In the shadow of the deficit

Indian Express, 26th February 2013

Finance minister must strike a balance between poll pressures and imperatives of reform

When Finance Minister P. Chidambaram stands up to present Budget 2013 later this week, he will have to walk a tightrope between a budget that makes investors optimistic about India and one that satisfies his party, especially those in the Congress who want welfare programmes and subsidies. In Chidambaram's earlier stint as finance minister, walking this tightrope was not as difficult as it is today because the economy was growing fast, the fiscal deficit was under control and the current account deficit was much smaller than it is today.

The forthcoming budget is expected to be the last one this government can present. Next year, there might be a vote on account, in view of the elections that will follow soon after. That makes this budget the last chance for the UPA to fulfil all the election promises it made. If Congress MPs feel that they are not going to win the next elections, the desperation to expand welfare programmes will only increase. This could involve a stepping up of expenditure, which the government can ill afford at the moment.

Introducing new programmes like the food security bill, or continuing old programmes and increasing expenditure on them, needs money. With a slowing economy, tax revenue growth is unlikely to be buoyant. Even if the finance minister tries to come up with proposals to tax the rich more, it is unlikely that he will raise much revenue from them. Further, even if he is able to introduce the GST, revenues might not go up in the first year. Infrastructure issues, compensation to states for Central sales tax cuts, and the costs of implementing the new system will mean that he cannot depend on higher tax revenues in the coming year.

So will Chidambaram project a higher budget deficit? No, because that would be a problem with domestic and foreign investors. Consequences of the fiscal deficit, such as higher inflation, private investment being crowded out by large government borrowing and the spillover to the external sector, remain concerns, as in the past. What is new, perhaps, is how close we are to a credit downgrade. If credit rating agencies believe that our fiscal deficit is going to be higher in the coming year, India could get a downgrade. That would push up the interest rate Indian companies have to pay when they borrow abroad.

The domestic banking sector, with its rising number of non-performing assets and loan restructuring, has seen its balance sheets weaken. External loans remain an important source of borrowing for large corporations. Domestic interest rates are also unlikely to come down very much unless inflation goes down, of which there are few signs so far. Unlike in previous years, when the size of the fiscal deficit was an academic debate rather than something that bites the corporate sector, it is different this time.

If Chidambaram is under pressure to increase expenditure in some areas, as his party desires, he has to cut expenditure in others. The freeing up of diesel prices has been an important development in curtailing expenditure. First, it has indicated Chidambaram's commitment to containing expenditure on oil subsidies. Second, the price hike passed relatively peacefully, without creating a political storm, as most people might have expected. This bodes well for the finance minister's plans. He can make projections of not just the oil subsidy going away in the coming year but also of other subsidies going down to provide, for example, for an increase in food subsidy.

The second major concern of business is the investment environment. While Chidambaram set up the Cabinet Committee on Investment a few months ago to speed up stalled projects, investors have not seen any action on that front. It has not inspired confidence and encouraged investment again. With no change in the legal framework, few believe that a government committee could solve the problems. However, many were willing to give Chidambaram the benefit of doubt, and to wait and watch. Here again, we run into trouble with politicians in the party who might want to say they stand for tribal rights, environment and land rights, much more than they would have when not faced with an upcoming election. If legal changes are proposed this year, they may not be in keeping with the kind of balance that India needs to strike between development and the protection of various affected groups. If they are not proposed, investors will continue to have low confidence.

A major concern of the minister would be to keep foreign capital coming in to fund India's large and growing current account deficit. One small mistake in the couple of hours when Chidambaram makes his speech could cause a loss of confidence, months of flight of foreign capital and a depreciation of the rupee. It could be new foreigner unfriendly taxes, such as the GAAR of last year. It could be a capital gains tax, since in India, taxes are not residence based and foreigners are taxed. Or the budget speech could talk about renegotiating the Mauritius double taxation treaty. Or it could be something else that the zealous tax department thinks of in its attempt to reduce the budget deficit. Any tax on capital inflows, at a time when the country needs to finance its current account deficit by attracting them, would not be pragmatic.

