Growth pick-up still a mirage

Financial Express, 30th April 2013

Even if all projects were to get clearances tomorrow, we may see actual activity in less than half

The Prime Minister's Economic Advisory Council (PMEAC) report suggests that higher GDP growth next year is achievable if government policies and administrative actions support investment. Primarily, if the government clears stalled projects, and environment and other clearance are given for projects through the Cabinet Committee on Investments (CCI), Indian GDP growth can rise to 6.7% next year.

The problem of stalled projects has seen some progress in recent weeks as the CCI gave clearances to oil and gas projects. The mandate of the CCI is to give clearances to large projects. While this is a step in the right direction, and would lift investment and growth even if only a few large projects get kick-started, there are additional difficulties that would need to be addressed before growth can pick up to 6.7% next year.

First, some of the projects that are stalled today were bid before the 2008 crisis. Remember the pre-crisis years? Growth in India was in double digits, the world economy was booming and almost every investment project looked attractive. The pegging of the rupee to the dollar led to a high growth of forex reserves and consequently bank credit. Some of the bids by the private sector were quite aggressive based on its over-optimism. In today's far more sober environment, it is not clear that even if given clearances, all of those projects would be attractive. At least a third of them might appear to be unattractive.

Second, the projects that are stuck in mid-way for many years have had financial implications for the balance sheets of the companies and banks involved. Long delays in completion of projects has meant that companies have not been able to pay back loans taken for the projects. Banks that had given loans have seen these loans get into trouble. Many banks are reluctant to call these non-performing loans. Many loans have been re-structured. RBI data shows that the growth of restructured advances has been much faster than credit growth of banks. Between March 2009 and March 2012, while total gross advances of the banking system grew at a growth rate of less than 20%, restructured standard advances grew by over 40%. Public sector banks account for a disproportionately large part of this. Restructured accounts have grown at a rate of 47.86% in public sector banks as against a growth rate of credit of 19.57%. Loans to industry, especially large industry, have seen the most restructuring. Public sector banks, especially after the recent corruption scandals, may be reluctant to lend to companies in distress even when they can.

The above suggests that even if a project bid by a large company obtains a clearance, the company may no longer be in a position to undertake fresh borrowing to undertake the project. Or banks may no longer lend to it for new projects beyond the lending they are doing to recover old loans. This may account for another one third of the stalled projects not being revived even if given clearances.

Further, the terms of restructuring loans to companies in distress usually assume that in a couple of years the economy will recover and the company will be able to pay back the loan. Figure 1 shows the sharp decline in GDP growth, down to 4.5% in the quarter ending December 2012 as one of the sharpest downswings in growth in recent years. The seasonally-adjusted quarter-on-quarter growth was 3.5%.

Nor have we seen investment pick up. Figure 2 shows the seasonally-adjusted quarter-on-quarter growth of investment by the private corporate sector. It was 0% in the January to December quarter. When investment is 0% and GDP growth is 3.5%, it will take a strong change in the business environment and sentiment for them to pick up.

Figure 3 shows that those signs of change in business perceptions are not to be seen yet. It shows new project announcements per quarter by all sectors and all categories of investors. Project announcements as a share of GDP have been declining quite steadily since 2010. When sentiments improve, this is the first place where we expect to see the optimism. Even if projects are not finally implemented, they must at least be announced for the investment to kick off.

What we might see in the next few months may be a pick up due to some projects being revived. Once investment activity starts, it may induce optimism. Yet one must be aware that even if all projects were to get clearances tomorrow, we may see actual activity in less than half. We will be fortunate if growth does not fall below that of the 5% we appear to have achieved in 2012-13.

China's rebalancing act

Indian Express, 30th April 2013

Its tilt to consumption-led growth is good news for India and the global economy

Unlike in India, the slowdown in Chinese growth appears to be not merely a cyclical downturn, but lower trend growth rate that Chinese policymakers see as desirable. It forms part of China's strategy to rebalance the domestic macroeconomy towards a slower growth rate of employment, lower investment and higher consumption. This is good news for global rebalancing as China's exchange rate policy should now become more flexible, Chinese current account surpluses should come down and accumulation of Chinese forex reserves should slow down or stop. For India, a relatively more consumption-oriented China could mean higher exports, both to China and the rest of the world, lower commodity prices and less of a pressure from exporters for exchange rate intervention.

