Financial Reform & Budget 2000 - 2001
Finance Minister
Yashwant Sinha is on the defensive. The all-round criticism of his budget,
even if for diverse reasons, and the negative response of the stock
markets, which he himself has made an important indicator of policy
correctness, have left him wondering in which direction to turn. If all
sections, including the BJP's allies, are to be accomodated, he would
denude this year's budget of even the little new content it has. This is
because the four measures he considers to be the significant advances made
in this budget, viz., the cut in food and fertiliser subsidies, the
reduction in interest rates on small savings, the 'rationalisation' of
excise duties through the introduction of the CENVAT tax and the tax on a
20 per cent of export profits, would have to be withdrawn. In particular,
any 'roll-back' of the subsidy cut would amount to reversing the only
measure in keeping with the promise made in the economic survey to take
harsh decision to curb government expenditures.
This unenviable situation is in part of Mr. Sinha's own making. Trapped in
a fiscal bind generated by years of financial reform, he has chosen to
persist with the reform strategy rather than seeking to reverse it and
extricate himself from a hopeless situation. In the run up to Budget, the
government - through its spokesmen and in the text of the Economic Survey
- had made the reduction of expenditure and of the fiscal deficit the
fiscal task of the moment. Despite this, the Budget could not proceed too
far in this direction. Total expenditure of the central government, which
had risen from Rs. 279,366 crore in 1998-99 to Rs. 303,738 crore in
1999-2000 is slated to rise further to Rs. 338,436 crore in the next
financial year. This projected 11.4 per cent rise, which is higher than
the 8.7 per cent rise of the previous year, has been seen as a failure to
ensure an adequate degree of fiscal correction. This has constituted the
principal basis of criticism of the budget by many industry and academic
experts.
This approach is based on two presumptions. First, that a reduction of the
fiscal deficit as part of a strategy of financial reform is the main task
facing the government. And second, that the failure of the government to
execute that task is the result of "excess" expenditure. It hardly bears
stating that in a context where growth in the commodity producing sectors
has been sluggish and where there has been virtually no progress on the
poverty reduction front during the 1999s, the budget must above all be
seen as means to trigger growth and alleviate poverty. The obsession with
the fiscal deficit and expenditure reduction amounts to downplaying these
more fundamental objectives.
In fact, the objectives of growth and poverty reduction call for more
expenditure rather than less, even if it involves a larger fiscal deficit.
And, given the large stocks of foodgrain with the government and the
comfortable level of foreign exchange reserves, it is more than likely
that such deficits would result in higher levels of output rather than in
inflation. The fact that the huge increase in expenditure as a result of
the implementation of the Fifth Pay Commission's recommendations has been
accompanied by unusually low rates of inflation is one indicator of this.
And higher GDP growth in turn would mean lower fiscal deficit to GDP
ratios.
Seen in this light medium term trends in the finances of the government
appear to be positive. The expenditure to GDP ratio, which fell from 19.2
to 14.8 per cent between 1989-90 and 1997-98, has in fact risen over the
last three years to touch 15.8 per cent in 1999-2000. Thus, Mr. Sinha can
claim credit for having reversed the decline that characterised the early
years of reform.
However, a closer look at the components of the government's expenditure
suggest that this reversal has occurred not because of but despite the
Finance Ministry's efforts to the contrary. Right through the reform
years, the ratio of the government's capital expenditures to GDP has
almost consistently fallen, with the performance in 1999-2000 being
particularly dismal. As Chart 1 shows, right through the reform years, the
ratio of the government's capital expenditures to GDP has almost
consistently fallen, with the performance in 1999-2000 being particularly
dismal. As a result from a high of 5.9 per cent of GDP in 1989-90, the
ratio has fallen to as low as 2.6 per cent during the current financial
year.
On the other hand, the ratio of revenue expenditure to GDP after having
fallen from 13.3 per cent to 11.7 per cent in 1996-97, has risen sharply
thereafter to touch 13.1 per cent in 1999-2000, which is close to its
1989-90 level. But what is interesting to note are the rather diverse
trends in outlays on "interest payments" and revenue expenditures net of
interest payments.
Till 1996-97, interest payments were continuously rising as a share of
GDP, whereas the rest of revenue expenditure was on the decline. It is
only after that, with the "unavoidable" implementation of the Pay
Commission's recommendations, that the rise in interest payments has been
accompanied by a rise in revenue expenditure net of interest. The only
expansionary impulse provided from the fiscal side is the result of the
Pay Commission which, together with the good harvest of 1998-99, has
contributed to the modest recovery in industrial growth in recent months
in the midst of extremely low inflation.
