In the home of the rope trick and the levitating swami anything, some might believe, is possible. The textbook tells us that surging government deficits cause both interest rates and inflation to rise. But here, deficits co-exist with ever-falling interest rates and low inflation ? like the lion and the oxen sitting together chewing on ahimsa. It?s a rude thing to say in this time of cheer, but that?s poppycock.

The fact is that over the years, private and government demand for funds have neatly tangoed, and the timing has been such that the effects of misalignment have been subdued. Take 1993-94: Private corporate investment dropped marginally, its savings rose by 1 percentage point (ppt) of GDP, and the net demand for funds fell by 1.1 ppt of GDP. Household financial savings rose by 2.3 ppt, while the current account deficit fell by 1.3 ppt in line with the stabilisation process. The outcome was a net increase in the domestic availability of funds by some 2 ppt, most of which was absorbed by government through lower public sector savings and higher investment.

Over the next three years (1994-97), private corporate investment soared, absorbing an additional 2 ppt of GDP in each of these years. Household financial savings on the average were actually lower by 0.6 ppt. Were it not for the 1.7 ppt of resources released by government, as part of the then ongoing fiscal consolidation, the liquidity crunch would have been severe notwithstanding the additional 1 ppt of net foreign savings that poured into the country in these years.

Ever since 1996-97 in each and every year, private corporate investment has declined. The net demand for funds (investment minus retained earnings) by this sector on a cumulative basis between 1997-98 and 2001-02 has fallen by as much as 3.5 ppt of GDP. In this period, net financial savings of households rose by 1 ppt. This amounted to the release of 4.5 ppt of GDP of domestic financial resources over the period. The current account balance changed from a deficit of 1.4 per cent of GDP to a surplus of 0.3 per cent. On a net basis there was thus an effective release of financial resources of 2.8 ppt of GDP between 1997-98 and 2001-02.

Further in this period, public sector investment as a whole declined by another 0.5 ppt of GDP due to curtailment of capital expenditure in government budgets. It is in this context that the revenue deficits of central and state government have burgeoned, with the negative savings of government administration and departmental enterprises rising by as much as 3.6 ppt of GDP.

Thus, compared to the mid-1990s, it was mostly financial resources released by lower investment by the private corporate sector and, to a much lesser extent the slightly higher net financial savings of the household sector, that permitted government?s ever-expanding revenue deficits to be financed under ever easier conditions. As for inflation coming down, it was a combination of three factors ? increased domestic competition, greater trade openness and finally, an economy that was growing at a slower pace: namely at 5 to 5.5 per cent, as compared to the 7 per cent plus of earlier years.

Most of the factors that have been critical to the ?deficits without pain? of the past half a decade are already undergoing, or are due for, radical change. Import competition has been largely ineffective in the face of hardening global commodity prices and a punitive import tariff regime. Then, as the domestic economy begins to lengthen its pace ? from 5.5 to 6.5 per cent and perhaps above ? the pressure of surging domestic demand is beginning to show in the inflation numbers. Then, after years of reorganisation, the private corporate sector is set to raise its demand for investment funds.

It is most unlikely that government will be able to release any resources, as it had in the 1995-98 years. Finally, the country is woefully short of infrastructure, and the expenditure has to, and will, be made. Any success on government?s part to trim unproductive expenditure will be taken up by expansion on the capital side. Stepped up privatisation will ease the process as it will encourage inflow of foreign capital which hopefully will finance higher imports under a saner tariff regime.

The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)