After growth at double digits for many years, China grew at a much slower 7.7 per cent in the first quarter of the year. At a recent conference in Beijing, I heard Chinese policymakers sounding fairly comfortable with this lower growth. Indeed, they argued lower growth in China was desirable. It almost seemed that it was planned.

The main arguments in favour of lower growth - an average of 8 per cent in the next 10 years and 7 per cent thereafter - was mainly China's demographics. As the Chinese working-age population starts shrinking due to the replacement of the current working population by those born after the one-child policy was put in place, there is less need for high job growth. The last few decades were ones in which China was trying to meet two objectives: earn foreign exchange and create jobs. The high growth rate of job creation was necessary to absorb the large number of people joining the labour force. If the same growth rate continues, China will have labour shortages. With a slower growth of the working population and labour force, wage growth rather than employment growth will be the focus.

Second, China has undertaken significant infrastructure investment in recent decades. In coastal areas, China has met its targets for infrastructure investment. It now needs to utilise better the infrastructure that it has created. Some estimates even show that China's infrastructure investment has been excessive. The need for additional investment in infrastructure is lower, and so the investment strategy will be modified accordingly.

A shift towards domestic consumption-led growth will make the Chinese growth model less dependent on exports. In episodes of global slowdown like the recent one, the Chinese economy can then continue to grow more steadily. The decline in the Chinese trade surplus and slower exports after the crisis have made it evident that, even if desirable, the policy of export-led growth was unlikely to be sustainable.

At the recent IMF-World Bank meetings in Washington DC, China has indicated that it will allow the renminbi to move in a wider band than it has hitherto. This effectively means that it will allow the yuan to appreciate. This will make Chinese exports more expensive and imports into China cheaper. Such an exchange rate regime will be more suitable for a domestic consumption-led, rather than an export-led growth strategy.

An appreciation of the yuan will also allow other emerging economies to permit their currencies to be more flexible. Today when China sustains a policy of an undervalued exchange rate through its intervention and sterilisation, other central banks often come under pressure to do the same. The context in which China has been able to financially repress the system and pay low or negative real interest rates to households is unlikely to work in more market-oriented and democratic countries. It will be a relief for other EM (emerging market) central bankers not to have the kind of pressure they face thanks to China today.

One of the origins of the global crisis was diagnosed to be the cheap funding available in the US economy owing to Chinese purchase of US treasury bills. The high level of liquidity, asset price bubbles and, finally, the meltdown were said to be caused by the Chinese policy of keeping consumption low, savings high and then pushing those savings into the US, where households consumed too much and did not save. This arrangement was facilitated by the Chinese exchange rate policy. A change in the Chinese policy is expected to lead to a global rebalancing.

For India, which has had an economy much more based on domestic consumption, where the domestic savings to GDP ratio is closer to 30 per cent, in contrast to China's 50 per cent, a rebalancing in China is good news. Not only is a more rebalanced world a better and more sustainable business environment, with less vulnerable risks, but India could gain directly as it is often seen as a competitor to China. In areas where India can compete with Chinese products for a share of the market, its exports can benefit. In addition, if India is able to enter the market in certain products, it stands to gain. As China focuses more on growth in services, as it has seen recently, as well as high-end products, away from the low-end manufacturing that dominated its growth model, Indian exports stand a better chance.

Lower investment in China is likely to lead to a softening of global commodity prices. As a large commodity importer, India stands to benefit from softer prices. Though it may be argued that global growth may slow down if China slows down, as the Chinese policymakers argue, if the growth can be higher quality growth, protecting the environment and reducing pollution, with higher wage growth, more innovation and less distortions, the world stands to gain.

Economic stability is not the only issue at stake. Political stability in China is a challenge as inequality has grown. If China does not follow a wider consumption-based growth model, the bigger challenge may be political rather than economic stability. It seems that the Chinese government has set the forces for domestic rebalancing in place, it remains to be seen how successful the policy will be.

Selling it right

Indian Express, 11th April 2013

Consumer protection should be at the heart of the financial regulatory framework

Does India need a new law for consumer protection in finance? One lesson from the global financial crisis is that unsuitable housing loans sold to poor, uneducated consumers could pull down the world's financial system. Very few people would have believed that sub-prime loans, which constituted a very small part of housing loans and that too only in one country, could trigger a crisis that led to banks failing, money markets crashing, governments falling, countries going bankrupt, millions becoming unemployed and the GDP of many nations going down. This is not to argue that the sale of unsuitable housing loans was the only regulatory failure that led to the global crisis, but an important lesson is that a regulatory system that does not prevent the sale of unsuitable financial products to consumers could be putting the financial system and the entire economy at risk. Not only is consumer protection an important end in itself, if it lies at the heart of financial regulation, bad practices that result in the failure of firms and markets can be checked.