Two lessons can be drawn from that experience. First, that the
expansionary stimulus from the state has to be sustained if the recovery
is to continue. And, second, that a conscious effort must be made to
reduce the share of interest payments in the "expenditure" of the
government.
An expansionary stimulus, in the form of more public expenditure, can be
financed in two ways : greater resource mobilisation through taxation and
a higher fiscal deficit. The strategy of economic liberalisation, however,
militates against the first. Not only are customs duties being reduced
consistently as part of the import liberalisation, but a range of direct
and indirect tax concessions have been provided over time resulting in a
fall in the net tax-GDP ratio at the centre from 7.9 per cent in 1989-90
to 5.9 per cent in 1998-99 (Chart 2).
The rise in oil prices and the slight buoyancy referred to earlier has
helped raise this figure to 6.5 per cent in 1999-00. The feeble effort
made in this budget to sustain this trend by raising the surcharge on
income tax and bringing export incomes into the tax net has, as expected,
been received adversely by those who see it as an unnecessary intrusion of
the state into private activity.
The net result of the trends in taxation and expenditure has been that the
fiscal deficit at the centre has proved stubbornly resistant to reduction,
rising from 4.9 per cent per cent in 1996-97 to 7.0 per cent in 1999-2000.
(These figures differ from those quoted by the government in the budget
papers, since it is based on the older definition of the fiscal deficit
which includes all the small savings accruing to the government a part of
which is transferred to the states. However, Chart 3 provides three
alternative estimates of fiscal deficit to GDP ratios: the official ratios
themselves, the ratios computed using the government's figures of the
fiscal deficit and the CSO's GDP estimates and ratios computed using the
older definition of the fiscal deficit and the CSO's GDP estimates).
But this rise in the fiscal deficit is not merely the result of past
non-interest expenditures financed with debt, which have contributed to an
increase in outlays on interest payments. It is also the result of the
change in the manner in which government deficits have been financed in
recent times as a result of financial reform. Till the early 1990s, a
considerable part of the deficit on the government's budget was financed
with borrowing from the central bank against ad hoc Treasury Bills issued
by the government. The interest rate on such borrowing was, at around 4.6
per cent, much lower than the interest rate on borrowing from the open
market. A crucial aspect of financial reform has been the reduction of
such borrowing from the central bank to zero, resulting in a sharp rise in
the average interest rate on government borrowing.
The shift away from borrowing from the central bank has been advocated on
three grounds. First, that such borrowing (deficit financing) is
inflationary. Second, that it undermines the role of monetary policy by
depriving the central bank of any autonomy. And, third, that it undermines
much needed fiscal discipline by providing ready access to credit to the
government at a low rate of interest. We need to consider each of these in
some detail.
The notion that the budget deficit, defined in India as that part of the
deficit which is financed by borrowing from the central bank, is more
inflationary than a fiscal deficit financed with open market borrowing,
stems from the idea that the latter amounts to a draft on the savings of
the private sector, while the former merely creates more money. In the
current context where new government securities are ineligible for
refinance from the RBI, this is partly true. Partly, because the need for
refinance to create additional credit arises only when the banking system
is stretched to the limits of its credit-creating capacity. If on the
other hand, as is true today, banks are flush with liquidity, government
borrowing from the open market adds to the credit created by the system
rather than displacing or crowding out the private sector from the market
for credit. This too can be inflation if supply-side bottlenecks exist.
But even if government borrowing is not financed through a draft on
private savings but through the printing of money, such borrowing is
inflationary only if the system is at full employment or is characterised
by supply bottlenecks in certain sectors. As mentioned earlier, not only
is the industrial sector burdened with excess capacity at present, but the
government is burdened with excess foodstocks and foreign exchange
reserves. This implies that there are no supply constraints to prevent
"excess" spending from triggering output as opposed to price increases.
Since inflation is already at an all time low this provides a strong basis
for an expansionary fiscal stance, financed if necessary with borrowing
from the central bank. To summarise, in the current context a monetised
deficit is not only non-inflationary, but virtuous from the point of view
of growth.
This brings us to the second objection to a monetised deficit, namely,
that it undermines the autonomy of the central bank. This demand for
autonomy, which is a central component of IMF-style financial reform,
assumes that once relieved of the task of financing the government's
deficit, the RBI would be "free" to use monetary policy as a device to
control inflation, manage the balance of payments, and influence growth.
The two interrelated means to realising these objectives are seen as
controlling liquidity and influencing interest rates.
