A misinformed policy debate

Governor Raghuram Rajan’s January 15 reduction in the policy repo rate from 8.0 per cent to 7.75 per cent has generated ecstasy in the stock market, industry and the media as if the Reserve Bank of India has resolved most of the problems of the Indian economy with a magic wand. It’s a typical case of irrational exuberance.

Memories are short; it was not too long ago that the RBI was criticised for the ineffectiveness of its policy actions-- that a series of increases/decreases of the policy repo rate have not produced the desired effect. Markets and opinion-makers often forget that monetary policy operates with a lag and it is futile to expect an instant policy impact.

The change in the repo rate is at best a signal. They at best bring about minor variations in banks’ lending rates. Banks, to defend their margins, would first reduce interest rates on fixed deposits. As a reduction in deposit rates is only on fresh fixed deposits and renewals, the beneficial effect on banks’ margins is very gradual.

In contrast, when lending rates are reduced, the impact is on all lending. As such, banks reduce lending rates only on select sectors. Since interest costs account for about 10 per cent of total industrial costs, a 0.25 percentage point reduction in lending rates reduces industrial costs by 0.025 percentage points. As such, the market reaction to the recent reduction in the policy repo rate was totally unwarranted. All that could be justifiably concluded is that the RBI has done its bit and passed on the relay baton to the fiscal authorities.

Dangerous ideas are being floated by some segments of industry that the medium-term fiscal consolidation programme should be abandoned and that more specifically, the heavens won’t fall if the fiscal deficit for 2014-15 exceeds the Budget estimate of 4.1 per cent of GDP. It is gratifying that the government has categorically indicated that it is committed to the 4.1 per cent target.

The fiscal deficit target is expressed as a percentage of nominal GDP. This is deceptive as the nominal GDP has a component of real growth and inflation, and the achievement of the target can have major qualitative differences. Hence, it is more meaningful to express the fiscal deficit as a percentage of total expenditure. Looked at this way, the fiscal deficit is close to 30 per cent of total expenditure, which is clearly excessive.

The time profile of the budget deficit shows a major qualitative weakness. According to the Budget estimate, the deficit is 30 per cent of total expenditure for the full year, but in the first eight months of the current fiscal year up to November 2014, the deficit is 49 per cent of total expenditure. The compression of the Budget deficit towards the latter months of the financial year is a result of undesirable measures.

Further, it is essential to ensure that the compression in the period from December 2014 to March 2015 does not fall exclusively on the vulnerable social sectors such as education and health; rather, it should happen in sectors where there are clear signs of wasteful expenditure.

The sale of public sector units (PSUs) raises a number of issues. When the government sells its family silver, it should reduce its debt and not use it to cover up its Budget deficit. Illustratively, the proceeds of PSU sales should be earmarked to build up a Consolidated Sinking Fund (CSF) to redeem the public debt.

This has been recommended on many occasions, but the fiscal pundits have shot this down on the ground that there is no point in building up a CSF.

As a result, the way the government undertakes its borrowing is to determine its net borrowing requirement and then add the repayments to derive its gross borrowing requirement; this is the epitome of a Ponzi scheme. Fiscal experts take comfort in the fact that the ratio of debt to GDP of the Centre and States has declined from 90 per cent in 2003-04 to 69 per cent in 2013-14. This argument is strengthened by the fact that the Indian debt to GDP is substantially lower than Japan (226 per cent), Italy (130 per cent), France (98 per cent), the UK (92 per cent) and the US (72 per cent).

What is generally not appreciated is that the major factor contributing to the lower ratio for India is the relatively high inflation in India as also the fact that in India the deficit excludes PSU borrowing. Inflation is a brutal non-transparent tax, which is totally regressive as it affects the lowest income group the most.

It is pertinent to recall that when Yashwant Sinha was finance minister, the sales of PSUs were specifically earmarked for the National Renewal Fund.

Later, however, as fiscal pressures increased, the proceeds of PSU sales were blatantly used to cover up the fiscal deficit.

Issues relating to taxation and expenditure control will require separate examination. ( to be continued )

The writer is a Mumbai-based economist