The Hindu Business Line : Puzzles in India’s macro-economy

A recent article on the role of institutions and the market in India’s development makes the important point that over-emphasis on fiscal deficit indicators without reference to the quality of government expenditure can lead to wrong policy conclusions. S. Venkitaramanan on what the article refers to as “a weakness in the conventional analysis of India’s macro-economic development”.

Recently, I came across an interesting article by Dr Michel Rashit, a well-known expert on India’s macro-economics, published in the volume Institutions and Market in India’s Development: Essays for Dr K. N. Raj. While the other chapters in the book are of equal interest, I was particularly impressed with Dr Rashit’s piece as it is timely in stressing that our emphasis on fiscal deficit indicators may be counterproductive. He has stated that the behaviour of the macro-economy since the mid-1990s has displayed a number of features that do not seem to conform to conventional economic logic.

One of the notable characteristics of the economy during this period is the deterioration of Government finances. Both fiscal and revenue deficits as ratios of GDP have ballooned, averaging 9.2 per cent and 6.2 per cent respectively. The debt-GDP ratio, which had fallen from 61.7 per cent in 1990-91 to 56 per cent in 1996-97, started rising relentlessly since then, reached 81.1 per cent in 2003-04.

The macro-economic conundrum arises from the fact that despite recurring revenue and fiscal deficits of such magnitude for more than seven years, the usual fall-out of persistent “fiscal profligacy” has been conspicuous by its absence. Conventional economic wisdom suggests that large fiscal deficits lead to rapid accumulation of external liability and the country’s creditworthiness is eroded, which makes it prone to BoP crisis. But, contrary to conventional wisdom, India did not face such a situation during the period under review.

According to the orthodox view, the negative impact of large-scale debt financing is on interest rates and savings. An increase in Government borrowing tends to raise interest rates and crowd out private investment.

Inflation pressure is intensified in the short as well as medium term. Government expenditure not financed through taxes raises aggregate demand and enlargement of public debt causes an increase in private consumption, which leads to crowding out of private investment and decline in savings. Conventional wisdom predicts a negative impact on economic growth and rise in interest rates and the economy ends up in fiscal crisis through cumulative unbounded increase in the debt-GDP ratio.

The performance of the economy since 1996-97 does not, however, follow the conventional paradigm. The behaviour of the major fiscal indicators during the period was, in fact, worse than in the pre-1990-91 years. While the average figures of fiscal and revenue deficits as ratios of GDP during the seven-year period from 1984 to 1991 were 8.98 per cent and 2.8 per cent respectively, the corresponding figures for 1997-2004 were 9.17 per cent and 6.17 per cent.

As stated earlier, the public debt scenario in the latter period was also much worse. Contrary to the deterioration in the country’s external account during the 1980s, there has been a marked improvement in the BoP in the recent period. Not only was the average current account deficit to GDP ratio during 1997-2001 a modest 0.3 per cent since then, it showed a declining trend for a year or so and it turned into a surplus.

Flawed Analysis

All this shows that there is a weakness in the conventional analysis of India’s macro-economic development. Over-emphasis on fiscal deficit indicators without reference to the quality of government expenditure can lead to wrong policy conclusions. One of the main reasons for the problems in the economy during this period is decline in agricultural growth, primarily due to the decline in government investment on infrastructure, especially in the rural areas.

Added to this was an unintended consequence of economic reforms, that of increasing the capital adequacy norms for banks, which led to banks becoming risk-averse in lending to agriculture and small and medium industries. Reduction in government investments in the rural areas together with reduction of credit led to a decline in agricultural prospects. This partially explains the decline in agricultural and overall growth rates during the period.

It is important to realise that in spite of the growing fiscal deficit, external investors’ confidence in India increased. Portfolio and foreign direct investment (FDI) were both higher.

The situation became one of relative affluence and the undesirable consequences of accumulation of higher reserves. It is important to realise that conventional economic analysis has serious limitations in understanding a complex economy such as India’s.

Dr Rashit says: “The behaviour of the economy during 1997-2004 has thrown up a number of puzzles, whose solution in terms of orthodox economic analysis appears difficult. The period was marked by persistent large fiscal deficit and, hence, increase in public debt, but at the same time current account balance showed a significant improvement”.

An increase in capital flows testified to the growing external confidence of investors. Despite large-scale debt financing of Government expenditure, not only inflation but also nominal and real rates of interest showed a decline. This suggests that conventional analysis cannot fully account for the various features of India’s macro-economic development.

These features of the economy appear paradoxical only because most analysts try to make sense of them in terms of received wisdom without bothering to identify the main drivers for the Indian economy.

“It cannot be over-emphasised” says Dr Rashit “that the ratios of fiscal and revenue deficits to GDP do not constitute primary instruments of Government policy, but results from the operation of the entire economy.

Hence, it is essential to consider changes in the various components of Government’s primary expenditure and in tax rates, over which public authorities have some direct control”. Perhaps, an most important point is that during the entire period non-agricultural sector accounting for more than 75 per cent of GDP suffered from excess capacity.

Right Approach

The implication is that the conventional explanation of fiscal deficit, leading to current account imbalances, etc., has to be substituted by detailed analysis of the composition of government expenditure and tax policy.

Besides, it is important that monetary policy and credit distribution keep in step with the requirements of the economy.

The most important policy conclusions from the above analyses may be summarised as follows, in Dr Rashit’s words:

For formulating the budget programme, it is essential to select carefully the primary instrument for fiscal policy rather than concentrate on intermediate target, such as ratios of fiscal and revenue deficits to GDP.

Wrong choice of ratios of instrument can not only prevent attainment of targets but even when the targets are achieved, lead to the negative consequences for growth, equity and resilience of the economy.

In addition, Dr Rashit emphasises that promotion of private investment, domestic as well as foreign, requires adequate infrastructural facilities, skilled labour and prevention of serious and chronic demand deficiency. In both respects , the responsibility lies with the government.

Further, financial sector reform should be reviewed so that credit agencies do not become inaccessible to agriculture and medium and small-scale industries. There is need for development of innovative credit delivery system for meeting the needs of such borrowers.

Economic reforms removing the barriers to entry, enhancing mobility of resources and ensuring competition are essential if the economy is to take advantage of the globalisation and withstand its volatility.

These are important takeaways from a seminal contribution by Dr Rashit to the debate on the role of institutions and markets for India’s development. A fitting tribute to Dr K.N.Raj, who was an outstanding contributor to India’s economic development!