Dear Montek

The Approach Paper to the Eleventh Five Year Plan is a rich document that deliberates on some of the most important issues and challenges for the Indian economy in the next five years. Some comments on the approach paper follow.

(i) Constraints to growth

The “proposed...target growth rate for the Eleventh Plan ... at 8.5 per cent per annum” (p.15) appears to be both feasible and desirable.

However, the growth target seems to have been fixed in view of the need to contain the risk to the balance of payments. The Approach Paper argues that the current account deficit (CAD) as a proportion of GDP is likely to go up by 40 basis points (from 2.0 per cent to 2.4 per cent and further to 2.8 per cent) for every percentage point increase in the GDP growth rate (from 7 per cent to 8 per cent, and further to 9 per cent).

It is possible to argue that the constraint to growth, particularly with the already tight ICOR of 3.9-4.0 assumed in the Approach Paper, will come not from a burgeoning CAD, but from an insufficiency of private investment because of the inability to provide a supportive investment climate through appropriate reforms. The argument about CAD constraining growth needs to be reconsidered from two other angles. First, in Table 7 (p.16), the Approach Paper projects the growth rate of imports and exports at 12.1 per cent and 16.0 per cent, respectively. With these growth rates, and the import (US$156.3 billion) and export (US$104.8 billion) figures in 2004-05, the trade deficit marginally narrows from US$55.5 billion in 2007-08 to US$55.0 billion in the terminal Eleventh Plan year of 2011-12. With such a trajectory of trade deficit, a deteriorating or even unchanged CAD as a proportion of GDP (which grows at an annual 8.5 per cent) requires a sharp deterioration in the net in invisibles. Does the Commission endorse such a bleak view on the invisibles front?

Second, although this demand-induced expansion of the CAD with growth-acceleration is a standard result of textbook macroeconomics, the recent experience of the Indian economy as well as of East Asia casts some doubts about such an eventuality. In a significant transformation, the CAD, observed for 24 years since 1977-78, had started shrinking from 1999-00. The contraction gave way to a current account surplus in 2001-02, which continued until 2003-04. Albeit, the CAD has staged a comeback from 2004-05, but it is difficult to claim that it is the CAD that is constraining growth.

(ii) Demand-constrained agriculture growth

The Approach Paper considers demand to be the major constraint on agricultural growth. It states “Several modeling exercises suggest that a 4% growth of agriculture will not be sustainable from the demand side unless aggregate GDP growth is much higher than 8%” (p.18). The experience of the past two years, however, indicates that it is more supply-side bottlenecks, such as in the case of wheat, pulses, sugar and edible oils, which is dragging down agricultural growth.

Knowledge deficit results in inadequate utilization of existing technology and hence low yields. The approach Paper points out that “unfortunately the extension system has virtually collapsed in most states, partly as a result of constraints on non-plan expenditure” (p.19). This, it may be argued, is a bit simplistic. Examples of goat farms without goats and extension centres with absentee extension workers abound. The Approach Paper may include some innovative way by which the dynamism of the private sector can be exploited by devising incentive-compatible extension schemes.

The Approach Paper points out the persistent problem in agriculture of lack of credit at reasonable rates and the failure of the organized credit system in extending credit (p.19). It may be useful for the Commission to come out with some suggestions about how to integrate the organized credit system effectively with the agricultural sector and about how to strike a balance between adequate credit and ‘cheap’ credit.

(iii) Delivery of essential public services to the poor

The Approach Paper rightly highlights that “the most important challenge is how to provide essential public services such as education and health to large parts of our population who are denied these services at present” (p.4). It also points out two important dimensions of the problem. First, “In our situation, access for the mass of our people can only be assured through a substantial effort at public financing of these services” (p.4). Second, “A major institutional challenge is that even where service providers exist, the quality of delivery is poor and those responsible for delivering the services cannot be held accountable. Unless such accountability is established, it will be difficult to ensure significant improvement in delivery even if additional resources are made available” (pp. 4-5). For example, the Paper argues that “Authorising panchayats and citizens’ education committees to oversee teacher performance can help increase accountability” and “A more powerful method of enforcing accountability is to enable parents to choose the schools where they will send their children” (p.46). It can be argued that you do not repair a leaking water supply pipe by simultaneously stepping up the water pressure. Thus, the enhanced public financing of these services must be preceded by a rapid implementation of vigorous institutional reform of the delivery mechanism. In this context, the whole question of assignment of responsibility for design, delivery, and financing at the Central, State and local levels need a reexamination. In particular, there is a need to implement the NCMP mandate of transferring “all centrally sponsored schemes except in national priority areas such as family planning” (p.14) to the States, by defining only a few areas to be of national priority.