Today in India, there is very little reference to consumer protection in primary legislation in the financial sector. Not surprisingly, none of the financial laws on which regulation is based, and which were written long before there was clear thinking about the need for consumer protection, provides consumers with basic rights or protections. Nor do they give regulators a specific set of relevant powers to pursue the objective of consumer protection. It is not treated as a core pillar of financial regulation. Many countries are rewriting laws to bring this perspective into financial sector regulation.

Some regulators have issued regulations based on the general rule-making powers given to them in their respective laws. For example, SEBI issued Disclosure and Investor Protection Guidelines in 2000. Various guidelines have been issued by the RBI and IRDA to protect consumers in banking and insurance. However, consumer protection regulation remains weak and varies across different sectors and services.

The approach adopted by the Financial Sector Legislative Reforms Commission (FSLRC) is that consumer protection needs to be treated as a core part of the legal and regulatory framework. So the first step towards ensuring consumer protection is to have good primary legislation that provides for it and makes it a priority for regulators, empowering them adequately. The primary law should require all regulators to formulate regulations that ensure consumers are protected from unfair practices. If, in a contract, there is a term that permits one party (often the financial firm) but not the other party (often the customer) to avoid or limit the performance of the contract, or to vary the terms of the contract or the services provided, the contract is unfair. If the conduct of the financial service provider, who often has greater market power, is misleading or abusive or coercive, such conduct is unfair.

Similarly, consumers should have a right to financial privacy, data ownership and data security. The laws were written before it was easy for an employee to sell a CD containing the digital records of his firm's customers for a small price. So the laws, unsurprisingly, were not geared to handle this eventuality. Today, we can argue that consumers should have the legal right to own their financial data. Consumers dealing with financial institutions must have the right to expect that their financial activities will have a reasonable amount of privacy. They must have the assurance that the data is secure.

Additional rights and protection need to be given to retail customers, who may be individuals or businesses, carrying out small value transactions. They are often at an even bigger disadvantage. Retail consumers should not be sold unsuitable products. The suitability of a financial service or product depends on the profile and needs of the specific consumer. The lack of knowledge often makes it difficult for the consumer to decide what will work best for her. The law should make it a right for the consumer to be given sufficient time, relevant information and, if possible, sound advice to help her decide on the suitability of the financial product she is buying.

For example, if a consumer is considering buying life insurance, in most cases, simple information disclosure is inadequate. There should be an assessment of the consumer's need. Proper advice would be necessary to ensure that the consumer purchases the right kind of insurance, with the optimal level of coverage. For certain services, the regulator may mandate advice. Providers of such services would then not be allowed to approach the potential consumer without some kind of a basic process of needs assessment and advice. For example, regulations could mandate that before a financial institution makes a recommendation to a consumer regarding a specific financial service, it gathers sufficient information from the customer to ensure that the service is likely to meet her needs and capacity.

Under the draft Indian Financial Code (IFC), advice would typically be accompanied by increased responsibility for the financial service provider, making it accountable for consumer outcomes, leading up to compensation for consumers if they have been poorly advised. Most services should come with a high level of responsibility for the providers, especially if the providers approach the consumer.

Consumers should also be given reasonable time to take the decision. For example, consumers going in for certain financial services with long-term implications could be allowed a cooling-off period, during which they may cancel the contract or decide not to enter it.

Consumer protection regulation is ineffective if consumers do not have an effective ex-post grievance redressal mechanism. At present, this is highly inadequate and varies across sectors. The draft IFC proposes to set up a fast and efficient non-sectoral, widely accessible consumer redressal mechanism.

It seems fairly obvious that consumers should have protection against unfair conduct and terms. But we need to put that in the law, because unless it says so, regulators cannot write regulations that ensure such protection or penalise firms that violate these principles. The draft IFC proposes to enshrine these principles in law.

Turf war in the offing

Financial Express, 26th March 2013

FSLRC recommendations would be challenged by the financial regulators

Two of the most important committees on financial sector reform in India in recent years-the Raghuram Rajan Committee and the Percy Mistry Committee-have recommended a change in the regulatory architecture. The problems of regulatory gaps, overlaps, turf wars, and tension with the government have only increased since these committees submitted their reports. While the Percy Mistry report recommended a single unified regulator, Raghuram Rajan recommended a more conservative approach-a banking and non-banking regulator, keeping RBI as the banking regulator. The Financial Sector Legislative Reforms Commission (FSLRC) has taken the more conservative approach of two reports, keeping banking with RBI while proposing a merger of other regulatory bodies into one regulator.

