Austere Budget and 'crowding out' effect

Written by K Vaidya Nathan | K Vaidya Nathan | Updated: Feb 28 2013, 14:21pm hrs
BudgetWhatever is holding back private sector investment, it is not the cost of borrowing. (Reuters)
The finance minister, a few days ago, indicated that he is planning to cut the public spending target for fiscal 2013-14 by up to 10% from this years original target, in what would be the most austere Budget unveiled in recent history as he tries to avert a sovereign credit downgrade. The finance minister has already slashed actual public expenditure in the current fiscal year by some 9% from the original target. So, the plan for 2013-14, at least on paper, seems to be to put a lid on spending.

The ministry has, in the past, not been able to achieve the austerity targets it set for itself. For instance, it missed its 2011-12 fiscal deficit target of 4.6% of gross domestic product by 1.2%, prompting threats of a downgrade from ratings agencies S&P and Fitch. India has a BBB minus rating with a negative outlook from both S&P and Fitch, the lowest investment grade rating possible. A cut would take our credit rating to junk status.

The finance minister, last Thursday, argued that a lower fiscal deficit will not only avert a rating downgrade threat but also bolster economic growth prospects as borrowing costs for private investors will fall, helping lift capital investment growth from a five-year low. The first reason about averting a rating downgrade is fine but I am not sure about the crowding out of private investment aspect. At least recent evidence doesnt seem to suggest so.

Back in the 1990s, we knew why we feared deficits. They raised interest rates and crowded out private borrowing. This wasnt an abstract concern. In 1991, the short-term interest rate was above 12%. The gross fiscal deficit of the government (Centre and states) had risen to 12.7% in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the government accumulated rapidly, rising from 35% of GDP at the end of 1980-81 to 53% of GDP at the end of 1990-91. With higher borrowing, the borrowing cost increased for the government. This meant that the interest rate for private borrowing was, for the most part, much higher, choking off investment and economic growth.

Enter Manmohanomics. The postulate was simple: Bring down deficits, and youd bring down interest rates. Bring down interest rates, and youd make it easier for the private sector to invest and grow. Make it easier for the private sector to invest and grow, and the economy would boom.

The postulation was correct. By the end of Manmohan Singhs tenure as finance minister, the gross fiscal deficit of the government (Centre and states) had dropped to 6.28% of GDP and the short-term interest rate had fallen to 5.75%. And the economy had, indeed, recovered significantly in those five years. The deficit reduction increased confidence, helped bring interest rates down, and that, in turn, helped generate and sustain the economic recovery, which, in turn, reduced the deficit further.

We should fear deficits today, but for reasons other than crowding out private investment. Currently, the interest rate on a 10-year Government of India Security is only 7.87%. Corporate credit spreads are also tight. So, whatever is holding the private sector back, its not the cost of borrowing. The problem with misplaced apprehensive consequences of high deficit is that theyre applying the framework of the 1990s to the economy of 2013, with predictably poor results. The reason to worry about the deficit today is not that higher interest rates will crowd out private borrowing or make corporate spreads wide, as theres no evidence either consequence is in the offing any time soon. Rather, the reason to worry about the deficit todayand, more to the point, the trends in government spending that drive itis that the most worthwhile kinds of government spending are getting squeezed out.

The key insight behind this story is that some forms of government spending rise quite rapidly closer to election, and are very politically difficult to cut, while other forms of government spending that are truly welfare-enhancing with considerable long-term benefit are not very politically-sensitive. As the pressure of reining in fiscal deficit increases, the politically-compelling government spending tends to crowd out the more meaningful fiscal programmes.

The risk with high fiscal deficits is not that it would crowd-out private investment, but that it may motivate the government to do precisely the opposite of what is sensible. In the last full-fledged Budget before the 2014 elections, it would be very tempting for the UPA to introduce some ambitious nation-wide social programme called Rajiv Gandhi blah blah blah. There will undoubtedly be political compulsions to introduce some such grandiose scheme to let the aam aadmi know that the UPA truly cares for him. The problem is it does not have the fiscal leeway. Nor can the country afford another expensive, poorly-targeted, corruption-ridden programme that will be difficult to reverse or modify after it is implemented. It may crowd-out more sensible but less grandiose programmes. In various states we are seeing that long-term political success rests ultimately on improved governance and sensible economic policies. It is high time the lessons percolated up to the draftsmen of the Budget.

The author, formerly with JP Morgan Chase, is CEO, Quantum Phinance