The Hindu Business Line : Bias against public spending

The economic package is a case of missed opportunities. It betrays a distrust of public expenditure, which stems from the belief that the state cannot be brought to book for shoddy implementation.

— V. Ganesan

Public expenditure alone can put money in the hands of those outside the market economy.

C. Shivkumar
A. Srinivas

By setting aside just Rs 20,000 crore as public expenditure in the stimulus package announced last week, the Centre has chosen to rely more on interest rate and indirect tax cuts than public spending to boost the economy. This is despite the fact that it could take months for the tax and interest rate cuts to take effect (if at all) whereas public spending has an immediate impact.

Excise duty and interest rate cuts may not have the same counter-cyclical effect as public expenditure — credit for consumption and investment may not pick up if sentiment is poor. What, then, explains this preference for indirect methods to spur the economy?

According to prevailing economic wisdom, public expenditure drives up interest rates and inflation. Whatever the merits of this view, it explains the focus on containing revenue and fiscal deficits. The Fiscal Responsibility and Budget Management Act (FRBMA), binds the Centre and States to achieve a zero revenue deficit and 3 per cent fiscal deficit by March 31, 2009. Attempts to meet this deadline have led to cutbacks in social sector expenditure, particularly in the States. Interest rate and indirect tax cuts might spur the economy, but they cannot promote inclusiveness. To achieve the latter, there is no escaping public expenditure, which alone can put money in the hands of those outside the market economy and smoothen out business cycles.

FLAWED APPROACH

The FRBMA is based on the notion that public expenditure ‘crowds out’ private spending by raising the interest rate. However, methods to increase money supply — which will take care of this problem — without resorting to monetisation have perhaps not been explored.

The Reserve Bank of India is yet to redeem short- and medium-term market stabilisation scheme (MSS) bonds worth Rs 1.32 lakh crore. The MSS bonds were introduced to soak up liquidity released from the RBI’s intervention in foreign exchange markets. Instead of exploiting the MSS facility, piecemeal redemptions were offered — buyback of MSS securities and replacing them with fresh government borrowings.

MSS redemptions would keep interest rates under check, and save further interest outgo on the bonds, leaving the Centre with more room for revenue expenditure.

Conversion of oil, fertiliser and Food Corporation of India bonds of about Rs 1.25 lakh crore into SLR-eligible securities was also an alternative. Such a move would have released an equivalent amount of liquidity for credit. The proposal, however, was turned down. The reason advanced was that conversion of subsidy bonds would upset the yield curve, implying the government’s borrowing costs would increase.

As Keynesians would argue, in an economy like India which is nowhere near ‘full employment’, there is room for private and public sectors to invest more. In the event of a slackening in private consumption and investment, public outlays can transform the economic sentiment and ‘crowd in’ private investment.

As for those who fear the inflationary effects of public spending, it should be borne in mind that India is a demand-constrained economy, its 300-million-strong consumer class notwithstanding.

Inflation is essentially caused by global market imbalances or rent-seeking behaviour. The latter is better tackled through administrative and specific monetary measures. Why rein in public expenditure?

Instead of targeting expenditure, State finances could have been straightened out by improving revenue collection. The States’ tax-to-GDP ratio declined from 10.68 per cent in 1999-00 to 9.28 per cent in 2007-08, while the Centre’s improved from 8.86 per cent to 12.63 per cent. The implementation of VAT and high petroleum prices do not seem to have helped the States.

While running up a 10 per cent fiscal deficit (Centre and States) is not a calamity in the present situation, this could have been averted, had State governments improved their tax governance. Besides, the Centre could have put off a reduction in petroleum prices and put the tax revenues to fruitful use. With inflation already in single digits, this was a feasible course of action.

MONETARY POLICY LIMITS

The obsession with fiscal deficit has given rise to excessive reliance on the banking system to revive the economy. With monetisation ruled out and MSS redemption happening slowly, rate cuts may not alleviate the liquidity crunch.

Unlike the last few years, external commercial borrowings have been hard to come by. During the first three months of the current fiscal, a net amount of $1.6 billion was raised, against $6.99 billion in the corresponding period in 2007-08. The dollar shortage has made access to ECB funds difficult, prompting potential borrowers to look inwards for resources, thereby driving up yields.

Even if ECB funds are available, the costs are prohibitively high. Even AAA-rated borrowers are faced with a spread of at least 300 basis points over the US Treasury Bills. The lesser-rated borrower would end up paying spread of 600-700 basis points over the London Interbank Offer Rate (Libor).

The ECB drought has led to high credit off-take (25-30 per cent growth) from the domestic banking system in recent months. Given their current levels of capital, banks cannot sustain such credit growth. They are expected to maintain a capital to risk-weighted asset ratio of 12 per cent, although the regulatory prescription is only 9 per cent.

Within this regulatory norm, minimum tier-one capital (paid up equity plus free reserves) is 6 per cent. It is here that the banking sector is beginning to face problems. With markets in the doldrums, it is not in a position to raise equity funds.

Missed opportunities

The alternative is for the government to put in equity/quasi-equity capital into the banks. That is an area where the government has so far remained non-committal. Without tier one capital, tier two capital also cannot be increased. Banks’ tier two capital, that includes bond issues of over five years’ maturity and revaluation reserves, are limited to 100 per cent of tier one capital. Banks are seeing a surge of deposits, thanks to the exodus from equity.

Time deposits are growing by at least 24 per cent per annum. Yet banks are unable to extend credit as a result of the capital shortage. Big ticket projects relying on borrowed funds — ports, ultra mega power plants, highways and refineries — have run into problems.

The government’s economic package is a case of missed opportunities. It betrays, like other similar initiatives, a distrust of public expenditure, which also stems from a belief that the state cannot be brought to book for shoddy implementation and leakages, whereas the private sector gets more out of every rupee that it spends. The view is not without basis, but the way out is to create institutions to increase the state’s accountability.

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