Not only does Chidambaram need to be careful about taxing foreigners, Part A of the budget speech, which is the government's reform agenda, has to be persuasive, investor-friendly and inspire confidence. Part B of the speech, which includes his tax and expenditure proposals, has to keep the deficit under control and his party colleagues happy.

With a non-performing government, a party seeking to buy votes, a declining economy, an uncertain global environment, persistent inflation, a large deficit and colleagues wanting an election-friendly budget, Chidambaram clearly has a tough job ahead.

Can't figure it away

Indian Express, 12th February 2013

Arguing over GDP numbers won't convince investors. Government must focus on fiscal correction

The ministry of finance has responded strongly to the Central Statistics Office (CSO) estimates for GDP growth of 5 per cent in 2012-13, saying that it is an underestimation. Normally, it would be surprising to see the ministry respond to growth numbers as loudly as it has done this time. But in this case, it was not entirely unexpected. The CSO's estimates can upset the finance ministry's promise of a lower fiscal deficit number. On his recent foreign tour, Finance Minister P. Chidambaram promised a 5.3 per cent budget deficit. This rests not only on projections of revenue, expenditure and the gap between them, but also on the denominator, GDP.

All the important assumptions made in the projections for the 2012-13 budget deficit have gone awry. During April-October, tax revenues grew by 14.54 per cent. This was lower than the 20 per cent growth assumed in the budget. Expenditure growth, at 14.6 per cent, on the other hand, was higher than the 13 per cent expenditure growth.

The fiscal situation is already difficult. With unmet disinvestment targets, a large subsidy bill that has yet to be impacted much by higher fuel prices and a newly launched cash transfer scheme that is unlikely to give efficiency gains or any reduction in expenditure in this budget, cutting expenses on the big ticket items is not easy. The finance ministry's credibility is already fragile. The CSO's GDP estimates can further hurt it. A smaller GDP number will yield a higher fiscal deficit to GDP ratio.

Under the current system of budget making, the government makes an assumption of GDP growth while preparing estimates for the budget. The ministry has insisted that growth will be 5.5 per cent. Since these are all only projections of production in the economy till March 31, 2013, it is surprising how anyone can be very confident about what GDP growth is going to be. Indeed, during the last two years, most projections of GDP growth for India have been slashed. The IMF's projection for GDP growth for India in 2012 is 4.5 per cent. Looking at the relentless decline in investment growth, it seems a more plausible estimate than the ministry of finance's 5.5 per cent. Even if the ministry is seeing green shoots of recovery, none of the publicly available indicators show them yet.

As it is natural for the government to try to show a low ratio for the fiscal deficit, it has the incentive to choose an implicit GDP growth rate that is higher, making the budget deficit ratios smaller. The best way to address this issue is to set up an independent panel to provide GDP forecasts.

Today, there are a number of independent forecasts for the Indian economy being made by those monitoring the economy. In general, these forecasters are conservative in that they tend to move with the consensus and their assessment may not be very far from what the government itself is saying. However, to the extent that they are not conflicted, in that they are not producing the budget revenue and expenditure decisions and the deficit ratios, the forecasts they produce are independent. These should go into the budget process.

Chidambaram has made an effort to cut expenditure and raise revenues in the last few months. Many positive steps, especially where policy decisions were in his hands, have been taken. The significance of cutting the deficit and its impact on the economy is high at this moment. A clue lies in the fact that the FM undertook a foreign tour to reassure foreign investors at a time when he would normally be busy with the details of the budget. The macro picture of the budget is extremely important today and that is why, perhaps, the ministry responded so strongly to the CSO estimates.

The reasons for the importance of the macro picture lie in the difficulties currently being faced on the balance of payments. India has had a large current account deficit of 5.4 per cent of the GDP. This means India needs to keep up an inflow of capital despite falling growth and worsening public finances. This can be done if foreigners are assured that in the long run, India is a good investment opportunity, that India is on the path of implementing reforms that will ensure a strong currency. A decline in capital flows can cause a rupee depreciation. A rupee depreciation would put further pressure on the fuel subsidy bill as the price of every barrel of imported oil will increase. Further, it will put pressure on domestic prices. While it is unlikely that a small change in the fiscal deficit number would stop foreign capital from flowing into India, it shapes views on future current account deficits and the strength of the rupee.

