Monday, Oct 25, 2004
Paradox of India's fiscal sickness
S. Venkitaramanan
A RECENT Working Paper by Prof Ricardo Hausmann of Harvard and Ms Catriona Purfield of the IMF discusses the paradox of India's fiscal sickness, which has not brought the dire consequences that such a condition has brought for other countries.
Like the proverbial bumblebee that flies in spite of the aerodynamics' laws, which says it cannot, India bumbles on, although all fiscal indicators state it is sick. What explains this phenomenon? The Working Paper expresses the views of the authors, who are careful to state that it does not have IMF's authority. The Paper states at the outset that India's fiscal problem has its deep roots in its federal system, where multiple players (the States and regional political parties, for instance) find it difficult to coordinate adjustment.
The size and closed nature of the Indian economy, aided by its deep domestic markets and large pool of captive domestic savings, has 'disguised' the cost of fiscal laxity and complicated the building of a consensus on fiscal reform.
The Paper grants that the new Fiscal Responsibility and Budgetary Management Act (FRBM) establishes a new rule-based system to overcome this coordination failure.
The magnitude of fiscal imbalances prevalent in India at 10 per cent of GDP would have rung alarm bells elsewhere. India's debt to GDP ratio at 80.6 per cent is high almost matching that of Turkey, Argentina and Indonesia. Its debt to revenue ratio running at 441 per cent is also higher than that of Turkey.
It comes close to the Philippines' 573 per cent and Indonesia's 414 per cent. More interestingly, the ratio of interest burden to revenue is low, reflecting deft debt management by the RBI. It stands at 34 per cent, compared to 480 per cent for Turkey.
The fiscal deficit being high means that India has to depend increasingly on debt to finance its expenditure commitments. But its credit rating has not been affected significantly mainly because its external debt-denominated in foreign currency is low. Nor has it had any threat of capital outflows based on its fiscal condition.
The Working Paper argues that the fiscal exceptionalism of India has much to do with the low volatility - low variability of its debt-service ratio. While India's revenue base, at 18 per cent, is below the developing country's average of 26 per cent - a signal to raise our tax base - it is far more stable than that of many other countries.
This reflects the relatively low volatility of India's GDP, which is less exposed to international trends. It also helps that India's forex transactions are sheltered at present behind a wall of restrictions. This prevents the fiscal sickness from overflowing into its external account by peer-pitching outflows of forex.
India's fiscal exceptionalism, such as it is, depends, to a great extent also, on its low exposure to external debts. As a result, exchange rate movements do not have such a traumatic effect on India's interest charges and magnitude of principal repayment, that is to say, its debt service as they may have in other countries similarly placed, but with a relatively higher foreign debt exposure.
But the Working Paper cautions that in spite of this relative lack of exposure to external borrowing even on domestic debt, our complacency may be misplaced. This is because the variability of interest rates is a danger that can affect banks, which have mostly funded India's gilt-edged debt.
The Paper cites a recent study by Professors Patnaik and Shah to show that Indian banks are inadequately hedged against the possibility of interest rate rise and may suffer heavily in spite of the RBI's efforts to counter this risk. Dwelling on the enforceability of the FRBM limits, the Working Paper acknowledges that sanctions may not work.
The device of the Maastricht Treaty and the Growth and Stability Pact for enforcing sanctions and fines on countries not reaching the set targets for fiscal deficit did not work.
Germany and France together got the relevant regulations liberalised to take into account what they called their special circumstances resulting in their going beyond the prescribed 3 per cent limit. There has been no question of shaming Germany and France into fiscal compliance. Indeed, they are like sportsmen who had changed their goal posts when they found the umpire ruling against them.
The idea of enforcing fiscal deficit targets through sanctions is, therefore, not recommended by the Working Paper. But, on the contrary, the Working Paper suggests example of New Zealand and some other countries where there are other penalties in force.
Whether a basically political decision, like the Budget, can be subject to such punishments enforced by extra political authority in a democracy as complex as India, especially given its federal structure, is not at all clear.
Why does India - in particular, its political parties - not resent the accumulation of debt that its fiscal deficit implies? This is obviously a problem of divergence of perceptions. Most of the political parties do state in their public pronouncements that they do not like to increase indebtedness. But the problem arises precisely because there is no coordination between those who decide to spend and those who have to raise revenues.
The fear of debt is not so high among the political participants, who pull the levers of political power, which determine spending commitments and decide on revenue-raising measures.
This is partly explained by the ease of access to debt, which India provides to both the Central and State Governments. The Working Paper refers to the comparative attractiveness of the savings schemes, which seem to provide increasing resources to fill the fiscal gap of States, in particular. This is obviously a function of the interest rate and the credibility of the State as a no-default mechanism.
Indirectly, the Paper grants that the postal savings system with all its defects has proved the bulwark of India's financial system, although fiscal purists may look askance at its creaky structure and its facilitating a debt solution, which makes for fiscal imbalance being easily funded.
While the Working Paper welcomes the FRBM and its stated goals, it acknowledges that there is a problem in its implementation. Its goals of reduction of revenue deficit have been diluted by extending the date by two years. A fundamental point raised by the Working Paper concerns the tendency of budget-makers to "cook" up estimates of revenue and expenditure to reach the stated goals!
Biased estimates of budgetary aggregates become attractive ways of reaching fiscal deficit targets - unless they are continually monitored. Also, the temptation to overestimate revenues and underestimate expenditure carries no penalty in our system.
No political party will like to surrender its spending authority to an extra-political power structure, especially in a democracy. The Working Paper goes into this question in some detail and suggests the setting up of an independent agency, which could be empowered to prepare Budget estimates, provide accounting standards and ensure compliance with the FRBM and other budgetary rules.
This body - a score-keeper - would be, in some senses, analogous to the Congressional Budget Office in the US. In a sense, the Public Accounts Committee, the Estimates Committee and other Committees of Parliament already perform part of this function, albeit post facto. The CAG also has an important role. There is little merit in the suggestion for an independent agency, which adds yet another layer to the task of Budget formulation. Nor is it politically feasible.
The Working Paper discusses the issues raised by the complexities of India's federal system, particularly its structure of devolution through the Finance Commission, overlaid by the grants and loans from the Planning Commission. It rightly observes that this needs to be rationalised.
It also refers to the moral hazard posed by successive write-downs and write-offs of Central loans and grants to State. The warning that this compromises the States' adherence to fiscal responsibility is definitely in order. But, who will listen when the Centre is obligated for its political survival to regional parties, many of whom run State Governments?
The Working Paper cautions that the absence of crisis on account of fiscal laxity should not lead to complacency. The warning is couched in strong medical terms. "As with cancer, it may not be good in the long run to be symptom-free, it prevents the patient from taking early action". Further, the steps needed to correct fiscal imbalance may be more traumatic if taken too late.
The Paper has rightly cautioned India about the danger of overlooking fiscal imbalance, although currently the sickness may not have immediate consequence and its remedies may be a bit unsuitable for India. We have, however, to evolve our own way of handling our troubles - fiscal and otherwise.
To sum up, that our seemingly `silent' fiscal problems may lead to an unsustainable terminal situation is the sure and well-meant message of the Paper. It is up to us to evolve solutions, but at least we must listen to the warnings, whatever the source of the message of adverse outcomes.
Copyright © 2004, The Hindu Business Line.