In almost every country where regulators have been unified as the financial system has become more complex and as regulatory walls have become hurdles to better regulation, existing regulators have fought back. The past and present staff of various regulatory bodies are amongst the biggest opponents of regulatory institutional change. No doubt, in India too, turf war will take place. The commission, in recommending a non-sectoral law, will no doubt make regulators and many regulated entities, happy in the present set up, quite unhappy. The debate on the draft law in public discourse will need to go beyond who will administer the law and beyond the unhappiness of regulators who find their turf encroached upon to the contents of the law. In many ways, who administers the law is the least important part of the recommendations of the commission.

Financial sector reform in India has been a slow process of responding to the needs of a growing economy. Other than the initiatives in the equity market, most changes in the framework of financial regulation in India have been made in response to the need of the hour. This has meant piecemeal changes to the various laws that give powers to regulators to regulate finance. In addition to the many amendments to the laws, there have been many committees looking into the difficulties of finance. A slow consensus has grown which recommends changes in the regulatory framework. However, many of these changes were not possible since the basic structure of the law did not allow it. The FSLRC was set up to review, rethink and redraft the basic laws so that Indian finance can be reformed to prepare India as a growing modern economy, without having to constantly amend existing laws to incorporate changes in technology or other innovation.

This commission, which submitted its report to the finance minister on March 22, 2013, was not a quick and dirty response to political pressure in a crisis situation. It was a serious, consultative, well-researched effort at rethinking the objectives of regulation, of regulatory governance, and of the independence and accountability of regulators in India. The job of the commission, which began two years ago, was not to simply tweak and fix the things that were not working, but to question the fundamental arrangements between regulators, the government, the regulated and the consumer for whose protection regulation is ultimately being done. The commission involved more than a 100 people doing research, learning lessons from the global crisis and consulting regulators, market participants and various stakeholders.

What is the most important element of the new draft law-the Indian Financial Code. This law puts consumer protection at the centre of all regulation. Whether we have to reduce the risk of failure of banks or an insurance company, so that depositors and policy holders are protected, whether we have to find ways of rescuing failing entities with minimum cost to the taxpayer, whether we have to find ways to ensure that a household is not sold unsuitable products, or whether we wish to prevent a disruption of financial services on the scale of the system as a whole, the objective of the regulation is to protect the consumer without putting the burden on the taxpayer.

The need for regulation arises because of the asymmetric power and information that customers of financial services have, in contrast to the providers, and they must be protected from unfair practices, or from the provider taking very high risks to earn high returns. In this framework, the objective of micro-prudential regulation, i.e. regulation of entities in the financial sector, is to protect customers. If regulation entails a higher burden on owners and shareholders, in proportion to the risks they take and the commitments they make, in order to protect customers, the burden may be justified. After the global financial crisis, whose origins lay first in the sale of unsuitable financial products to consumers, and then in the lax regulation of financial firms that were holding those assets, the commission has focused on the extremely important role that good regulation can play in making the financial system resilient.

A major theme of many of the recommendations of previous committee reports in India has been the opposite problem of those that led to the global financial crisis. Instead of suffering from too much innovation as the US is supposed to have witnessed in the run up to the financial crisis, Indian regulators have often been found to do excessive regulation and strangle of innovation. This issue can be addressed by giving regulators clear objectives, through enumerated powers. If the regulator simply wishes to ban something so that he does not have to witness any risk on his clock, the law will not give him the power to do so. He needs to demonstrate that the regulation is required to meet the objectives assigned to him, and is within his powers to do so, and that a cost benefit analysis of the regulation shows that the additional cost, monetary or otherwise, of complying to this regulation is going to bring clear benefits to the economy. The regulator would be hopefully restricted by the proposed accountability mechanisms not to prevent all innovation. Further, even if he does go ahead and issues regulations that do not meet the objectives that are given to him, the regulation can be challenged in a newly set up Financial Sector Appellate Tribunal.

Once the draft code becomes law, regulators would be required to write regulations in line with the powers and role given to them by the new law. The process may take time, but the framework provided by the FSLRC would lay the foundations of a well regulated modern financial system in India.

