FROM THE TELEGRAPH OF 4 DECEMBER 2006
The next great reform
There are
reformers in this world, and there are those who enjoy the fruits of reforms;
seldom do the two coincide. India is one of those exceptional countries.
Manmohan Singh and P Chidambaram implemented the reforms in the early 1990s;
today they are at the helm again. It is even more unusual because they did not immediately
inherit the fruits of their reforms. Both were in the wilderness for years; it then
looked as if their path-breaking policies had only benefited their political
opponents, who had done nothing to deserve the fruits. So there is poetic
justice in their return to power at the peak of the golden boom that reformed
India is enjoying.
It is therefore
not surprising that they feel rather elated and tend to rest on their oars;
they deserve it. And it is understandable that when they think of what to do
next, their ideas fall somewhat short of their best. If Chidambaram thinks of
tripling loans to farmers, Manmohan Singh thinks of jobs for Muslims. If Chidambaram
proposes tax cuts, Manmohan Singh proposes capital account convertibility.
Chidambaram does not recognize that so called bank loans to agriculture already
represent a substantial proportion of agricultural credit, but that they go
largely to big farmers who do many things besides farming, and use those loans
for many other purposes. Manmohan Singh does not betray knowledge of the fact
that the low proportion of Muslims in prized jobs has much to do with the
smaller proportion of them acquiring education that is the gateway to those
jobs, and indeed to fewer of them finishing school at all. Chidambaram wants to
reduce taxes even though no one is complaining of high taxes, and has not
considered what other uses the tax revenue he wants to forgo might be put to. Manmohan
Singh does not say why he wants capital account convertibility – because Indian
savers can then invest globally, or because foreign capital inflows would
increase, or because cost of capital to Indian businesses would come down. If
he did, he would see that all these potential benefits are uncertain,
conditional and not necessarily large. At one time, a Japanese friend taught me
Go. He used to beat me in every game. After every win he would tell me, “Don’t
make weak moves.” It is difficult to avoid the impression that the reformers of
yore are making consistently weak moves.
I believe
something better is now within the government’s reach: a revenue surplus. However
desirable it might have been, it was unthinkable till now. The deficit was too
large, and demands of spending ministries were too strident. But because of the
ongoing boom, central revenue is rising at an extraordinary rate. Even if
Chidambaram did nothing, the revenue deficit would come down. If he put a
slight brake on government expenditure, it would be possible to abolish the
revenue deficit in two years, and from then on to run a surplus. Instead of
forcing banks to hold a high proportion of their assets in government
securities, it would then be possible to retire or buy off government debt from
them. And the more the debt contracts, the greater will be the funds that banks
can lend to businesses. Retirement of debt will bring down the share of
interest payments, currently 60 per cent of government expenditure, and will
enable the government to spend more on infrastructure.
A revenue
surplus, being deflationary, will lead to an improvement in the current
account. A stronger balance of payments will give Reserve Bank the choice of
either accumulating foreign exchange reserves even faster, or of appreciating
the Rupee. As we have experienced in the past four years, reserve accumulation
leads to a rise in money supply, greater liquidity, lower interest rates,
higher business profits and greater industrial investment. Appreciation of the
Rupee would reduce the price of imports, bring down inflation and intensify
competition in the domestic market. Real production and incomes would rise
faster once the economy got through the initial deflationary impact – which in
current conditions of buoyancy would a good thing anyway.
One possible
danger to our long-term growth has been the current account deficit; if foreign
capital inflows stopped today, foreign exchange reserves would decline. That
would reduce money supply, raise interest rates and reduce the growth rate. If
reserves fell beyond a certain point, Reserve Bank would panic, push up
interest rates even further and deflate the economy. This danger can be avoided
if a sufficient revenue surplus is achieved to rectify the payments deficit.
All countries (other than the US) that grew rapidly over long periods had a
current account surplus; if India achieves one, its growth would be much less
vulnerable. A payments surplus does not preclude net capital inflows. China has
a huge current account surplus and still receives large capital inflows. It
chooses to accumulate reserves; we could choose any combination of reserve
accumulation, exchange rate appreciation and import liberalization.
Those are the
real effects of a revenue surplus. In addition there will be a monetary effect.
As the supply of government securities declines, a higher proportion of the
rise in banks’ deposits will become available for financing productive
investment. The government has no budget constraint, and can afford to borrow
at any interest rate. Government borrowings define a floor to interest rates.
When the revenue budget goes into surplus, government borrowings will become
negative; the government will begin to buy off debt from banks and other
institutions and retire it. Its borrowings will no longer place a floor under
interest rates; interest rates can then fall to any level. A reduction in
interest rates will lead to a rise in demand for all the expensive goods that
are generally bought with borrowed funds – plant and machinery, and land and
buildings. It will lead to a rise in investment, and hence in the growth rate
of the economy.
The past three
years have seen a fall in the government’s savings deficit, and a simultaneous
rise in the domestic savings and investment ratios. Improvement of the revenue
balance will have the same effect; and as domestic savings and investment
increase, the growth rate also will rise.
Thus,
achievement of a revenue surplus is the strongest growth-stimulating measure
the government can take. From 8-9 per cent, it could push up growth to 10 per
cent and above by spending less. If India is serious about catching up with
China’s breathtaking growth, this is the most promising step the government can
take towards that goal.
The fact that
India has accelerated its growth despite high fiscal deficits has created the
belief that fiscal balance does not affect growth – a belief that can be
supported by running regressions on annual data. But such regressions exclude
many other influences on growth as well as lagged effects, and are therefore
unreliable. The macroeconomic effects of an improvement in fiscal balance are
easy to work out in any model, and will give the same results in all – that it
raises the growth rate. Now our celebrated reformers have a chance to see this
work out in practice. It is an experiment they cannot afford to miss.
