Feel bad factor

A pronounced `feel good factor' continues to dominate sentiment about India. Upbeat stories about India such as the recent cover story in Business Week must be very heartening for Jaswant Singh. No doubt, such stories will encourage more Fortune 500 companies to craft a strong India strategy. In the midst of all this euphoria, let us not lose sight of the things that can go wrong, and the very genuine challenges that we face.

The central challenge that we face is that of governance: of how government can produce public goods. This requires re-inventing government so that expenditures actually turn into public goods, but first, this requires a government that is not bankrupt. A key indicator to watch in this is the ratio of government debt to GDP. For many years, this hovered in the region of 60 percent. From 1999 onwards, however, this has resumed its inexorable march up, and is now up to nearly 80 percent.

This escalation of indebtedness should frighten every parliamentarian. It highlights the extent to which government is being steadily strangled by the internal debt trap. As of yet, there is no sign of progress on the fiscal deficit. It is very difficult to improve governance, i.e. to do better on producing public goods, in this fiscal environment.

For over a decade now, India has been able to pursue an imprudent fiscal strategy without overt signs of trouble. For many politicians, large deficits appear to be business as usual, and their focus is on garnering handouts to favourite constituencies. It would be easy for the finance minister to believe that a large and growing public debt is really not a problem and he does not need to address it, especially in an election year. The feel-good that is in the air will perhaps generate myriad hare-brained spending schemes, such as trying to start a clutch of new branches of AIIMS.

It will not be surprising if the finance minister believes that alarmism about the deficit is misplaced. After all, despite the rising debt, inflation has not gone out of control. Also despite the rising debt, nominal interest rates have been falling. The large fiscal deficit has not spilled over to the current account. On the contrary, we have witnessed current account surpluses for six consecutive quarters.

The above could therefore easily lead someone to think that to address the fiscal situation now may indeed be a luxury. That it may be more sensible to build public infrastruture at any cost, and aim for higher growth which will take care of the other problems. Jaswant Singh was given a blueprint for tax reform - the Kelkar reports - and he thought he had the luxury of averting his gaze.

Many in the political system have watched economists playing Cassandra on the fiscal deficit for a decade. There may be some who think that India can live with a deficit of over 5 percent without suffering apparent damage. The key point is to see how large deficits in the last few years have driven the debt/GDP ratio up from 60 percent to 80 percent. Assuming an average interest rate of 6 percent , roughly 5 percent of GDP will be spent per year on the annual interest payments alone. When debt/GDP was at 10 percent, the country could have a few years with a 5 percent deficit and it was okay. When debt/GDP is at 80 percent, interest payments will choke off all other spending.

The lack of seriousness about public goods and fiscal prudence is central to what we may call `the feel bad factor'. It is important for all of us to ask: How might this play out now?

One element is the expenditure side. A higher debt GDP ratio implies higher interest payments and constrains other government expenditure. Many people engage in wishful thinking that when the government has its back against the wall, the public goods will stay and the handouts will be jettisoned. This is the hope that the next steps in improving governance in India consist of attacking PDS, closing down the Food Corporation of India, the Ministries of Steel, of Commerce and Information and Broadcasting.

We need to recognise the real possibility that the outcomes could turn out upside down; that Parliament could choose to hang on to the handouts and kill off the genuine public goods. Choking off the supply of public goods will choke off the engine of growth.

Some state governments have problems paying salaries to policemen and school teachers. It is hard to see a more dire sign of fiscal distress. It is important to note that Parliament has chosen to devote resources to the fertiliser subsidy and to bailing out UTI, rather than spending that money to pay salaries to policemen in certain states.

In case no move is made to start containing the deficit, one soft option may be for the government to monetise part of the deficit. A MoF with its back against the wall could play the monetisation card, i.e. exploit the inflation tax.

But there will be a host of very painful consequences. This will pull up nominal interest rates, as inflationary expectations rise. An interest rate shock will be devastating for the banks, given RBI's mistakes in measurement and regulation of interest rate risk. NAVs of income funds will crash. Tens of thousands of crore will flee from income funds, who will have to sell bonds as a consequence.

In the years after 1996, there has been no sustained pick up in private investment. Today we see signs of the private sector keen on investing. As Raghuram Rajan remarked in a recent interview on the Indian economy, the problems associated with a large public debt will become visible if private investment in India starts to rise. The hopes about India are predicated on all this unfolding in an orderly way. There is a good chance that it will not.

And then, there is the political system. In the late 1980s, when India's economy was not performing well, this brought out the worst from the political system. Politics then became focused on trying to grab a bigger slice of a shrinking pie. The relative calm of 1993-2003 in politics was partly driven by the growing pie. If that changes we could revert to a situation like the late 1980s and early 1990s. We could well see a resurgence of destructive influences. If we don't take governance seriously, hopes about India will flounder.


The author is at NCAER. These are her personal views.

Ila Patnaik