Caps unlock

Indian Express, 20th March 2013

Finance Minister P. Chidambaram is reported to be considering removing FDI caps in various sectors. The imperative for the removal of caps in sectors where they are below 100 is to attract capital flows to India in a situation where the current account is expected to be 5 per cent of the GDP. While FDI in multi-brand retail, pensions and insurance have become political issues, in other sectors such as credit information, asset reconstruction or private security agencies, where the issue is not political, it may be possible to remove restrictions more easily.

Even though it makes good economic sense to ease unnecessary capital controls at times when the country needs inflows, opponents often whip up fears of what might happen when controls are reduced. Instead, we need to determine what the objectives of controls are, the kind of controls that the country would like to keep, and which ones are detrimental and should be removed.

Capital controls, or controls on the cross-border flow of money for sale and purchase of assets, are imposed for three broad reasons. In largely open economies, concerns about terrorism or money laundering require that information be provided before money can be transferred across borders. When a country becomes a member of the Financial Action Task Force (FATF), it is required to pass laws that require it to prevent money flows from being used for such activities. These require financial firms to fulfil various know-your-customer (KYC) obligations. When India became a member of the FATF, it introduced these laws. The regulations in India that flow from these laws are, it has often been felt, far more stringent than in other FATF member countries, involving proof of residence and paper documents beyond proof of identity. While the excesses would need to be sorted, controls arising from FATF obligations will have to remain.

A second reason for capital controls is national security. Again, almost all countries in the world, including the most advanced ones, have laws that prevent foreign ownership of, say, ports, airports or other infrastructure facilities where the government feels that the security of the country may be compromised. For example, the government may choose to prevent FDI in a port by a foreign government or an entity owned by it, especially by a government it does not trust. Such capital controls are in place in India as well as in advanced open economies and it is unlikely that such restrictions will go away as long as national security remains an issue.

In addition to the above, capital controls have been seen, primarily in emerging economies, as tools for macro-economic policy. When emerging economies witness pressure on their currencies, they loosen or tighten capital controls. These controls are of many kinds. They include price-based measures or quantitative restrictions. Controls may be on various kinds of asset classes such as debt, equity, derivatives, bank capital, mutual funds or direct investment. Controls may differ according to whether residents or non-residents are investing. They may differ depending on whether they concern inflows or outflows.

Emerging economies often have many of the above kinds of restrictions. When the domestic economy is doing well, foreign inflows come in search of higher returns. This may lead to an upward pressure on the currency. In such situations, a country may impose controls on capital coming in. Similarly, when domestic business cycle conditions are bad, money may flow out, putting pressure on the currency to depreciate. The country may respond by imposing controls on outflows.

Whether such controls are able to reduce the pressure on the currency is still not settled. There is a large empirical literature examining whether controls achieve their objective at least for a short time and whether that is useful, considering the costs they impose. However, one thing appears to be clear - almost all emerging economies have slowly removed controls that permanently impede cross-border capital flows. The two exceptions are India and China. Countries such as Brazil have opened up their capital account, but have kept in place transparent price-based controls that can be imposed by the government.

In India, we have tied ourselves up in knots. Even at a time when the country needs capital inflows, it is not easy for the government to move at the required speed. The U.K. Sinha committee on capital controls documented the complex maze of capital controls that has taken the power of switching controls on and off, depending on the need of the hour, away from the government and into the hands of a number of financial regulators. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. This has created a situation in which, even when macroeconomic stability requires that at a time when the flow of capital is weak, when the current account deficit is strong, when the government wishes to reduce capital controls, it is unable to do so.

Today, even when the FM does roadshows abroad, when he sends out the message that India wants to attract foreign capital, the experience of foreigners with the Indian financial regulatory system, the legal complexity and the tax uncertainty are such that capital does not flow in easily. As the experience after last year's Union budget showed, we cannot take foreign capital flows for granted. Considering how vulnerable a large trade account makes the country, it is not surprising that other emerging economies have got rid of the complex capital controls and moved to simple, transparent frameworks.

Hopefully, the finance minister will be able to attract more foreign capital as he proposes to. But it is equally important that the system of controls now be re-examined and rationalised keeping in mind the objectives they serve.

Budget has two faces

Indian Express, 5th March 2013

How a Congress-friendly budget also addresses the markets

Initial reactions to the Union budget, 2013-14, were based on an analysis of numbers as Finance Minister P. Chidambaram chose to represent them in his budget speech. The budget was seen as a tax and spend document - expenditure on the Congress's pet projects was increased, to be financed by higher taxes on the super rich. The budget was mostly in line with the Congress's politics of the last ten years. It was pro-rural poor and anti-rich.

