by a simultaneous cut in the budgeted expenditure of another. There will always be undisciplined and uncontrollable elements in the government: the Prime Minister cannot be prevented from giving Rs 400 crore to Narendra Modi and Rs 1000 crore to Rajnath Singh. But such indiscipline must be anticipated and reined in: there should be a large Prime Minister’s discretionary fund with which he and his senior party colleagues can play politics.

(b) A cap on subsidies: Abolishing subsidies is impractical; instead, they should be capped at the past year’s level. That will force the food ministry and the fertilizer ministry to work out how best to use the money available to them. Fixed subsidies would be inconsistent with price controls and minimum price support; the Agricultural Price Commission should be abolished, and producer pricing should pass to the relevant ministries.

(c) From product to personal subsidies: The numerous subsidies on food, fertilizers, electricity, irrigation water etc are neither equitable nor efficient; states should be forced to integrate and target them. They can all be subsumed under two subsidies: a personal subsidy varying inversely with personal or family income, and a negative agricultural income tax varying inversely with agricultural income. States should be forced to convert their subsidies into these two basic forms. The center can itself work out a model subsidy for the poor and land subsidy that can be financed with its food and fertilizer subsidies, work out each state’s entitlement and pass it on to the states for them to do whatever they like with the money.