In addition, a large fiscal deficit could cause a ratings downgrade for India. This would increase the cost of borrowing by Indian companies abroad. Domestic credit growth has declined. Banks are reluctant to lend because their own balance sheets are not looking healthy. External financing is relatively cheaper, but only so far as the credit rating is good and the rupee is not expected to depreciate. Both these require the fiscal deficit to remain low.

A slightly higher denominator in the budget deficit to GDP ratio may appear good in the immediate context. But if the health of India's fiscal condition does not improve, no one is going to be fooled for long. The difficulty may get worse if the current account balance does not improve. Instead of focusing on how to defer the bad news, the government needs to focus on how it will actually do a fiscal correction. If the government is going to introduce the Food Security Act, there should be a clear indication of what it means for this year's and the following year's government expenditure. Unless such careful analysis is done of various government programmes, no amount of relatively good news obtained by arguing over GDP figures is going to convince any investor that India is worth the risk.

Right hand, left hand

Indian Express, 5th February 2013

Government hasn't thought cash transfers through. Food security bill adds to the confusion

Does the UPA government believe that the public distribution system is broken and cash transfers are needed, or does it believe that the PDS works well and can serve a multiple of the numbers it is currently catering to?

In the budget session of Parliament, the government is expected to further push subsidy expenditure through cash transfers. In the same session, it is expected to table the food security bill. Surely, it is clear that there is a contradiction between the philosophy of the two. The strategy of cash transfers, when it means giving money to poor households to bring them above the poverty line, is based on the philosophy that households should be free to choose what they buy. Providing subsidised cereal to households is a policy that is based on the notion that it is best if the state decides what is good for the people and provides it. It is unlikely that in the mind of this government, that has not yet clearly articulated the full policy, cash transfers are designed to be like a negative income tax where freedom of choice is given to the individual and the family, which can buy what it chooses to. A badly designed cash transfer scheme would be one linked to consumption of specific items - food, education, kerosene, fertiliser, etc. Under this scheme, the choice of where to buy would lie with the household.

Currently, cash transfers are limited to a few small items like scholarships and pensions. They can be kept limited to these items and incrementally expanded to include a few more. Or, they could be expected to cover all subsidies, where an income subsidy amount is paid directly to the beneficiary, rather than through a price subsidy on particular items. If the logic of cash transfers was to be carried forward, each poor household would be given a sum to money to pull it above the poverty line. Like an income tax, which is paid by better-off households to the government, this would be a benefit or a "negative income tax" the government pays to households.

Giving poor households money is based on the belief that no one understands the needs and priorities of the household better than the individual and her family. If she chooses, a person below the poverty line could pay for the transport that takes her to a hospital instead of buying 10 kg of rice. Cash transfers are genuinely meaningful if they become the main plank of a government's anti-poverty programme. If it is one of many programmes, then it has a marginal impact on both efficiency and government expenditure.

Cash transfers in, say, scholarships or pensions, can only solve the problem of delay in payments. If combined with Aadhaar, there will be some additional saving for the government, as ghost and duplicate beneficiaries can be removed from the system. This might save as much as 10 to 15 per cent of the expenditure under that head. The big savings through cash transfers can come if, instead of paying a price subsidy, say on wheat, the government could transfer money directly to a family to buy a minimum consumption bundle to rise above the poverty line. That would enable the government to get rid of a large number of price subsidies, such as those on kerosene, LPG and food. Families would then buy these directly at market prices. The theft and wastage from the public distribution system would go away.

The food security bill, as proposed to be tabled, is based on a completely different philosophy. Not only does it assume that it is best for the poor in India to eat wheat and rice - instead of pulses, fish, vegetables, eggs or milk - it also assumes that the state will handle the purchase, storage and sale of this wheat and rice better than the market can. It assumes that this wheat and rice (often rotting, as it is stored in the open due to the shortage of warehouses with the Food Corporation of India) will be bought by the people. It assumes that people are not buying large quantities of wheat and rice because the price is too high, and that once it is supplied by the government at a low price, they are going to buy it.

