The Hindu Business Line : More government doesn’t mean less private enterprise

The Prime Minister’s recent remarks about weak demand provide the best clue to the real problems confronting India. They could form the basis for ministries to hammer out measures that can get investments going and meet the more important crisis of the real economy head on, says ASHOAK UPADHYAY.

The Government must look at core sector spending and urge multilateral institutions to commit more for roads and airports and health-care.

At long last the highest policymaker, professional economist, reluctant politician and statesman-in-the-making, has entered a somewhat inchoate policy debate on how best to handle a crisis steadily rippling through the economy. On his way home from Beijing last Sunday, Dr Manmohan Singh thought India was “in a typical Keynesian situation where there is a lack of demand, private sector demand is very weak, but strong government demand, both for social services and for investments will provide the essential stabilisers…”

That is a radical departure from the positions held by the RBI and North Block; the former vigorously and the latter weakly have asserted since 2005 that aggregate demand pressures have formed the basis for monetary tightening. Just last week the RBI’s mid-term review reiterated that contention.

Exactly what the Prime Minister’s observation will translate into is, at this point, uncertain; but it could form the premise for almost every economic ministry to get together and hammer out measures that can address that weakness, get investments going and finally meet the more important crisis of the real economy head on.

They would do well to recall that the RBI, in its mid-year review, pointed out that real Gross Fixed Capital Formation (GFCF) growth had fallen to 9 per cent the quarter ended June 2008 from 13 per cent in last year’s corresponding quarter.

Why is demand weak?

Significant as it is, the drop is also intriguing: if credit growth has been robust at 25 per cent (discounting the disbursals for petroleum and fertilisers) and if FDI has been the highest, at $16 billion, why has the GFCF growth rate declined? The much-touted time lag, perhaps? Maybe; but no policy-maker ought to bet on it. The way the economy is responding to its internal weaknesses and the global turbulence, investment on the ground may just get postponed indefinitely, beyond the expected “time lag”.

A more prosaic reason for the lower number might rest in weakening business expectations despite high liquidity (as measured by credit growth). Evidence on the ground suggests falling demand for autos and capital goods much before the Lehman crisis; in fact, industrial output had begun to decline last fiscal.

The Finance Minister may find the Index of Industrial Production numbers suspect but those are the best so far, and the policymakers have relied on them so long as they told happy stories. Now they describe, however weakly, a slide; and that fall in output is a result of two crucial elements that should figure in any public policy formulation: falling demand and high input costs.

In other words, inflation has dented the costing picture of companies, with steel, cement and oil having shot through the roof till early September this year. But interest costs had also started pinching; many firms held them responsible for higher manufactured product prices, and then, for output cutbacks.

Some analysts, echoing the RBI, have insisted that excess liquidity (or, what is the same thing, excess demand) has fed inflation and so needed to be excised. Perhaps; but why, then, is demand for goods and services falling and why are essential food prices still sky-high?

Where does the excess liquidity pressure originate if not in private consumer demand, as it did when the RBI first began to get worried about “overheating” four years ago?

Public borrowings, RBI’s headache

Some clues lie in the last Currency and Finance Report under Dr Y. V. Reddy’s governorship. Government borrowings were viewed with some alarm as deterrents to the RBI’s price stabilising efforts.

Thus the RBI has begun to locate another source for those strong aggregate demand pressures. The central bank is right that demand pressures have built up but they have done so through higher government borrowings that have to fund the generosity of the UPA towards its employees, the Defence services and the indebted farmers, not to mention fertiliser subsidies and help for the oil companies.

So, what effect does monetary policy have on inflation? It is, willy-nilly, exacerbating it. By keeping interest rates high, the central bank has, in effect, encouraged the Government to continue its deficit financing and increased the cost of capital for consumers and producers. A tight monetary policy has also allowed interest rate arbitrage and kept capital flows streaming in. Till September.

With the crisis first engulfing Wall Street and its ripples moving with widening force to the emerging markets, the “second epicentre”, the problems for the Indian economy became more acute. More than the tangible effects of direct global links — FIIs, exports and ECBs, the economy is being hit by the intangible and more pernicious effects of falling expectations. Already eroding with weaker demand since last June and falling investment demand a year later, the economy will slide further, not simply because exporters will lose markets but because manufactures will lose markets. Period.

resurrection of spending

Under the circumstances, what should policymakers do? There are two problems: one publicly acknowledged, the other getting its due. The former is the lack of credit since September for manufacturing and retail borrowers; the latter is weak private demand that has been eating into business confidence even before the crisis hit us in the face.

The first manifest itself in a lack of funds in September, and North Block and the RBI responded admirably, quickly pumping in funds through repeated CRR cuts and the first repo rate trim in months. Yet, credit still appears scarce; banks are getting risk-averse, an attitude that seems to have returned like some spectre to haunt borrowers.

So, what is to be done now to get those tight-fisted bankers to lend? Can policy arm-twist them? If they were as dependent on government largesse as their British counterparts are on their government to keep them afloat, then New Delhi could emulate Gordon Brown and mandate lending as a precondition. But Indian banks, as the policymakers have assured us, are well-capitalised and, barring ICICI Bank, have shown healthy results, although with rising NPAs.

In a market scenario, governments can only plead for, or corral, more credit for priority sectors: nothing more. Bankers have to feel lending is lucrative for them to open up and move away from safe government securities. Right now they do not think it is. Why? Probably because no one thinks this is the right time for any investment decisions. The air is foul with gloom each passing day. Everything appears expensive and risky.

This is where the government has to step in with two kinds of policy. First, interest rates have to come down so that the RBI can send a positive signal that it means to help growth rather than fight a futile battle against inflation that, again, only better supply side policy and good fortune can mitigate. Second, the government must step in with some festive season tax cuts and as the Big Spender.

Which taxes can be cut?

The Centre must consider sacrificing some of its indirect tax revenues and reduce the average excise and Customs duties. Sates must be encouraged to find ways to trim sales tax on ATF, for example, though just how they do so should be left to them.

But, foremost, governments must spend. It is when demand rises that banks will see an opportunity for lending. The causation does not work the other way around, except in exceptional circumstances, of the kind that the British system finds itself in, or under directed planned lending.

Finally, what kind of spending can work? So far, the government has been borrowing to meet its social sector commitments. Now it must look at core sector spending and urging multilateral institutions to commit more for roads and airports and health-care.

Many may see this as a return to pre-1991-style government intervention. Maybe, but if public spending boosts private sector confidence, India may, after 60 years of trying, show the world that more government does not mean less private enterprise.