The disappointment that followed was mainly due to expectations from Chidambaram, who was seen as more market-friendly than the rest of his party but had failed to present a budget that pushed investment and helped growth, or to defy the party line. Arguably, the budget was not more market friendly than that which could have been presented by any other Congress minister.

There seem to be two issues here. First, shouldn't it have been expected that the last budget before the elections would be one that represented Congress ideology? In the last ten years, the Congress has not portrayed itself as pro-business or even pro-market. It is only when the economy started slipping into a bottomless hole that the party brought in its most competent and most market-friendly cabinet minister to take charge. Chidambaram's job was to convey to the markets that it was not a complete return to the days of the licence-permit raj. But to expect that the Congress was ready to give up its agenda of welfare programmes, or the pro-poor, anti-rich image it has been trying to build, was perhaps unrealistic.

As a consequence, the budget essentially had to be a tight-rope walk between the instincts of the Congress and the needs of a government rapidly losing the confidence of industry, foreign investors and credit-rating agencies.

The second issue concerns the message of the budget speech. The reaction to the speech was perhaps what the finance minister calculated it would be. The budget would be seen as pro-rural poor and anti-rich. After all, in his speech, the minister chose to interpret his budget numbers as he liked. The speech was more Congress-friendly than market-friendly. But the same budget may have been used to convey a very different message - one of moving towards a smaller government and restricted spending on welfare schemes.

For example, in his Congress-friendly speech in Parliament, Chidambaram said: "I have been able to set the budget estimates of total expenditure at Rs 16,65,297 crore and of plan expenditure at Rs 5,55,322 crore."

A market-friendly version of the same numbers would have read: "I propose to allocate Rs 16,65,297 crore for total expenditure, thus raising expenditure by 11 per cent over last year's budget estimates. Since I expect the GDP to grow by 13.5 per cent in nominal terms, this means reducing the size of the government in the total GDP."

Similarly, Chidambaram said: "Hon'ble Members will be happy to know that plan expenditure in 2013-14 will be 29.4 per cent more than the revised estimate of the current year."

A market friendly version of the budget numbers might have read: "Plan expenditure in 2012-13 was budgeted to be Rs 65,000 crore. Owing to the difficult fiscal situation, I propose to allocate only an additional Rs 3,000 crore, or Rs 68,000 crore for planned expenditure in 2013-14. This will mean that the amount budgeted for plan expenditure will shrink in real terms."

Further, in his Congress friendly speech, the finance minister said: "The ministry of rural development steers a number of flagship programmes. We estimate that they will be able to spend Rs 55,000 crore before the end of the current year, and I propose to allocate Rs 80,194 crore in 2013-14, marking an increase of 46 per cent. MGNREGS will get Rs 33,000 crore."

A market friendly version of the same speech might have read: "Last year the ministry of rural development got a budget allocation of Rs 76,000 crore. This year I propose to allocate Rs 80,194 crore, a contraction in real terms. Expenditure on MGNREGS was budgeted to be Rs 33,000 crore in 2012-13. I do not propose to raise the allocation for MGNREGS in 2013-14. This implies almost a 10 per cent reduction in the allocation for MGNREGS in real terms."

This is not to say that the Congress is actually moving towards a smaller size of government. If there has been a contraction compared to what was proposed last year, there has been little change in the long-run growth path of government spending, at roughly 15 per cent.

Similarly, the tax on the super rich might yield less returns in terms of economics and more in terms of politics. The finance minister clearly ignored the advice of the chief economic advisor, who said, "higher and higher tax rates impinge more and more on incentives to undertake taxable activity, while encouraging tax evasion". Higher taxes on luxury goods, a surcharge on corporate income tax and dividend distribution may raise tax revenue in 2013-14, but it is unlikely to facilitate a good tax policy for the country in the long run. That can only come with a simpler tax code, fewer exemptions, increased compliance through a GST and lower taxes discouraging evasion. The increase in non-tax revenue based on spectrum sale and disinvestment may be able to finance the budgeted expenditure next year while keeping the fiscal deficit down, but it will not lay the ground for sustainable fiscal consolidation. The tight-rope walk of a finance minister trying to marry Congress ideology with the need for growth and investment in the economy cannot be a long-term strategy.

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.