Several assumptions about individual preferences are being made here. It is being assumed that the behaviour observed in household data that shows that diversity in food, and particularly the preference for protein such as dal, eggs, fish, chicken and meat, does not hold true or will not hold true as incomes rise. But the evidence suggests otherwise. In the last few years, there has been an increase in the price of proteins and some observers have linked the price rise to the increase in demand resulting from rural incomes going up. On the other hand, cereal prices have not been the fastest growing prices. The prices of non-cereal food items have grown the fastest, reflecting growing demand.

In addition to the issue of preferences is the problem of leakages from the PDS. The problem is well known and understood to be large. Many committees have suggested shutting the PDS down and replacing it with food vouchers. If the bill is passed, then for providing 67 per cent of the population some 50 million tons of cereals, the PDS will have to be expanded.

The answer to why the government is moving in two opposite directions does not appear to lie in the political beliefs or philosophy of the Congress. Maybe it lies in the strategy of providing goodies to voters in whatever way possible. If the strategy works and the Congress is voted back to power, the food security act will likely become one of the biggest headaches of the next government. Instead, the government should focus on fiscal consolidation and growth in this budget, and not promise more money down leaky pipes.

Reform, then remove STT

Financial Express, 28th January 2013

The rate must be lowered, foreign participants should be reimbursed, and finally the tax must be removed over 4-5 years

Realistic discussions about whether the Union Budget should propose to remove the securities transaction tax (STT) or introduce a commodities transaction tax need to be more balanced than simply saying a complete no or yes to either. The first principles of public finance teach us that we should not tax transactions. Taxes like customs, octroi or excise-which tax transactions-have to be removed. All the tax revenue of the government must come from three sources: income tax on individuals, the goods and services tax, and property tax. This is the long-term direction of tax policy.

In this setting, STT was clearly a move in the wrong direction. But, in 2012-13, it was estimated that it would raise R5,920 in tax collection. This is a sizeable amount of money. To be pragmatic, it is unlikely that at a time of fiscal crunch, the tax would be removed completely. It can, however, be reformed slowly, in the following three stages. The first stage is to lower the rate by increasing the tax base. This would be revenue-neutral and reduce the visible distortions associated with the tax. The second stage would be to reimburse foreign participants, as is done with zero-rating of VAT. The third stage would be to set a timetable for removing the tax over a four or five year period. These steps add up to a feasible strategy for the reform of STT.

The introduction of STT in the equity market has given distortions in the financial system. There are four components of the financial system: currency, fixed income, commodities and equities. The imposition of STT upon only one-the equity market-has given incentives for market participants to focus on the other three. There is an artificial avoidance of equity market activity, with employees, public participants and capital shunning the equity market in favour of the other three markets.

All taxes are distortionary, and a basic principle of public finance is that we should have a low rate that is spread across a large tax base. It would hence make sense to cut the magnitude of STT and apply it across all organised financial trading-i.e. equities, currencies, commodities, and fixed income. This would generate no adverse impact in the short run while reducing the distortions in the economy where market participants are avoiding activity on the equity market.

A major problem that India now faces is the loss of market share of onshore finance. The most important financial products of India are stock market indexes-Nifty and BSE Sensex. In both cases, severe competition is now found from overseas markets which do not have an STT. Nifty futures, trading in Singapore, have no STT. This puts the onshore market at a disadvantage. As figure 1 shows, the offshore market has rapidly gained market share in Nifty futures.

When foreign investors send an order to India, there is an entire chain of activity where revenues are generated. This includes brokerage companies, accountants, lawyers, hotels, aviation services, etc. When the same foreign investor sends this order to Singapore instead, this entire chain fuels the Singapore economy instead. The magnitudes of the impact on the economy is vastly bigger than those seen as tax revenues for the government through the existing STT.

