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15.03.2000

Budget 2000: Mortgaging the Nation

C P Chandrasekhar

Finance Minister Yashwant Sinha is on the defensive. His Budget has disappointed almost all segments of economic opinion, though of course for diverse and even conflicting reasons. Further, the stock markets, which he himself has made an important indicator of policy correctness, have responded negatively. This has left him in a situation where he is unclear in which direction to turn. If all sections are to be accommodated, he would denude this year's Budget of even the little new content it has. This is because the five measures he considers to be the significant advances made in this Budget, namely, the cuts in food and fertilizer subsidies, the reduction in interest rates on small savings, the "rationalisation" of excise duties through the introduction of the Central value added tax (Cenvat), the liberalisation of imports and the tax on 20 per cent of export profits, would have to be fully or partially withdrawn.
 
In particular, any "rollback" of the subsidy cut, under pressure from the allies of the Bharatiya Janata Party in the National Democratic Alliance (NDA), would amount to reversing the only measure in keeping with the promise made in the Economic Survey to take harsh decisions to curb government expenditures. This unenviable situation is partly Yashwant Sinha's own making. Trapped in a fiscal bind generated by years of financial reform, he has chosen to persist with and advance the reform rather than seek to reverse it and extricate himself from a hopeless situation.
 
In keeping with this strategy, in the run-up to Budget, the Government - through its spokesmen and the Economic Survey - had made it clear that the reduction of expenditure and of the fiscal deficit is the fiscal task of the moment. Despite this, the Budget could not proceed too far in this direction. Total expenditure of the Central Government, which had risen from Rs. 279,366 crores in 1998-99 to Rs. 303,738 crores in 1999-2000, is slated to rise further to Rs. 338,436 crores in t he next financial year. The projected 11.4 per cent rise, which is higher than the 8.7 per cent rise of the previous year, has been seen as a failure to ensure an adequate degree of fiscal correction.
 
This has constituted the principal ground for criticism of the Budget by many industry and academic experts. This approach is based on two presumptions. First, that a reduction of the fiscal deficit as part of a strategy of financial reform is the main task facing the Government. And second, that the failure of the Government to execute that task is the result of "excess" expenditure. It hardly bears stating that in a context in which growth in the commodity-producing sectors has been sluggish and in which there has been virtually no progress on the poverty reduction front during the 1990s, the Budget must above all be seen as a means to trigger growth and alleviate poverty.
 
The obsession with the fiscal deficit and expenditure reduction amounts to downplaying these more fundamental objectives. In fact, the objectives of growth and poverty reduction call for more expenditure rather than less, even if it involves a larger fiscal deficit. And, given the large stocks of foodgrains with the Government and the comfortable level of foreign exchange reserves, it is more than likely that such deficits would result in higher levels of output rather than in inflation. The fact that the increase in expenditure resulting from the implementation of the Fifth Pay Commission's recommendations has been accompanied by unusually low rates of inflation is one indicator of this. And higher GDP growth in turn would mean lower fiscal deficit to GDP ratios.
 
At first sight it appears that the Finance Minister can take credit for having increased expenditures during his tenure, his public rhetoric notwithstanding. The expenditure to GDP ratio, which fell from 19.2 per cent to 14.8 per cent between 1989-90 and 1997-98, has in fact risen over the last two years, and is expected to touch 15.8 per cent in 1999-2000. However, a closer look at the components of the Government's expenditure suggests that this reversal has occurred not because of, but despite, the Finance Ministry's efforts to the contrary. For example, right through the reform years, the ratio of the government's capital expenditures to GDP has almost consistently fallen, from a high of 5.9 per cent in 1989-90 to a dismal 2.6 per cent during the current financial year. On the other hand, the ratio of revenue expenditure to GDP, after having fallen from 13.3 per cent to 11.7 per cent in 1996-97, has risen sharply thereafter to touch 13.1 per cent in 1999-2000, which is close to its 1989-90 level.
 
But even here the increase is in large part on account of larger outlays on interest payments. Until 1996-97, interest payments were continuously rising as a share of GDP, whereas the rest of revenue expenditure was on the decline. It is only after that, with the "unavoidable" implementation of the Pay Commission's recommendations, that the rise in interest payments has been accompanied by a rise in revenue expenditure net of interest. Thus the only expansionary impulse provided from the fiscal side is a result of the Pay Commission's recommenda tions, which, together with the good harvest of 1998-99, has contributed to the modest recovery in industrial growth in recent months in the midst of extremely low inflation.
 
Two lessons can be drawn from that experience. First, the expansionary stimulus from the state has to be sustained if the recovery is to continue. And, second, a conscious effort must be made to reduce the share of interest payments in the "expenditure" of the government. An expansionary stimulus, in the form of more public expenditure, can be financed in two ways: greater resource mobilisation through taxation and a higher fiscal deficit. The strategy of economic liberalisation, however, militates against the first option. Not only are customs duties being reduced consistently as part of import liberalisation, but a range of direct and indirect tax concessions have been provided over time, resulting in a fall in the net tax-GDP ratio at the Centre from 7.9 per cent in 1989-90 to 5.9 per cent in 1998-99. The rise in oil prices and the slight economic buoyancy referred to earlier have helped raise this figure to 6.5 per cent in 1999-2000.
 
