Dependence on a private sector-led boom in infrastructure and foreign finance to offset the balance of payments deficit is not sound policy
P. Chidambaram has upped the ante by referring to the “laws of economics” implying that they cannot be bucked and suggesting that his own actions reflect an awareness of them. Space now unfolds for a serious discourse on the current stance of economic policy of which he is the sole architect. Of his announced strategy for the economy, two elements deserve our attention — the one for raising the investment rate and that for financing India’s soaring deficit in the balance of payments.
Let us for a start agree with the Finance Minister that the solution to the flagging economic growth is to raise the investment rate. It has, after all, fallen from its peak in the year 2007-08, the last time a 9 per cent growth rate had been recorded. The Minister is also right in identifying infrastructure as the segment where the increased investment most ought to occur. Infrastructural investment increases the supply of producer services essential to economic activity, raises aggregate demand and creates employment across the economy. It would appear then that it is not in his objective but in the means that he has adopted that such follies as may be found must lie. Principal among them is that he has provided for only the slightest increase in public capital formation in his budget, having explicitly assumed that the necessary increase in investment will come from the private sector. To precipitate private investment, he has announced a slew of measures that are financial incentives. Among these, the most important is the encouragement of debt funds by allowing tax-free bonds up to Rs. 50, 000 crore. It must be agreed that this is a substantial figure for exemption. However, while financing is an issue, the measure itself is unlikely to be a big draw at the present moment.
A trick appears to have been missed in the strategy in that when private investors are skittish, tax breaks per se are unlikely to make the difference as much as the government wading in to invest. Then there is what economists refer to as ‘the accelerator’ to be reckoned with. In an environment of slowing growth, private investment slows as firms see no incentive to add to capacity. When the growth of aggregate demand thus slackens it slows output growth in turn, and a vicious cycle sets in. Something of this kind is playing out in India currently. The right medicine for a languid economy was identified over 75 years ago by J.M. Keynes. Autonomous, in our case public, investment must be stepped up when private investment sags. Instead in India since 2008-09, when it had peaked, public investment as a share of GDP has steadily declined. Predictably, growth has slowed in tandem. However, it is not known widely enough that not even private corporate investment has declined as much as the public. In fact, for the private sector as a whole, investment has marginally risen even as growth has slowed. These data may be read in the first chapter of the government’s own Economic Survey. While it may sound harsh to state that the government precipitated the current slowdown in growth, we would be quite right in querying its investment strategy in the midst of such a slowing.
The Finance Minister gambles on a private sector-led boom in infrastructure. Looking at the world around us, something economists no longer do enough of, we would find this questionable as a strategy. Here two examples should be instructive. In the winter of 1999, the Los Angeles County Museum held an exhibition titled ‘Made in California’. As Californians are conscious of the importance of the economy to their lives, the exhibition had featured the major economic developments in the State. Of these, after the Gold Rush was mentioned the great transformation of agriculture and, finally, the impact on its economy of the construction of the Federal Highway system. While the last was on, close to a million dollars are said to have been spent in a day in the State, and this was done entirely by the federal government of the United States. So, in the land of private enterprise the highway was funded by the government and not by Wells Fargo. British private capital had of course played a role in the building of the Indian Railways in the 19th century. But it is a reflection of the inextricable involvement of government, especially in the form of financial guarantees, that a separate Railway Budget was presented every year by the colonial Government of India. The point of all this is to show that public funding is likely to remain crucial to building Indian infrastructure for some time to come.
Decline in public saving
But public saving has virtually collapsed in India since 2007-08 when the growth rate peaked. The figures are revealing. What had been 5 per cent of GDP in that year was down to 1.3 per cent in 2011-12. Once again, private saving has not declined by anything on a similar scale. In a situation when both the public debt and the fiscal deficit are high, as they are in India, the government has no avenue but its own saving if it wants to invest. The strongest economies of the world, notably those in Scandinavia and in the Far East, have maintained a high rate of public saving.
The U.S. may have neither high private saving nor public. But then its infrastructural deficit is somewhat less than India’s, and in any case it has monopoly over the world’s reserve currency with which its government can purchase what it likes.
Some part of the decline in public savings in India must be traced to the relatively recent upsurge in social sector spending. While some social spending, such as on health and education, has a positive long-term impact on growth and thus public revenues, when social spending begins to eat into what is available for investment it can lower the growth rate of an economy. As mentioned already, certain forms of capital crucial for growth are more likely to come from the public sector, and hence must be financed by public saving. We cannot rely on the private sector here, as the Finance Minister suggests we can. At the same time, while still on matter of investment, we must not lose sight of the efficiency of the spending. This is apparent when we recognise that some of the years of high growth during 2003-08 were years which had witnessed a lower investment rate than what it is today. Clearly, the productivity of the investment has declined. This is not unrelated to what has been flagged as the government’s pre-occupation with social programmes. The enfeebling impact of this can also work independent of funding. A government that sees its task mainly as the handing-out of welfare cheques can lose sight of its ultimate responsibility in a democracy, which is to maintain the public infrastructure and create the public goods vital to growth and well-being, respectively. The latter only the government can do and there are only 24 hours in a day to do it. So they who chant “policy paralysis” have got it wrong. The truth is that we have a “governance paralysis,” only that the domain of governance must be understood to extend beyond law and order to the governance of public infrastructure. So, before we fix our sights on ‘mag-lev’ trains we may want to reflect on what it is costing us in terms of income generation in not having an efficient waste disposal system in our cities. Think of the number of economic proposals that are left unrealised due not to the absence of finance but an industrial waste disposal facility.
The second issue that the Finance Minister has spoken about of late is his intention of attracting foreign direct investment (FDI) to finance the deficit in the balance of payments. He is indeed right to draw our attention to the disturbingly large deficit we now face, but it is questionable whether financing it via FDI inflows is the right approach. While they may not be debt-creating, to assume that they constitute no draught on an economy’s foreign exchange reserves is plain wrong. Only, this emerges in the future, when profits are ripe for repatriation. And, depending upon the volume of profits to be transferred overseas, the final requirement of foreign exchange could even be larger than the original inflow. So, by relying on FDI for our foreign exchange needs we only postpone the imperative of earning the foreign exchange to pay for our spending. We need to learn to cut through the thicket and treat the problem at source. For India, there is no alternative to becoming more competitive. Two decades from 1991, we can see that macroeconomic policy has a limited role here. Governance is all, and it cannot be outsourced.
(The author may be reached at www.pulaprebalakrishnan.in)