In this situation, a reduction in the magnitude of STT on the equity market would help in two ways. First, it would bring capital and labour back into the equity market to a greater extent, and thus increase liquidity of the onshore equity market. This would, of course, benefit the domestic economy. In addition, a foreign market participant would be more inclined to send an order to India as opposed to Singapore when the Indian market is more liquid. The second and direct impact would come through the impact of a reduced STT which directly reduces the cost faced by a foreign investor operating in India.

This first stage of STT reform-reducing the rate and applying it to all organised financial trading-is revenue-neutral. In the jargon of economists, implementing it would be 'Pareto superior': it yields gains without hurting anyone.

The second stage of the STT reform should be the establishment of a system through which foreign investors are refunded the transaction taxes paid by them. The decision by a foreign investor to send an order to Singapore versus India should not be distorted by tax considerations. We have already done this in the field of goods. When steel is exported from India, the entire burden of indirect tax suffered in India is refunded through 'zero rating of exports'. By the same principle, when trading services are exported to a non-resident, the entire burden of domestic taxation should be refunded to him.

Through this, we would get a level-playing field on taxation, in the eyes of foreign investors, about trading in Singapore versus trading in India. The competition between Singapore and India in finance should be played on genuine factors, such as pricing and service quality. It should not be about avoiding policy mistakes in India.

This second stage of the STT reform costs money for the government. Given that FII transactions account for roughly 15% of turnover, it would involve a direct reduction of revenue for the government of roughly R900 crore a year. At the same time, some of this difference would come back to the government through increased tax revenues on the increase in GDP that comes when foreign transactions that are going to Singapore shift to India.

The third stage of the STT reform is linked to a broader programme of fiscal consolidation. Indian public finance is in very poor shape. The strengthening of public finance critically relies on building the GST, removing subsidies, and on scaling back the UPA's welfare programmes. These changes will not be achieved in a short time. Hence, the government must commit to a five-year programme through which the taxation of financial transactions would be phased out. This is the kind of time horizon over which the GST, and efforts are reducing subsidies and welfare programmes, would kick in.

Bank for the buck

Indian Express, 24th January 2013

This year the government will put in Rs 12,500 crore for recapitalising public sector banks. Year after year, the ministry of finance puts more money into PSU banks. To expand banking in India, the government has chosen a two-pronged approach: putting more money into public sector banks while giving new licences for banking to private companies. In the present Indian system - with its lack of transparency, absence of the rule of law and pervasive corruption - a better policy to expand banking in India would be to divest public ownership of banks and convert them into widely held private banks.

Such a policy would address some of the RBI's concerns about industrial houses owning banks, limit the use of taxpayer money to support inefficient banks and give the country a competitive banking system. India's experience with public banks that have become widely held private banks, such as HDFC and ICICI, has been better than with new private banks, where family-dominated firms obtained licences.

Policy-makers in India like to claim that we have not had a banking crisis for a while. This claim is called into question when we witness the stream of money that has gone into PSU banks. Almost every year over the last two decades, the government has injected taxpayer resources into PSU financial firms. If we had done a recapitalisation of Rs 100,000 crore at one shot, it would have been obvious that there were big failures of financial regulation and policy. But when we dribble it out as Rs 10,000 crore per year for 10 years, it is not seen as rescuing a failing financial system.

PSU banks are not profitable enough to grow on their own steam. This reflects the failure of bureaucrats as bankers. Normally, profits are reckoned after paying for bad loans, and retained earnings are ploughed back into the equity capital of the bank. The equity capital with a bank determines how much of deposits it can take. A PSU bank that does not have equity capital will be forced to not take more deposits from the public. This constraint does not bind it as much as it should, as the RBI has often been lenient, tolerating the inadequacy of equity capital.

Indian banking has been rigged in favour of PSU banks in numerous ways. The RBI has blocked the entry of foreign banks and new private banks in an attempt to protect the cosy domination of PSU banks. A man who deposits money in a PSU bank knows it has the backing of the government. This is not the case with their competitors, and that helps increase the market share of PSU banks. Despite these violations of competition policy, PSU banks have failed to be adequately profitable. This makes them go back to the finance ministry for more equity capital.

