Reading the tea leaves of ratings

To alter perceptions, evolve a strategy of meaningful reforms

S.S. Tarapore

The inevitable has happened. International credit rating agencies have downed the hammer on India’s rating. We all knew that there was nothing new in the rationale behind the downgrade. Then why the official outrage and the almost subservient support of the official position by industry associations? The media however, barring a few exceptions, has shown considerable maturity and judgement in advocating a sensible response to the downgrade.

The strength of the external payments position is unprecedented, with virtually all the key parameters reflecting resilience. But obviously that is not the central concern of the rating agencies. External payments crisis never emanate suo moto from the external sector; the problems always are in the weaknesses in the domestic economy. In today’s integrated economy, the international propagation of economic cycles is much faster but these factors invariably impinge on an already weakened domestic economy.

We need make no pretence that our domestic economy is free from problems. The combined fiscal deficit in the current financial year could well exceed 10 per cent of GDP and government debt could approach 70 per cent of GDP. These are serious warning signals. To talk of self-fulfilling prophecies and fiscal bashing as being hazardous and therefore to blind ourselves to these problems can only aggravate an already difficult situation.

About a year ago, there was great hope that the Fiscal Responsibility and Budget Management Bill would be quickly enacted. Subsequent developments have, however, totally belied such expectations. Quite apart from populist pressures for larger spending, influential economists have been raving about the joys of pump priming and further reductions in interest rates. These are dangerous ideas and any move towards pump priming and further reducing interest rates would be a standing invitation to international rating agencies to further downgrade India.

We can say that we don’t care about rating agencies and that foreign investors will continue to invest, but the harsh reality is that there could be an eerie parallel between 1990-91 and today. Of course, we could proudly assert that we have $44 bn of forex reserves and, that all our external debt parameters are very favourable but equally, we must be aware that the economy is more open than what it was in 1990-91 and that weaknesses in the domestic economy could rapidly spill over to the external sector.

If we want to have a proper Le defi Indien (the Indian challenge) then we should not make the Fiscal Responsibility Bill a political issue. The role of the Opposition should be to strengthen, not dilute, the proposed fiscal discipline. The purpose should not merely be to satisfy international rating agencies but to bring about fiscal rectitude which would transmit proper signals through the economy.

India, like any other country, is subject to industrial cyclical problems. The issue is not excess savings but over investment. In India ‘over investment’ is misunderstood. It does not mean that the country is not consuming enough and investing more than required; it means that consumption is excessive and therefore, savings are inadequate. Savings match investment through ‘forced savings’ which is nothing but an injection of created money. It is thus dangerous to go for pump priming.

To the extent we wish to remove bottlenecks in the economy, we have to locate areas with excess capacities and reduce investment in these sectors; and step up investments in areas with capacity shortages. In other words, we need to rectify ‘malinvestment’. This is the only way of kick starting the economy; the printing press is not the answer.

The other major area where early action is required is the financial sector. We need to stop monkeying around with the interest rate structure. Excessive reductions in interest rates only attenuate the banks/financial institutions (FIs), promote unviable investments and punish the saver, generating disequilibrium in the economy. In a capital-short economy real interest rates need to be significantly higher than in industrial countries, though admittedly real interest rates should not be higher than the real rate of growth.

The financial legislative changes sought to be implemented should not be blocked in Parliament. It is proved beyond a doubt that public ownership of banks/FIs and efficiency of operations are mutually inconsistent. As Reserve Bank governor Jalan has cogently argued, the public sector character of banks need not be given up while reducing the public sector ownership from the present minimum of 51 per cent to 33 per cent, as recommended by the Narasimhan Committee.

There is a pressing need to lighten the regulatory framework while making supervision effective. Regulation/supervision have to become highly specialised. After all, we do not expect a physician to undertake skilled surgery. Likewise it is high time we recognise that generalists cannot be regulators/supervisors. We are dealing with a relatively deregulated financial system and if the financial system has to be safeguarded from explosive crises, regulation/supervision of market activity has to be proactive and not reactive.

Lastly, if we are to generate international confidence in our economy our exchange controls, particularly on the capital account, have to move away from meaningless controls on small transactions of individuals. Freeing of individual resident capital transactions within reasonable limits –– say, upto $25,000 per year — would provide favourable external perceptions which no other measure can; but would our authorities earn this effortless mileage? I doubt it!

We can be indifferent to international opinion only at our own peril. This is a costly lesson we learnt in 1991 and we need to avoid the same mistake ten years on. Using attack dog tactics of yesteryear to set out self-serving tosh would only convince investors that a full-blown crisis is in the air. We need to evolve a strategy of meaningful reforms to alter the perceptions of rating agencies.