The Hindu Business Line : ‘India has a huge fiscal problem’

The global economic crisis will not have any structural impact on the Indian economy but India has to deal with its unprecedented fiscal deficit before it derails growth, says Dr Ramana Ramaswamy, a former senior economist at the IMF.

Dr Ramaswamy, who is now a hedge fund manager based in London, believes that there is no meaningful alternative to the dollar, despite all the talk of currency diversification.

Excerpts from a recent interaction in Chennai:

In hindsight, how much has India been impacted by the global economic downturn? What is the global market’s perspective on the impact of the downturn on India?

I’ve just returned from the IMF meetings in Istanbul, where central bankers from all the developing countries were represented. One thing that came out from the meetings is that banking systems in all the emerging countries, be they Korea, Brazil, Turkey or India, are in pretty good shape. Banks are adequately capitalised, liquidity is comfortable and so on. I think the epicentre of the crisis lies within the US and in the Euro area. All the downside risks to the global economy over the next 12-18 months really depend upon what happens to the US and to the Euro area.

My reading of it is that the entire impact of the Lehman collapse and the housing collapse in the US hit the global trade system and squeezed credit lines. I think that is slowly healing itself. So I don’t see this crisis having a long-term structural impact on emerging economies at all. I think there is a danger of the US going in for a double dip recession- maybe sometime next year. If that happens, it will again have an impact on asset prices, stock markets, currency markets and so on. But that is more of a cyclical impact.

A couple of years ago, India was planning for a scenario where its GDP growth would accelerate to 9-10 per cent. How does this downturn impact those plans?

I don’t think India’s potential is to grow at 9-10 per cent, the infrastructure bottlenecks are huge. I think 7-8 per cent is more likely. With or without a crisis in the West, attaining a 7-8 per cent growth rate depends mainly on what we do within India. It has nothing to do with what happens in the West. In the longer run we have to deal with infrastructural bottlenecks and fix basic issues such as education.

Has the stimulus worked? Did we need more spending? What about the impact of that on the fiscal deficit?

I think the fiscal stimulus they gave in India was the right thing to do. It was also the right amount of stimulus. Some people argued that India needed to do more — look at China and the size of stimulus they gave! Now, there are a couple of issues out there. India has the biggest fiscal problem in the emerging markets, unprecedented in this part of the world. No one else has a fiscal problem of this size — Brazil, Turkey, Indonesia or Argentina.

The debt ratios of India are again very large. Once you take into account the bond issues for subsidising fertilisers and oil and include local government debt, the debt to GDP ratio would be in the nineties. This is large in the emerging market universe. Look at Indonesia. It reduced its debt to GDP from 90 per cent six years ago to about 35 per cent now. Their fiscal deficit even after stimulus is 2-3 per cent of GDP. Turkey has 40-45 per cent, Brazil has a debt ratio of 40-45 per cent. Every Asian competitor has a lower debt ratio.

Therefore, India has a huge fiscal problem. That doesn’t manifest itself because it is a fast growing economy. As long as you keep growing at 7-8 per cent, the fiscal problem doesn’t come back to bite you, but the moment you slow down, the issue will be a big deal. The other facet is that banks are financing a lot of this fiscal deficit, reducing their lending to the private sector. That is indeed why private companies borrowed overseas, creating more risks to the system. This really isn’t the time to tighten (monetary policy), but if the global economy picks up over a 2-3 year time frame, India has really got to deal with it. Most people in India do not realise the magnitude of this problem.

However, the fact is that India does not really depend upon foreigners to fund its fiscal deficit. The Indian banks fund it. You look at Indonesia, the Philippines, Sri Lanka… they issue external bonds to fund their deficits. In that sense, there is not that much external pressure to consolidate the fiscal deficit in India.

What could India do to curtail the deficit without impacting growth?

Today, when the global economy is fragile, there are downside risks to growth and that may be difficult to do. But once things stabilise there is so much that can be done. There are so many subsidies which are inefficient, they can be reduced. The tax base has to be widened. India’s economy is vibrant and growing, that should make it easy to do that.

How worried are international investors about India’s fiscal deficit? They are still pumping money into the stock markets.

You cannot use equity markets as an indication of financial flows. You have got to look at FDI and other factors. However, foreigners are not worried about India’s fiscal deficit because they are not funding it. They are looking at the return on their investments and may have a time horizon in mind — 6 months, 2 years or several years when they pump in money into stocks. It is an issue for the country because you cannot continue to grow at a rapid rate, with this fiscal problem. Fiscal deficit will not have an impact on the capital inflows unless international investors see a default situation.

Will the US dollar weaken further?

The dollar has already weakened a lot and my view is that the euro is in overvalued territory. It is not as if the euro area does not have its own problems, but central banks are keen to diversify their reserves. At some stage, you will find strong currency becoming a problem for the region. Banks in the region have major structural issues. Therefore you can say the dollar is going to get weaker, but weaker against whom? I don’t think a weaker dollar will solve the world’s problems, if the alternative is the euro. I think the debate on an alternative to the dollar is not meaningful. There is really no alternative.

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