At present, we have a finance ministry that is tightfisted when it comes to putting equity capital into PSUs owned by other ministries and discusses disinvestment of its holdings, but it is willing to put in additional capital when it comes to banks that are in its domain. The finance ministry needs to be as sceptical about putting equity capital into PSU banks as it is about putting equity capital into any PSU. If Air India does not get money, why should the SBI?

India is in a dire fiscal crisis and every single opportunity for cutting expenses should be harnessed. Even if there was money available for spending, it has better applications. In recent years when we have typically been lavishing Rs 10,000 crore every year into PSU financial firms, India would have done better if this same Rs 10,000 crore had been spent on building 2,000 kilometres of highways, or a metro system for a mid-size city like Nagpur.

A better option is to dilute government ownership in PSU banks and allow them to run and grow as normal private banks. In 1969, when banks were being nationalised, Indira Gandhi's economic policy team thought it was wise for government to have 51 per cent ownership of PSU banks. We have reversed almost every element of Indira Gandhi's economic policy framework, and this should be no exception.

We have two successful privatisations of PSU financial firms before us: HDFC and ICICI. Both were once controlled by the government and both are now dispersed shareholding companies. They were not sold off to some family, they became modern corporations. This roadmap - building dispersed shareholding private companies that are controlled by no family - should be followed for all PSU banks. This will require carrying legislation through Parliament, and it would make good use of the scarce political capital that the UPA possesses.

The government has made a case for giving out new licences for private banks. The RBI has rightly expressed concerns about banks run by industrial houses. In the past, Indian banking has suffered as the mechanism to prevent theft of depositor money by private banks lending to their business interest has been an issue. Banks must be dispersed shareholdings with professional managers - as is the case with ICICI or HDFC. In an ideal situation one would argue that the banking regulator should give licences to firms that it deems fit to run banks, but in today's India, most people, and perhaps the regulator itself, is correctly concerned about the political pressure that may be brought to bear on the regulator if it opens up the gates to new private bank licencing. It would be wise to gather experience with enhanced supervision of lending to conglomerates before venturing to give bank licences to large industrial houses, who are often the ones with the money to apply for such licences. As the recent IMF financial stability assessment report also points out, in the current context, the risks of this policy may outweigh its benefits.

Another option to expand banking in India is to open up the sector to the entry of foreign banks. At present, India limits foreign banks, in all, to 18 bank branches per year. A much more open policy framework is required, through which foreign banks can build subsidiaries in India, who are then regulated by the banking regulator on the principle of ownership neutrality and given national treatment, including the lifting of all restrictions on opening branches.

The government should consider these policy options more carefully to give India a safer and more competitive banking system.

A finer balance

Indian Express, 10th January 2013

India's current account deficit has risen sharply to above 5 per cent of the GDP. Finance Minister P. Chidambaram is reported to have reacted to the balance of payment statistics by saying that he may have to increase the import duty on gold. If the solution to the country's balance of payment problems lay in high import duties, India would never have had the 1991 crisis.

Fortunately, in the July-September quarter, the previous finance minister's budget proposals on taxing foreign capital flows were not implemented, otherwise the balance of payment situation could have been much worse. The government should now conduct a stress test capturing the scenario of a sudden drop in foreign investment flows and its impact on the economy. This should form the basis of thinking about a policy framework in which the Indian economy would be resilient to such shocks.

The current account deficit in July-September 2012 stood at 5.4 per cent of GDP. Thanks to foreign investment inflows, both direct and portfolio, India did not witness a sharp depreciation of the rupee during this period. Depreciation would have made the already high inflation worse. It would have put a lot more businesses, already looking for debt restructuring, in greater difficulty. Portfolio inflows between July and September 2012 were $7.6 billion. In the same quarter of 2011, there was a net portfolio outflow of $1.4 billion. Suppose a similar swing takes place in the next quarter - what will be the impact on the economy?