Needless to say, there are strong grounds for scepticism regarding the
efficacy of this policy. The limited success of the central bank in its
effort at bringing down interest rates and trigger growth, is a case in
point. Despite easing liquidity conditions through a variety of means,
including periodic reductions in the cash reserve ratio, and despite
reducing the Bank Rate or the interest rate charged on bank borrowing from
the RBI, real interest rates in India have proved quite sticky. This has
forced the government to reduce the interest rate on small savings and
provident funds. It is the government rather than the central bank which
is at the forefront of the drive to reduce interest rates.
But that is not all. IMF-style financial reform has hardly increased the
autonomy of the central bank, since it not merely involves curbing the
government's borrowing from the RBI, but also liberalising regulation of
capital flows into and out of the country. Since such flows are extremely
volatile, the central bank is constantly forced to adjust to these
"autonomous" capital movements.
In recent times, for example, portfolio inflows which went way above the
$50 million a day mark, increased foreign exchange availability in the
market and threatened to raise the value of the rupee, even when the trade
deficit was widening. This has required the central bank to intervene in
the foreign exchange market and purchase dollars to stabilise the rupee,
resulting in a sharp increase in the foreign exchange reserves with the
RBI. Since an increase in the central bank's foreign assets increases
high-powered money and therefore the supply of money, monetary policy
remains solely concerned with neutralising the effects of foreign capital
inflows. Relieved of the dominance of fiscal over monetary policy, the RBI
now finds itself straitjacketed by international finance.
Finally, the evidence quoted earlier makes clear that even putting an end
to the practice of monetising the deficit has hardly affected the fiscal
situation. Fiscal deficits remain high, though they are now financed by
high-interest, open-market borrowing. The only result is that the interest
burden of the government tends to shoot up, reducing its manoeuvrability
with regard to capital and non-interest current expenditures. This effect
of financial reform on the fiscal manoeuvrability of the State can be
assessed by comparing actual fiscal trends with a hypothetical situation
where the government had continued financing the same share of its deficit
(around 30 per cent) with central bank borrowing as it did in 1989-90.
We assume the interest rate on central bank borrowing to be 4.6 per cent,
and the interest rate on open market borrowing to be the same as has
actually prevailed in individual years during the 1990s. Then, a simple
simulation exercise shows (Chart 4), the interest burden in the budget
would have risen from Rs. 17757 crore to only Rs. 88464 crore in 2000-2001
as compared with the estimate of Rs. 101266 recorded in this year's budget
papers. This close to Rs. 13000 crore or 12.6 per cent saving in interest
payments in the terminal year, is obviously the culmination of a rising
gap between actual and hypothetical interest payments starting from the
mid 1990s when the practice of monetising a part of the deficit was done
away with.
This cumulative saving would have implied a huge reduction in the size of the fiscal deficit, assuming expenditures remained the same. The gap between the hypothetical deficit and the actual deficit relating to recent years in Chart 5 illustrates this. Over the 1990s as a whole, the cumulative reduction in the deficit would have been more than Rs. 100,000 crore, which is far more than what the government could possibly have mobilised through disinvestment.
This gap points in a number of directions. First, the government would
have been more successful in curbing the fiscal deficit if it had not done
away with the practice of monetisation of part of the overall deficit.
Second, if deficits had been maintained at actual levels along with
monetisation, the expansionary effect of recent budgets would have been
quite significant, with positive results on the growth and poverty
alleviation front. And, finally, if the government had not merely stuck
with monetisation but also dropped its obsession with the fiscal deficit,
especially in recent times when food and foreign reserves have been
aplenty, the 1990s would have in all probability been a decade of
developmental advance.
Budget 2000 reflects the fact that the BJP-led government has consciously
chosen to forego this opportunity by making "second generation" reforms
its principal thrust. Central to that strategy is a further push to
financial liberalisation. In hypocritical fashion, the Budget speaks of
formalising the autonomy of the RBI, even while it ties the central bank's
hands by liberalising the conditions for foreign capital inflows.
Financial flows on the capital account into the country have been further
liberalised by offering tax concessions to venture capital funds, raising
the ceiling on equity holding by FIIs investing in firms in secondary
markets to 40 per cent and promising to sell public equity in banks up to
67 per cent of the total, some of which would be picked up by foreign
investors. So long as India remains the flavour of the time with foreign
investors this would only enhance the quantum of foreign capital inflows.
