A crisis and an opportunity ahead

Finance Minister Pranab Mukherjee gestutres while presenting the budget. Photo: PTI / Lok Sabha  

Finance Minister Pranab Mukherjee is not like his predecessor. But he is without any soft options today, shackled as he is by the recent past of the Finance Ministry's stewardship. Hence it is no surprise that despite a heroic effort to put together a dynamic budget, he has produced what could at best be termed a damp squib.

The global financial crisis is not a valid excuse for this flop of a budget. That crisis need not have affected the Indian economy at all. China was affected because its economic boom was export-led, and consequently there was a huge trade surplus with the United States and the European Union, and rising foreign exchange reserves. Therefore a slump in demand for Chinese goods hurt China. But India's exports to the U.S. and the E.U. as a ratio of GDP is still small. Then why was the Indian economy, which was not export-led like China's, affected?

Nor did the sub-prime loan default crisis in the U.S. directly cause it. The U.S. financial crisis was created by weak oversight of banks which cascaded into bankruptcy. But Indian banks are strictly regulated by the Reserve Bank of India (RBI), and they are forced to hold reserves in the name of statutory liquidity ratio (SLR) and credit reserve ratio (CRR), and to purchase government treasury bonds. In fact, except for HFDC Bank — owing to its own foolishness — no bank in India collapsed or even made losses during this period.

Then why did India suffer? That is the key question to answer first, to know what kind of budget we needed.

The Indian economy had a setback not because of any financial contagion spreading from the U.S., or because of the interdependent global trade system, but because of the perfidious financial derivative called Participatory Notes (PNs). Its effects have been compounded by an anti-national agreement with Mauritius to permit even companies with a paid-up capital of $1 incorporated in that country to invest in Indian stock markets and not be subjected to capital gains tax.

The financial crisis in the U.S. was officially acknowledged following the collapse of Fannie Mae and Freddie Mac, the U.S. government-owned loan providers, followed by that of Lehman Brothers in September 2008. A liquidity crunch developed in the U.S. and later in Europe. Interest rates rose as liquidity froze and funds were in demand.

The PNs, which were “hot money,” were then just shipped out of India without any hindrance — to the tune of $60 billion — in October 2008-January 2009, causing a stock market crash in India that was symbolised by a steep fall in the Sensex. It is this that caused the financial crisis in India and not the U.S. sub-prime loan defaults or exports drying up.

These two “gifts” from the previous Finance Ministers, Yashwant Sinha and P. Chidambaram, made India vulnerable. Hence, the budget should now have incorporated measures to nullify the exemptions available to PNs and scrapped the Mauritius agreement to insulate the Indian economy from the future-induced crisis.

But the PN perfidy continues without accountability. Thus, billions of dollars of “hot” money enter every year into the Bombay Stock Exchange, and these are used to buy and sell shares with PNs almost in the manner of cash transactions. In fact, it is better because cash purchases of over Rs.10,000 have to be reported with details to the Income Tax Department. Moreover, since PNs came via Mauritius, the speculators did not have to pay capital gains tax. By September 2008, PNs accounted for 60 percent of the foreign institutional investor funds in the stock market, from near-zero level in 2003. Moreover, by a special order the Finance Ministry under Mr. Chidambaram had exempted PNs from the purview of the Securities and Exchange Board of India, the RBI, the Enforcement Directorate and the Central Bureau of Investigation. SEBI, headed then by M. Damodaran, protested and repeatedly wrote to the Ministry to permit it to require reporting of the buyer and the seller as also the source of funds as with any other stock market transaction. RBI Governor Y.V. Reddy kept warning of the dangers from PNs. But these were ignored.

The Tarapore Committee on Financial Reforms strongly condemned PNs and wanted the system scrapped. National Security Adviser M.K. Narayanan made bold to warn the country that terrorists too were earning on the Indian stock market (obviously via anonymous PNs) to finance the killing of Indians, but he was silenced. Now he is a State Governor.

Are we coming out of the economic crisis of the last two years? We certainly are, but it is not owing to the much-touted stimulus. On the other hand, it is the stimulus that is responsible for the galloping inflation. The money pumped in by loosening bank credit norms, and printing currency notes, has gone into the hands of people who are now manipulating food prices through forward trading and hoarding.

But thanks to the durability of the private manufacturing sector relying on retained internal company earnings, and the innovative IT software sector, India has survived the government- induced financial crisis. Despite the agriculture sector performing poorly for reasons other than the global financial crisis, the GDP growth rate persists.

But this is no time to breathe easy. Another financial crisis of its own making awaits India. But when it arrives, India will not be able to overcome it easily. The coming crisis will be due to internally induced factors: the developing Union budgetary bankruptcy and exploding public debt. Can India prevent it? It can, but that will require major economic and financial reforms which the present dispensation is incapable of implementing. Budget 2010-11 reflects this impotence.

Despite the chorus of praise from business houses, from the usual government-compliant academics and courtier intellectuals, the budget has failed to reduce the fiscal deficit in real terms. The Finance Minister claims the fiscal deficit will be reduced to an estimated 5.5 per cent in 2010-11. This figure is arrived at by dividing the budgeted deficit of Rs. 3.9 lakh crores by the estimated GDP of 2010-11 at current prices, which is projected to grow by 14 per cent. Translated into the retail price index, this means a rise of 15 per cent in prices in the coming year. The government statisticians are in a fix: if they lower the current price GDP level, the fiscal deficit will rise to over 7 per cent, exceeding this year's revised level of 6.9 per cent.

The budgetary crisis looming on the horizon means this: allocations under major heads of expenditure that cannot be cut without causing a crisis — such as for employee salaries, pensions, police and defence, subsidies, interest to be paid for loans taken by the government — now cover 98 per cent of the current and capital account revenues accruing to the government. These allocations represent revenue expenditures, not asset-building or investment for development projects.

Thus the revenue budget is in a huge deficit which is covered by taking more loans from public sector banks. This situation, however, cannot continue for long because the loans the public sector banks have extended to the government have to be paid back. But here the government faces a developing debt-trap. India is heading for a situation where loan repayments will exceed the new loans the government will take. At present the government pays back 96 paisa for every rupee for new loans. Public debt is now over 90 per cent of GDP and on an exploding trajectory.

My projection is that by 2013 this amortisation will be more than a rupee to be paid back against a rupee of new loan. Then India is in a debt trap and bankrupt. If the government tries to get out of this by printing more currency, it will generate an unbearable level of inflation.

We still have three years to rectify matters with new financial reforms, but with the present dispensation it is not possible. As in the past, a crisis, this time stemming from budgetary bankruptcy, may turn out to be a blessing in disguise for India and enable reforms. Every crisis, starting with the food crisis of 1966-67 to the foreign exchange crisis of 1990-91, has made the Indian people come out and assert themselves. So did the 1962 war with China and the Emergency of 1975-77. So let us wait for 2013 with optimism.

(The author, a former Union Minister for Commerce, is the president of the Janata Party.)

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