Complacence on the part of policymakers would be a mistake. The total quantities of exports or imports are not determined by the government. Policies can only change incentives to buy or sell globally traded goods and services. If, due to a change in global conditions, there is a change in global financial flows, the current account deficit would be financed by trade credit or debt flows. This could potentially pave the way for a much bigger crisis. There would likely be greater pressure on the rupee to depreciate. The government would, in all probability, step in with a number of knee-jerk reactions to stop capital outflows, to prevent dollar borrowing, to push the RBI to intervene to prevent rupee depreciation, to first impose higher duty on gold and then post additional customs officers as well as have stringent checks at international ports and airports to prevent smuggling. Measures with origins dating back to the licence quota raj will be conjured up, with the hope that this time they would work.

The most important aspect of the recent BOP statistics is that the rise in the current account deficit is due to a decline in exports, not a sudden increase in imports. In fact, imports are lower as well. As the world economy has slowed down, so has export demand. Even with a relatively weak rupee, the effect of a slowdown in the US and Europe has reduced exports.

For now, service exports have held up. But if difficulties in the West continue, it is hard to see how Indian exports can keep growing. We certainly should not have policy frameworks that avoid a crisis only in the very optimistic scenario of Indian exports growing fast or foreign investment flowing to India, despite all the turmoil in global markets. Today, that is our policy framework for the external sector. How will a fall in exports, a depreciation of the rupee, a sudden stopping of foreign investment affect our balance of payments? To make the economy resilient in the face of lower export demand and in the event of a fall in foreign investment flows, we need to ask whether our policies make imports elastic as well.

Imports of gold, silver, precious stones and gems, mainly used in jewellery exports, fell in July-September 2012. Other imports, meant for domestic consumption, however, continued to grow. If we believe that demand responds to changes in prices, as we seem to in the case of gold, we should think about our bizarre policy of subsidising imported goods and making them cheaper. Our biggest import, petroleum, and its products, such as diesel, kerosene and urea, are sold to consumers at subsidised rates, encouraging consumption of these products. Exchange rate changes to these products are passed on slowly as the government fixes diesel prices in rupee terms and changes in administered prices are made only after huge delays. If market prices had prevailed, a fall in exports would have led to a rupee depreciation. This would have pushed up the price of imported oil and, at least in the long run, reduced consumption.

Subsidising imports is different from subsidising a domestically produced non-tradable service like education. If the expenditure is financed by borrowing, not only does it push up domestic demand, it does so for an import-intensive good. This was not an issue in the first decade of the 2000s, when Indian exports were growing rapidly. The main focus of the debate in the context of the oil subsidy was the large subsidy bill, the fiscal deficit, the price distortion, the leakages, the adulteration of diesel with cheaper kerosene and so on. But now that the current account deficit has risen to more than 5 per cent of the GDP, we need to think about oil subsidies in terms of the impact they have on the current account deficit as well.

For many years, economists have been crying themselves hoarse about the dangers of a large fiscal deficit. They have warned that large deficits may lead to higher demand, resulting in inflation, and spill over into a current account deficit. But the Indian economy seemed to defy this logic. As the world economy did well, exports, both merchandise and service, grew rapidly. At the same time, as India's financial integration increased, dollars came into the capital account, financing our trade deficits. So, not only was the current account not very large, usually between 2 to 3 per cent of the GDP, the dollar flows kept it easily financed and there was no crisis. But this time may be different.

Why reforms aren't lifting growth

Financial Express, 28th December 2012

Investment is unlikely to take off as highly leveraged firms and stressed banks can't take on more risk

Recent initiatives by the government-the postponement of GAAR, FDI in multi-brand retail, and the proposal to set up a Cabinet Committee on Investment (CCI), earlier called the National Investment Board, have not started showing up in pushing growth up as yet. This is not surprising because deeper problems remain. Power projects still face problems in obtaining coal as raw material and collecting money for power distributed and sold to states. Highly leveraged companies and banks with stretched balance sheets are in no position to take further risk. Investment is likely to remain low till policy changes to solve deeper problems and companies and banks have time to clean up their balance sheets. The cautious optimism that came with policy reforms has not yet started giving signals of a growth upswing.

Recent data on output, exports and credit do not show an improvement. Under these circumstances, GDP growth in 2013-14 could well hover around 5-5.5%. The government seems to be banking on fast track clearances to stalled projects. This is unlikely to be have a large effect in the short run. Few companies are in a position to start investing in new projects today. Few banks are in a position to lend to them. Perhaps these are among the reasons why data is not showing a pick-up so far.

