The winter session of Parliament has passed a record number of bills ? an unmitigated plus. But what, one wonders, will be the fate of the Fiscal Responsibility and Budget Management (FRBM) Bill. Reportedly, in the process of deliberations by committee, it has been utterly de-fanged. Will it be resuscitated, and if so how? For, without self-denying covenants declared unto the public as law, it will be difficult to emerge from the present difficulties, tangled far more than it was in 1991.
Government pronouncements, including the Tenth Plan recently approved by the National Development Council, indicate commitment to fiscal consolidation. The context in which this assertion is being made is, however, different from that of today: One that envisages significantly higher capital and other developmental expenditures, for building economic and social infrastructure in line with an economy desired to grow at 8 per cent annually. Which will have two direct consequences.
First, serious adjustments will be needed in government finances. Today, the bulk of the fiscal deficit is due to establishment expenses and subsidies. It is unclear how appropriate space will be made to incorporate the ambitious slate of public investment, but plenty of space-creating, for sure, will be needed. Second, private sector demand on domestic financial resources has been subdued since 1998, when broad-based corporate restructuring involving extensive asset sale and acquisition began. The next phase of upturn in demand for financial resources by the private corporate sector is due, and will certainly be given a big impetus by any step-up in public fixed investment. Which will wipe out the excess liquidity of recent times and replace it with a more competitive framework. One where government may not be able to obtain as favourable terms for its debt, as it does today.
Pre-emption of credit by the State sector can be accommodated to a surprisingly large extent under conditions of residuary regulatory control. Witness China, with a much higher degree of bank intermediation [bank credit to gross domestic product (GDP)] than we have. The bulk of bank credit however goes to State-owned enterprises (SoE) ? a quasi-fiscal outcome. Now SoEs are for the most part inefficient. The concentration of SoEs and, therefore, of bank credit is thus higher in the slower growing regions, while the best performing regions have concentrations of non-State players which are for the most part efficient and account for little of bank credit.
From where did the non-State players, who have made China such a manufacturing powerhouse, obtain their finance? Aziz and Duenwald (IMF WP/02/194: Nov 2002) argue that it is foreign direct investment (FDI) and internal generation. So China has run up both, huge current and capital account surpluses and sits on a dragon?s hoard of foreign exchange reserves.
In India, the large fiscal appetite could be accommodated with declining interest rates, by a combination of circumstances. The private sector?s demand for finance declined at about the same time as government?s appetite increased, beginning 1998. Low inflation, an outcome of price competition and possible productivity gains, coupled with capital controls completed the picture. These conditions are not eternal. An increase in the appetite for finance by the private corporate sector is the most likely to change in the near term. Like China, we could perhaps seek to finance this increased demand from overseas through FDI and portfolio flows and, provided the supply exists, government borrowing could continue to swallow much of domestic financial savings, while foreign exchange reserves would rise.
There are three obvious difficulties with this course. First, postulating adequate supply of foreign investment on terms that would be acceptable to domestic players is sanguine. Second, to accommodate additional developmental outlays, either expenditure will have to be restructured, or revenues rise like a tide, or the fiscal deficit becomes larger than household financial savings. Third and finally, if fiscal consolidation does not take place and the higher outlays are given effect to, government would effectively become the sole depository of household financial savings: A point where our households are likely to develop an aversion to rupee assets ? the start of a ghastly meltdown.
Which is why this resolution must be kept.
(The author is economic advisor to ICRA)