Crisis
on the horizon
India's
large fiscal imbalances pose a serious threat in the medium
term, warns a World Bank review. Rahul Nayar checks how
serious is the threat
Rahul
Nayar
30 July 2003
India's
large fiscal imbalances pose a serious threat to sustained
growth and development over the medium term. If current
fiscal situation is left unchecked it will keep economic
growth below potential, as growing interest payments will
crowd out public investment, and high real interest rates
will constrain private investment. Slower growth will
also speed up the deterioration in debt.
The
recent World Bank development policy review on India sounds
more like an alert cautioning India on the impending dangers
relating to the precarious fiscal situation.
The
most disturbing fact that the policy review brought out
is that primary deficit and public debt are worse than
1991 levels when India had faced a major crisis. And the
fact is that India's present fiscal situation is worse
than that of many countries, which have faced macroeconomic
crisis.
![](images/primary_deficit_graph.gif)
![](images/liabilities_graph.gif)
Finance
ministry's defence
The Indian finance ministry reacted with the usual approach
of looking at the positive side of the report. The ministry
said the World bank has not painted a dismal picture of
the Indian economy and pessimistic news coverage of its
report titled 'India: Sustaining reforms, reducing poverty'
is based on selective and partial readings of the report.
The
finance ministry highlighted the point that on the reform
front, the report has not warned the country about an
impending economic crisis. Rather, the report has noted
that rising external reserves and low levels of short-term
external debt give the country a very comfortable cushion
to counter any speculative attack. Thus, India is not
vulnerable in the short-term to the type of collapse suffered
by Russia or Argentina.
The
finance ministry defended itself on the public finances
situation by quoting the World Bank's view on the Fiscal
Responsibility and Budget Management Bill. The World Bank
has said that fiscal discipline at the centre is likely
to be reinforced, but not guaranteed, by the new Fiscal
Responsibility and Budget Management Bill, which mandates
the elimination of the centre's revenue deficit by March
2008. Three states have passed similar Acts to limit their
own deficits, and others are following suit.
Truth
and only the truth
An objective look at dangers that the World Bank report
has highlighted brings forth the point that although India
is not facing a crisis as of now, it is gradually heading
towards one if corrective action is not taken. This notion
arises from the fact that the earlier thought-out perception
about the influence of politics on economic policy gradually
declining has been proved wrong.
The
government's recent policy statement on putting on hold
the disinvestment process as the general election is approaching
bears testimony to this fact. The result is bound to result
in a higher fiscal deficit.
Secondly,
there seems to be a lack of will on the part of the government
to check fiscal deficit and public debt. The most important
step in this direction is to cut on the rigid non-plan
revenue expenditure, which basically means a reduction
in central and state government employees.
No
government in a political system like one in India has
the courage to take a step having political ramifications.
So we cannot expect wonders on fiscal deficit to happen
despite a Bill like the Fiscal Responsibility and Budget
Management Bill being in place.
![](images/fiscal_deficit_graph.gif)
Crisis:
Where from?
Fiscal: India's large fiscal imbalances pose a
serious threat to sustained growth and development over
the medium term. Although in the short run, the risk of
a speculative attack is reduced by a compliant financial
system, a large pool of household savers, the limited
convertibility of the current account, and a flexible
exchange rate. Thus, in the absence of a rapid increase
in interest rates and weakening growth performance, India
is not vulnerable to the type of collapse suffered by
Russia or Argentina in the short term.
Over
the medium term, however, there are consequences of leaving
the current fiscal situation unchecked. While current
policies have helped reduce external vulnerabilities,
they have also kept economic growth below potential,
as growing interest payments have crowded out public investment,
and high real interest rates have constrained private
investment. Slower growth, in turn, speeds up the deterioration
in debt dynamics.
Even
though interest rates have declined over the past 18 months,
public debt dynamics have continued to worsen. As interest
rates can be expected to increase from the current historical
lows, the growth-interest rate ratio, which has prevented
the current fiscal vulnerabilities from translating into
a full-blown macroeconomic crisis, could deteriorate.
The persistence of current fiscal trends will, at best,
further limit growth and job creation. If this negative
cycle continues, a full-fledged fiscal crisis cannot be
ruled out over the medium term.
The
government is downplaying the risk, as it is politically
easy to do so. The finance ministry is hoping that higher
growth and lower interest rates will eventually solve
the fiscal problem. However, experience suggests it would
be unwise to sit back and wait for such a virtuous circle
to emerge.
Political:
An important risk is that the comprehensive reforms needed
to accelerate development will be delayed due to the primacy
of political concerns, such as general or state elections.
Another is the diversion of policymakers' attention (and
public resources) to other issues, such as the tensions
with neighbouring countries.
Political
obstacles to the needed hardening of budget constraints
between the centre and the states, in particular those
states which yield large political power, are risks that
threatens to further deteriorate state level finances
and discourage reforming states. There seems to be no
solution to this problem as of now.
External:
In the short run, expected developments in the external
environment cannot be expected to be strong positive forces.
The recovery of the global economy is expected to be slow.
There remain weaknesses in demand in the world's largest
markets Western Europe, Japan, and North America. This
will slowdown growth in industry, albeit to a limited
extent because India still is a relatively closed economy,
but in particular in services.
A
slowdown in the inflow of remittances is also likely.
At least part of the increased inflow of remittances observed
in India is likely to have been a one-off episode, motivated
by the events of 9/11 in the US and resulting partly from
a "flight to safety" event. This level of inflows
can be expected to weaken, emphasising India's fiscal
vulnerabilities.
Although
the government is right to set ambitious targets for growth
and social development during the Tenth Plan, the key
now is to implement the policy and institutional changes
needed to achieve these goals. Central and state governments
will have to be proactive in reducing the fiscal deficit,
shifting expenditures into more productive areas, and
removing structural impediments to higher private investment
and productivity.
The
sooner the roadmap for these reforms is put in place,
and concrete action taken to show commitment to follow
through, the more manageable will be the adjustment path,
and the quicker the pay-off in terms of higher growth
and poverty reduction.
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