Let us look at the most recent data. Monthly and quarterly data needs to be seasonally adjusted before it can be used. Otherwise, seasonality in the data can make month-on-month comparisons meaningless. But once this is done, it offers more insights into the most recent trends in the economy than the yearly growth rates do. Instead of being an average of the last 12 months, the data can reflect the month-on-month moving average. This indicates what year-on-year data would do with a lead of about 5 months. We look at a few leading and coincident indicators of the economy using seasonally-adjusted data below. This data is available at here, from where it can be downloaded. In most cases, the data shows the 3-month moving average of the month-on-month seasonally-adjusted variable.

Figure 1 shows the seasonally-adjusted growth rate of GDP. This number has now settled just about 5% and is not showing up and down swings of the kind that were happening till 2010.

Similarly, figure 2 shows the 3-month moving average of the seasonally-adjusted IIP growth. Again, once growth declined after 2010, it has not swung back. The monthly volatility has dampened and growth is fluctuating around zero.

Figure 3 shows the growth in non-food credit. This is measured in nominal terms, unlike production data indices, which are measured in real terms. Again the month-on-month seasonally-adjusted rate has slowed down, and on average the growth has been roughly 15%, which is just a little higher than the inflation rate. Credit growth has thus slowed down to the growth rate of roughly to about 5%. Credit growth usually rises before an upswing in production. The slow growth shows that the credit has not started expanding yet.

Figure 4 shows the increase in the rupee value of non-oil exports growth. We focus on non-oil exports since oil exports have more to do with the domestic fuel pricing policy induced refining in India, rather than an indication of business cycle conditions. Again, the month-on-month growth data is dismal. While export growth depends on the conditions in the rest of the world, it is sometimes a leading indicator for output in the Indian economy. When exports start rising, other production rises in response.

Figure 5 shows the growth in the rupee value of non-oil imports. This is often a coincident indicator as higher production requires higher import of raw materials, and India is a large importer of raw materials. More investment requires more imports of machinery. But, as we see, import growth shows no upswing.

To summarise, the variables that are in general seen to show an upswing when the economy shows an upswing, are not showing improvement so far. This does not bode well for the economy. Other evidence, which shows that investment growth has slowed down this year, from more than 12% to around 5%, has been a cause for concern. Returns from projects in which companies have invested appear to be low, or are zero, as companies grapple with missing infrastructure, stopping of raw material supplies due to delay in environmental clearances and concerns over forest peoples rights. These companies are highly leveraged, have capital trapped in large projects that have been stalled due to government incompetence or corruption issues. In many cases, these companies have had to go in for debt restructuring of their bank loans. These companies are not particularly in a mood to invest. Even if interest rates are lowered, there is likely to be nothing more than a marginal increase in investment, if at all.

Will the CCI, that will push to getting stalled projects started again, be able to bring back high GDP growth. First, there are questions about the power and the legal framework in which the CCI will function. The committee might not have had the required powers to work had it been under the ministry of finance. Other ministries had objected to it giving clearances to projects that the relevant ministries had not given. It has, therefore, been brought under the Cabinet, which can play the role of coordination and apply time lines for all clearances. But it still remains to be seen how well this will work and whether projects once cleared do not get embroiled into controversy and get stuck again in court battles.

Further, will the committee be able to push all stalled projects? First, a large number of projects may have been stalled as they seem profitable under favourable conditions when the world was looking good, the economy was in a boom and credit was growing at over 30% with real interest rates zero or negative. Even if clearances are given, these projects may not be attractive today. Second, while a large number of projects may have originally got stuck due to, say, a land acquisition problem, but during the delay, the balance sheet of the company weakened as it was unable to get the returns it expected and make the payments it needed to, including interest payments to banks. Infrastructure companies, for example, would be far more cautious today about investing money in a stalled project. The bureaucracy, regardless of whether it is in the ministry of finance, or in the environment and forest ministry, will be far more cautious in giving clearances today than last year. It seems that it will be some time before a see a pick up in investment and economic activity.