(iv) Financing the Public Sector Plan and FRBM targets

The Approach Paper argues that improved irrigation and water (0.5% of GDP), health (1% of GDP), education (0.75% of GDP) and NREGA to cover the entire country (0.75% of GDP) alone will “call for additional expenditure, above current levels, of about 1.0 percentage point of GDP in 2007-08 rising to about 2.5 percentage points of GDP in 2011-12” (p.66).

Simultaneously, it points out that “The scope for increasing the fiscal deficit as a means of financing Plan expenditure is constrained by the Fiscal Responsibility and Budget Management (FRBM) act which requires the central government to reduce the fiscal deficit to 3% of GDP by that year and also to bring the revenue deficit to zero in that year. Similar Acts have been passed by most of the states. This forces the combined fiscal deficit of the Centre and the States to be limited to 6 per cent of GDP from 2008-09 onwards. Far from any increase in fiscal deficit as a means of mobilizing resources we are constrained to work with a reduction of the fiscal deficit of around 1 percentage point of GDP to be achieved in the first two years of the Plan.” (pp. 67-68). The Paper goes on to raise two questions: Whether the FRBM targets should be shifted further out by two years? Whether the FRBM targets should be specified not in absolute but in cyclically adjusted terms?

As the RBI’s Technical Note on the Observations of Planning Commission’s Approach Paper on FRBM Act Related Issue (attached) points out, a shifting of the FRBM targets will aggravate the macroeconomic imbalances and have repercussions on inflation and interest rates.

A relaxation of fiscal consolidation at this stage is particularly risky because of the off-budget borrowings by the Centre such as through the oil bonds (Rs. 28,000 crore) and FCI bonds (Rs. 16,000 crore).

A relaxation of the FRBM targets will seriously undermine the credibility of the Government, as it would also imply a shifting of the responsibility to the future government after the election.

Changing the goalpost to a cyclically adjusted deficit may not be prudent for three reasons. First, it will undermine credibility and be interpreted as changing the rules when the going got tough. Higher and rising interest cost will add to the revenue deficit and any slippage in containing or eliminating revenue deficit will inevitably mean a slippage in containing fiscal deficit.

Second, cyclical adjustment makes a large difference to the deficit when a deficit caused by a slowdown is matched by a surplus generated in an upswing in the business cycle. According to the RBI the cyclical fiscal balance during 1981-2001 has ranged between a deficit of 0.12 per cent of GDP and a surplus of 0.21 per cent of GDP. Thus, changing the goalpost will not create much fiscal space for increasing expenditure.

Third, it is doubtful that the current conjuncture of the Indian economy can be characterised as the downswing of a business cycle. Our fiscal deficit is structural and the cyclical component is small. Thus, a rule based on cyclically-adjusted deficit may actually be more stringent than an unadjusted one.

(v) Redefining the Revenue Deficit

The Approach paper points out how the revenue deficit targets under FRBM “could prove difficult to achieve because of the shift in Plan expenditure towards the social sectors has meant that a large proportion of the expenditure undertaken will be revenue expenditure as per the current budgetary definition” (p.69). It goes on to suggest a redefinition of revenue deficit to “exclude revenue expenditure clearly linked to asset creation” (p.70).

As the RBI Technical Note points out such a redefinition is problematic because of international accounting tradition, Constitutional recognition, and the ownership of returns on the assets created from revenue expenditure.

Furthermore, it will seriously undermine the credibility of the government. It will be argued that the Government is following a subtle, two-step strategy. First, with a shift in Plan expenditure towards the social sectors, it is questioning the appropriateness of the definition of and ceiling on revenue deficit. After destroying the first line of FRBM defence in the form of ‘reduction and elimination of revenue deficit’, it will mount an assault on the fiscal deficit target itself on the ground that, even according to classical principles, there is nothing wrong the raising loans to create capital assets. Such an undermining of the credibility of the fiscal stance will destroy macroeconomic stability and increase interest rates with serious implications for private investment and achievement of the Eleventh Plan’s growth target itself.

In conclusion, it may be important for the Approach Paper to emphasise the need for having a sharp focus on improving delivery of publicly-funded services, maintaining fiscal discipline as enunciated in the FRBM Act, creating a more investment-friendly environment through appropriate structural reforms and to delineate some innovative ways by which modern technology such as improved seeds and farming practices (including fertilisation and water management) can be disseminated in agriculture.

With regards, Yours sincerely
(P Chidambaram)