In the mood for reform

Indian Express, 17th September 2012

Now the government must outline path of fiscal correction, put investment back on track

The UPA government announced a number of reform measures last week. The announcements indicate a willingness to take political risks to push the reform process. The measures are signals for investors, domestic as well as foreign, that the Indian government is willing to undertake reform. In all likelihood, India will now avoid a rating downgrade. Yet, the economy is still staring at a deceleration to 5 per cent GDP growth, lack of job growth and inflation. Now that the government has shown its mood for reform, it must push further, to put India back on a healthy growth path. The two priorities of the government today must be fiscal correction and putting investment back on track.

The time till the next general elections in 2014 should not be spent merely managing the political downside of the reform, but in building up an argument for it and promising high growth in the next term as well, if the UPA comes back to power. The UPA government must, first and foremost, outline its path of fiscal correction. Will the diesel price hike be followed up by more hikes, removal of subsidy and eventually a freeing up of diesel prices? The subsidy regime for food, fertiliser and fuel has thrown the Indian fisc into an unsustainable debt path. The present correction, owing to the oil price hike, will only mean a correction of about 0.2 per cent of GDP. The disinvestment announced could bring in another 0.2 per cent of GDP. This does not solve the fiscal problem. The deficit needs to come down by roughly 2.5 per cent of the GDP to be sustainable.

At the same time, large welfare programmes, such as the NREGA, and the proposed health expenditure, will need greater spending. Anyone looking at the rising subsidy bill, at the size of the welfare programmes, and contrasting it with the limited tax base, can only wonder why India will not have a fiscal crisis. A continuation of the present policies cannot but land the country into a huge problem. Either before a crisis or after it, there is little doubt that the current expenditure path has to change.

Will Congress rule push India into a fiscal crisis? If not, can the Congress articulate how that will not happen. Prime Minister Manmohan Singh is reported to have said that good economics is good politics. What is the prime minister's view of what is good economics on the Indian government's expenditure policy? While he has supported a concurrent evaluation of the NREGA programme, is the problem only with leakages, or can India sustain such a welfare programme even if there were no leakages? Even if every scheme works well on its own, will that put the fisc on a sustainable path? What are the projected expenses on the government's welfare schemes if the schemes work without leakages? By what per cent is the expenditure expected to reduce?

When the slogan of inclusive growth, or NREGA, was proposed, it was popularised as a promise that the poor will not be left out of the growth process. In other words, it was implicitly assumed that India would be growing fast and a section of the rural poor would be left out of the growth process. This was why the country needed NREGA. It would help in reducing social tensions caused by high growth in some sectors and slow growth in other sectors such as in rural hinterlands. Implicit was also the argument that NREGA will be paid for by the high tax collection that the fast growing sectors of the economy would yield. Growth was to be made inclusive through a redistribution of incomes. This was the scenario when India was growing at 10 per cent and leaving some people behind. It was a scenario that might stand the test of time if India continued to grow at a long-run steady state of 10 per cent growth. This plan did not appear to evaluate the fiscal path of such a programme when growth halved.

Today India is no longer on the high of a business cycle. What is the sustainability of a large population-wide employment guarantee programme funded out of a small tax base? If production and job growth decline, will the government be able to fund such a programme? The planning commission meeting on September 15 reportedly discussed a low growth scenario of about 5 per cent during the 12th plan period. While the details of the policy logjam have not been reported, it is likely that this relates to a situation of low investment and low growth. What is the path of fiscal expenditure and taxes, debt, deficits, borrowing and interest payments in that scenario?

The other immediate priority of the government is to put investment back on track. Finance Minister P. Chidambaram is reportedly leading an effort on clearing problems caused by three years of government inaction. While one element of the story is to speed up action on the part of ministries and departments, another part of what may be required are small but effective changes in policies.

Data indicates that, one, the announcements of government projects have fallen sharply, and, two, a large number of private infrastructure projects are stuck due to lack of government clearances. The first is reportedly being pushed by the finance minister. On the second, there needs to be more policy change.

Recently, a representation from the infrastructure sector has emphasised the role of the government versus private sector in obtaining clearances. They have argued that future infrastructure projects should be bid with all sovereign clearances packaged in. They have correctly argued that securing sovereign clearances cannot be left to the private sector, and state agencies should play their role as the first partner in the public-private partnership. This would mean that the way bids are structured and awarded would be refashioned. Presently, the concerned ministry, or bid sponsor, sees its role mainly as the licensor or concession awarder. The argument makes perfect sense. This kind of streamlining can be done by the government with immediate effect and can help push investment back on track.

Sovereign warning

Indian Express, 7th September 2012

There are fears that India’s sovereign rating will be downgraded in the near future. This may, however, not happen if the policy environment is better than it was a few months ago. The new finance minister and his team have already raised the hopes of both Indians and foreigners. If the government accepts the GAAR committee recommendations on taxation, and the Kelkar committee recommendations on fiscal consolidation, the policy environment will certainly look better. A diesel price hike, if implemented next week, as reports suggest, would also play a crucial role in preventing a downgrade.