To partly neutralise the impact this would have on the central bank's
operations, the government has chosen to ease the access to foreign
exchange of domestic capitalists for undertaking investments abroad. The
other route through which foreign exchange reserves would be run down is
through the indiscriminate import that is likely to result from
accelerated import liberalisation. Even while the BJP's capitulation to US
pressure to advance the dates for doing away with quantitative
restrictions on the import of 1429 items (714 to April 1, 2000 and another
715 to April 1, 2001) threatens to deindustrialise India and adversely
affect the livelihood of primary producers, the maximum rate of duty on
agricultural products has been reduced from 40 to 35 per cent. Allowing
indiscriminate access to foreign exchange without imposing any conditions
which tie such use to the earning of foreign exchange to meet future
commitments is a sure way of paving the way for financial crises of the
Sutheast Asian kind.
The attack on domestic producers via the import-competition route occurs
in a context where developmental expenditures are being squeezed. While
the Budget claims to increase Plan outlays by 13 per cent relative to last
year's Budget estimates and 22 per cent over the actual spending in
1999-2000, plan outlays in many crucial sectors, such as agriculture,
rural development, irrigation and so on, have actually been lowered. In
addition, the actual spending on these important areas may turn out to be
even lower. Thus, in both the previous fiscal years, the Central
Government spent much less than it had budgeted for in almost all the
crucial sectors of Plan outlay, such as agriculture, rural development,
irrigation, energy, industry and minerals and so on, thus depriving the
economy of important sources of growth. There have also been shortfalls in
expenditure on social services. So these critical areas of spending
continue to be shortchanged.
The slated 13 per cent increase in capital expenditure in this Budget at
first appears to reverse this tendency. However, 80 per cent of the
increase in total capital expenditure is accounted for by defence alone (Chartt
6). One consequence of this 'new militarism' characterising the BJP's
tenure is that, in an effort to dampen US criticism of this tendency, the
government is willing to make huge concessions on the economic front, with
regard to trade and foreign capital flows. The other is that, non-defence
capital expenditure is budgeted to remain stagnant or decline in real
terms.
Further, in his effort to prove that despite this hike in defence outlays, overall expenditures and the fiscal deficit are to be controlled, the Finance Minister has chosen to attack food and fertiliser subsidies, besides capital expenditures unrelated to defence. The orchestrated outcry on the unsustainable level of food and fertiliser subsidies appears as almost a conspiracy. In fact, even if we only consider revenue expenditures other than interest payments (Chart 7), the share of food subsidies in expenditures has been more or less constant in recent years, and the combine share of food and fertiliser subsidies has in fact been falling.
Yet, the most striking "achievement" of this year's budget is that at a
time when the evidence points to a decade-long stagnation or even increase
in the incidence of rural poverty, the prices of food distributed through
the public distribution system are to be hiked to realise a 12 per cent
reduction in food subsidies.
To sanitise this effort, Sinha has presented the subsidy reduction as an
effort to target subsidies at the needy, namely the population below the
poverty line. That population he argues would now be eligible for double
the quota available earlier. What he left virtually unstated was the fact
that this larger quota is available at a per unit price which would be
much higher. Households below the poverty line would now have to bear with
68 per cent increases in the issue prices of wheat and rice.
Even people above the poverty line, many of whom are also poor in a wider
definition, would have to pay 23 per cent more for wheat and 30 per cent
more for rice because they will now be charged the full economic cost. Not
only does this mean that most people who use the PDS system will end up
paying much more, but it also penalises the state governments that have
been running a more broad-based and efficient PDS system. This is because
this price relates to the rate at which the Central Government releases
foodgrain to the individual state governments, some of whom have been
supplying it at a lower rate to consumers through the PDS.
The irony is that, while this measure will clearly hit ordinary people
very hard, it may not lead to a decline in the food subsidy bill at all.
This is because as prices rise, offtake from Fair Price Shops tends to
decline, and so the FCI is left holding even more stocks, with high
carrying costs which add to its losses. This is indeed one reason why the
level of stock holding of foodgrain is already so high.
As mentioned earlier, the availability of large foodstocks with the
government is calls for an effort to use the surplus foodstocks to part
"finance" employment programmes that help strengthen rural infrastructure.
This would have helped improve agricultural growth performance as well as
increase rural incomes and reduce poverty. The Finance Minister has,
however, chosen to ignore this opportunity and pursist with a strategy of
reform that goes to the contrary. The financial component of such reform
requires curbing borrowing from the RBI and cutting a range of
expenditures as part of the effort to appease finance, even if the
consequence is a combination of policies which squeeze the poor and
undermine growth prospects. These are further indicators of the fact that
under the BJP the overall interests of international finance have come to
dominate economic policy making in India. And it is that dominance which
has put the government in a state of paralysis with respect to triggering
growth and reducing poverty. The interests the BJP government seeks to
serve and those it wishes to penalise are therefore clear.