Carrying reforms forward

Pranab

There is no reason to be surprised at the Budget's deficit figures. Higher domestic absorption and inclusion, which the Budget aims for, is a pre-condition for a second wave of reforms.

Expectations before the Budget were either that the government paralysis would continue or that the opportunity would be seized to undertake substantial reform. That the stock market rose strongly after the presentation suggests that expectations were exceeded. But the positive surprise was largely the Budget figures, as a list of pending reforms remains.

We argue there is no reason to be surprised at the deficit figures. The positives are the many initiatives for better governance. The first wave of reforms was important to initiate higher growth, but higher domestic absorption and inclusion, which the Budget aims for, is a pre-condition for a second wave of opening out.

FINANCIAL REFORMS

Consider the relaxation of the cap on foreign investment in long-term rupee infrastructure bonds from $5 billion to $20 billion. This further step towards capital account convertibility follows the sequence Indian reforms established, which worked to India's advantage.

Foreign portfolio investment was liberalised first as it shares risk— what it takes out in bad times is less than what it brings in during good times. Debt, especially short-term debt, is the worst in this respect, and continues to be restricted.

Long-term debt funds are required to remove infrastructure bottlenecks. But foreign capital is reluctant to assume currency risk, and prefers short-term paper. Therefore current inflows under this category, at $700 million, are below the earlier cap. For corporate debt flows to come in, the domestic markets have to deepen first. Incentives for States to reform stamp duty regimes are a step towards this objective. Relaxing the cap is not in itself sufficient for inflows.

It is ironic that foreign individuals are to be allowed to invest in equity MFs when the share of domestic household financial savings in shares and debentures, including MFs, had itself fallen to 2.6 per cent in 2008-09. But the move may lead to strengthening the distribution platforms for index funds and ETFs, which are likely to be more popular with distant investors, and help make these instruments more accessible to domestic savers.

Since they do not generate large commissions for brokers they are undersold at present. KYC norms have the potential to be a good hassle-free filter. Our large 30 per cent plus savings will fully contribute to growth only when they are better intermediated through the financial system.

There are concerns that more stable FDI flows have decreased. But the reasons are poor infrastructure, land acquisition problems and high transaction costs. FPI comes in because a smooth electronic highway exists, just as software exports took off since poor roads did not hamper them. Greater ease of doing business will encourage both domestic and foreign companies.

Freeing inflows is such an easy and tempting reform. But doing this without hard prior domestic reform is dangerous. The rise in the economy's absorptive capacity makes it possible to raise limits, reducing time and transaction costs, and improving public service delivery, and is the reform most urgently required at the current juncture. The Budget does take steps towards this. High growth and inflation both increase nominal GDP and decrease debt and deficit ratios. These factors help explain the impressive fiscal consolidation. As long as these continue, they will help achieve the 4.6 per cent fiscal deficit projected. In addition, initiatives towards better governance will cut wasteful expenditure. Oil subsidies may be underestimated, but there are too many uncertainties at present. Periods of very sharp rise in oil prices, as over the past six months, have historically been followed by a sharp fall. Analysts do not seem to have adequately recognise these positives.

EXPENDITURE

The Budgeted increase in expenditure is low. But the crisis demonstrated the effectiveness of a countercyclical fiscal policy. To the extent government spending rose to counter the crisis, it has to slow down. If the tendency to splurge can be reined in, the revenue boom will create the fiscal space to respond to the next downturn.

Expenditure targets in irrigation, energy and communication were not met last year. However, they were exceeded for agriculture and rural development —perhaps part of the 3G money was spent there. This base effect makes planned expenditure growth in these two sectors low. Incentives created are better if sectors that are able to spend effectively are allocated more, and those unable to meet targets are penalised. This has been done with NREGA, where large unspent amounts were allocated to other schemes. There is movement in the right direction but still a long way to go to improve implementation.

INFLATION

While being faithful to a long-term vision, a yearly Budget must convincingly address pressing current problems. However, it fails to convey the seriousness of the attack on supply-side issues, bolstering inflation. High food prices mean hikes in wages and prices down the road. The many schemes announced do not reach a critical mass. States are told to reform the APMC and improve connectivity in agricultural markets, but are not incentivised to do so.

(The author is Professor of Economics. IGIDR, Mumbai. >[email protected])

Published on March 10, 2011

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