There are two issues related to a downgrade. First, when good governance and fiscal prudence can keep India’s credit rating high, Indian companies are able to compete on an equal footing with the rest of the world. By adopting better policies both for its budget and for economic growth in general, the government can provide Indian companies a better environment. Second, at a time when India has a difficult balance of payments situation, it cannot afford to have lower capital inflows that could put further pressure on the rupee. Not adopting measures that would improve the rating, but simply criticising either the ratings agencies or the ratings mechanism, will be damaging for the economy.

Today, if India does see a ratings downgrade, it will make the cost of borrowing abroad higher. When borrowing is cheaper abroad, it is attractive to borrow in dollars. A ratings downgrade will serve to raise the cost of borrowing, thus imposing a private cost on companies that borrow in dollars. Even if an Indian company is as good as a comparable one, say, from China, if India gets a downgrade then the company has to pay more for its borrowing. In a domestic environment that is already difficult, imprudent fiscal policy imposes further costs on Indian companies.

Balance of payments data for the last two quarters shows a decline in foreign loans, both in external commercial borrowings (ECBs) and in short-term loans. In almost each quarter of 2010 and 2011, companies borrowed more than $6 billion. After the last quarter of 2011, when net foreign loan inflows were $8.5 billion, there has been a sharp decline. In the first quarter of 2012 (January-March), they fell sharply to $1.6 billion. They remained low, at $2.7 billion, in the following quarter.

There has been a decline in both ECBs and short-term loans. In ECBs, we see a sharp change in 2012. There were no net flows in the first quarter. In the second (April-June), they picked up, but were about half of the net flows in the last quarter of 2011. In short-term loans, the story is even more striking. From an average of more than $2.5 billion per quarter, they have fallen to less than $152 million.

The all-in-cost ceiling imposed on ECBs by the RBI allows borrowers to pay only 350 basis points above Libor for three- to five-year loans, and only 500 basis points above Libor for loans with more than a five-year maturity period. Only a handful of Indian companies are considered creditworthy enough in international markets to be able to borrow at such low interest rates. Those with explicit or implicit sovereign borrowing or those with significant international presence may be able to do so, but the bulk of Indian companies may not be able to borrow abroad at these rates.

In earlier years, two factors played a role in Indian companies being able to borrow more abroad. First, the Indian economy was doing well, sovereign ratings were higher and more companies were able to fall within the ceiling. But, equally importantly, a large number of companies borrowed through Foreign Currency Convertible Bonds (FCCBs). The Indian borrower gave the foreign lender two options-— when it was time for loan repayment, the lender could take back his principal and pre-negotiated interest dollars or he could choose to take his repayment in the form of shares of the Indian company at a pre-determined price, often the price prevailing at the time the loan was taken.

Although most companies would have found it hard to borrow at the low all-in-cost ceilings imposed by the RBI, it was possible for them to get foreign loans through FCCBs because it also included a bet on the apparently ever-rising Indian stock market. If the share price of the company was expected to increase, the foreign borrower would be willing to lend to the Indian borrower even when it would not have done so at the interest rate the company was allowed to pay. After the crisis, when stock prices fell, lenders chose the option of asking for the principal and the interest in dollars, rather than in shares. Today, expectations from the stock markets are not looking good enough to attract a lot of money through FCCB. If the RBI leaves the all-in-cost ceiling unchanged, a sovereign credit rating downgrade would make it more difficult for Indian companies to borrow abroad and take less foreign currency risk on their balance sheets.

At present, India is running a large current account deficit, to the tune of more than 4 percent of the GDP. In the April-June quarter of 2012, the current account deficit was $21 billion. Of this, $16 billion was financed by net capital flows. The bulk of capital coming into India in 2012 is portfolio investment. In the April-June quarter, $14 billion came in through portfolio investment. Only $2.7 billion came in through loans. Foreign currency denominated loans may not be the best option for financing the country’s current account deficit but at the moment, India needs to keep up with the flow of loans, given the pressure on its balance of payments. It can ill afford a downgrade.

RBI is fighting the right battle

Financial Express, 1 September 2012

If cutting rates gives a signal of lack of commitment to controlling inflation, it will do more harm than good

GDP growth at 5.5% for the latest quarter available suggests that the slowdown hitting India is getting well entrenched. For the year 2012-13 as a whole, growth may fall below 6%. This decline in growth has been expected as both investments and exports have slowed down. The uncertainty in the world is not over and it may continue to affect both the investment environment and export growth. Improving the policy environment for investment, controlling the fiscal deficit and reigning in inflationary expectations are essential policy interventions to improve growth. Read more...

The emerging slowdown

Indian Express, 31 August 2012

Emerging economies survived the global shock in 2008 quite well. But now that the industrial countries have not fully recovered, the crisis in Europe continues, the uncertainty in world markets remains high and large emerging economies are seeing a rapid fall in GDP growth. Weak growth in emerging markets will, in turn, slow down the world economy. In the last decade, growth in the US and China contributed to a benign global environment, which made it possible for India to get away with more policy mistakes. Now, the government needs a bigger focus on building confidence in private investment. Read more...