Don't look, leap
Indian Express, 25th May 2012
Fuel price hike is the first of many big steps govt must take to rescue the economy
In the midst of a sharp depreciation of the rupee, the government announced a hike in petrol prices. This is perhaps the first of many steps the government must take to keep the economy from deteriorating further. Rescuing the economy requires a focus on macroeconomic policy that includes fiscal deficits and inflation. And better governance requires leadership in high ethical standards, the rule of law and a well-articulated and -implemented supportive environment for private and foreign investment.
The crash in the rupee and in stock prices has served as a vote of no confidence in economic policies. The recent movement of the rupee and stock prices are mere barometers of the economy and reflect deeper problems of macroeconomic mismanagement. We must stop looking for quick fixes - for one micro tweak after another - which we hope will solve the problems. Macroeconomic problems cannot be solved by any number of microeconomic interventions. If we ban currency futures trading, the rupee will still depreciate. Forcing exporters to bring half their proceeds home quickly will trigger off a new wave of capital flight.
Indeed, every time distortionary micro measures are used, it further damages the credibility of policymakers. The world at large understands that the government has a weak understanding of macroeconomics, when they see the procession of microeconomic distortions that have been rolled out in recent months. This loss of trust in Indian policymaking is a central problem that needs to be addressed.
The biggest credibility gap of the Congress is on the fiscal deficit. The budget focused on raising taxes more than on expenditure reduction. This is a bad sign; sustained fiscal consolidations are led by expenditure reductions. For many years, India was in a slow process of reforming tax policy and tax administration, which would transform the tax-GDP ratio. That policy continuity has been lost in recent years. The thirst for revenues seems to have triggered off elements of an inspector raj, which will not deliver tax revenues, and will damage confidence in India.
Policymakers have been complacent about foreign investors. We have a shortfall of capital of 4 per cent of the GDP or $80 billion a year, or Rs 1,700 crore a day. We have been complacent in thinking that every single day, Rs 1,700 crore on average would come in. We have become arrogant in thinking that regardless of how badly we conduct domestic policy, this money will flow in. However, this flow of capital is not unconditional. If we make mistakes in the tax treatment of non-residents, or if the world loses confidence in India's march towards becoming a mature market economy, there can be hiccups.
For over a decade, attempts to increase the supply of dollars in the foreign-exchange market through various capital controls and through RBI intervention have proved to be useless. We have learned that the RBI does not have much power to manipulate the rupee. The foreign-exchange market is too big to have the desired effect.
The first move in the right direction, in recent months, is the petrol price hike. But it will reduce the loss of oil companies and the subsidy the government provides only to a small extent. A complete decontrol of diesel and kerosene will be needed for the government to avert a bigger crisis. However, it is a welcome change in that the move is in the right direction, unlike other attempts in recent months.
Under UPA 1, the economy was booming. Tax collection was high. The Tax Information Network gave it a fillip. In a booming economy, fiscal problems tend to get buried. Mistaking cyclical conditions for long-term gains, the government was encouraged to increase expenditure. There were key problems with the kind of expenditure undertaken. It was either proposed as "rights", which makes it legally difficult to cut down, or the expenditure was on items that were ideological issues, like diesel, kerosene and food subsidy, which makes it politically difficult to cut down. UPA 2 continued the profligate way of life of UPA 1, despite the global financial crisis and the decline in domestic investment. Macroeconomic stabilisation was not on the UPA's agenda despite many warning signals, such as persistent inflation, that there were basic problems.
India runs a current account deficit. This was fine as long as foreigners were willing to invest their money in India. But the moment foreigners lost confidence in the government, it suddenly became impossible to finance the deficit without borrowing too much in dollars. Borrowing from abroad for financing our overspending is terribly risky. In no time, we could build up billions of dollars of debt. The key, therefore, is to immediately cut spending and bring down the fiscal deficit.
On the contrary, if the UPA 2 government continues the way it has been doing till now and brings in, for example, the Right to Food Act, when its fiscal deficit is already large and when the country is facing a sharp decline in the growth rate of investment, it could trigger a much bigger crisis. Short-term, private, dollar-denominated debt could pile up in the process of funding the current account, and if, like in many emerging economies, there is a sudden reversal of the debt as well, there will be few options left. Many people propose that the RBI sell reserves to finance the deficit. In effect, we would buy oil using past savings and sell it cheap to households. Consumers would continue to consume large amounts of fuel as there would be no incentive to cut consumption. The current rupee depreciation, at least, has helped to bring this issue into focus: long queues to purchase fuel could make the government even more unpopular than higher prices.
The UPA, in its three-year celebrations, has indicated that policies need to change. Instead of following a policy of reform by stealth, the government now needs a sharp, clear and well-articulated reform agenda. The Congress itself needs to break free both from old socialist and newer, European-type, welfare-state ideologies that are proving to be beyond what India can afford.