The feeble effort made in the Budget to sustain this trend by raising the surcharge on income tax and bringing export incomes into the tax net has, as expected, been received adversely by those who see it as an unnecessary intrusion of the state into private activity. The net result of the trends in taxation and expenditure has been that the fiscal deficit at the Centre has proved stubbornly resistant to reduction, rising from 4.9 per cent in 1996-97 to 7.0 per cent in 1999-2000. (These figures differ from those quoted by the Government in the Budget papers, since these are based on the older definition of the fiscal deficit which includes all the small savings accruing to the government, a part of which is transferred to the States.)
 
But this rise in the fiscal deficit is not merely the result of past non-interest expenditures financed through debt, which have contributed to an increase in outlays on interest payments. It is also the result of the change in the manner in which government deficits have been financed in recent times as a result of financial reform. Until the early 1990s, a considerable part of the deficit on the government's budget was financed with borrowing from the central bank against ad hoc Treasury Bills issued by the government. The interest rate on such borrowing was, at around 4.6 per cent, much lower than the interest rate on borrowing from the open market. A crucial aspect of financial reform has been the reduction of such borrowing from the central bank to zero, resulting in a sharp rise in the average interest rate on government borrowing.
 
The shift away from borrowing from the central bank has been advocated on three grounds. First, that such borrowing (deficit financing) is inflationary. Second, that it undermines the role of monetary policy by depriving the central bank of any autonomy. And, third, that it undermines much needed fiscal discipline by providing the government with ready access to credit at a low rate of interest. We need to consider each of these in some detail. The notion that the budget deficit, defined in India as that part of the deficit which is financed by borrowing from the central bank, is more inflationary than a fiscal deficit financed with open market borrowing, stems from the idea that the latter amounts to a draft on the savings of the private sector, while the former merely creates more money.
 
In the current context where new government securities are ineligible for refinance from the Reserve Bank of India (RBI), this is partly true. This is in part because the need for refinance to create additional credit arises only when the banking system is stretched to the limits of its credit-creating capacity. If, on the other hand, as is true today, banks are flush with liquidity, government borrowing from the open market adds to the credit created by the system rather than displacing or crowding out the private sector from the market for credit. This too can be inflationary if supply-side bottlenecks exist. But even if government borrowing is not financed through a draft on private savings but through the printing of money, such borrowing is inflationary only if the system is at full employment or is characterised by supply bottlenecks in certain sectors.
 
As mentioned earlier, not only is the industrial sector burdened with excess capacity at present, but the government is burdened with excess foodstocks and foreign exchange reserves. This implies that there are no supply constraints to prevent "excess" spending from triggering output as opposed to price increases. Since inflation is already at an all-time low, this provides a strong basis for an expansionary fiscal stance, financed if necessary with borrowing from the central bank. To summarise, in the current context a monetised deficit is not only non-inflationa ry, but virtuous from the point of view of growth.
 
This brings us to the second objection to a monetised deficit, namely, that it undermines the autonomy of the central bank. This demand for autonomy, which is a central component of International Monetary Fund (IMF)-style financial reform, assumes that once relieved of the task of financing the government's deficit, the RBI would be in a far better position to control money supply and therefore "free" to use monetary policy as a device to control inflation, manage balance of payments, and influence growth. In practice, IMF-style financial reform has hardly enhanced the autonomy of the central bank, since it not merely involves curbing the Government's borrowing from the RBI, but also liberalising regulation of capital flows into and out of the country. Since such flows are extremely volatile, the central bank is constantly forced to adjust to these "autonomous" capital movements. In recent times, for example, portfolio inflows which went way above the $50 million a day mark increased foreign exchange availability in the market and threatened to raise the value of the rupee, even when the trade deficit was widening.
 
This has required the central bank to intervene in the foreign exchange market and purchase dollars in order to stabilise the rupee, resulting in a sharp increase in the foreign exchange reserves with the RBI. Since an increase in the central bank's foreign assets has as its corollary an increase in its liabilities in the form of the supply of money, monetary policy remains solely concerned with neutralising the effects of foreign capital inflows. Relieved of the dominance of fiscal over monetary policy, the RBI now finds itself straitjacketed by international finance.
 
Finally, the evidence cited earlier makes it clear that even putting an end to the practice of monetising the deficit has hardly had any effect on the fiscal situation. Fiscal deficits remain high, although they are now financed by high-interest, open-ma rket borrowing. The only result is that the interest burden of the government tends to shoot up, reducing its manoeuvrability with regard to capital and non-interest current expenditures. This effect of financial reform on the fiscal manoeuvrability of t he state can be assessed by comparing actual fiscal trends with a hypothetical situation where the government had continued financing the same share of its deficit (around 30 per cent) with central bank borrowing as it did in 1989-90. In that case, a simple simulation exercise reveals, the interest burden in the Budget would have risen from Rs.17,757 crores to only Rs.88,464 crores in 2000-2001 as compared with the estimate of Rs. 101,266 crores recorded in this year's Budget papers. Such a possibility of saving in interest payments of close to Rs.13,000 crores or 12.6 per cent in the terminal year is obviously the culmination of a rising gap between actual and hypothetical interest payments starting from the mid-1990s when the practice of monetising a part of the deficit was done away with. This cumulative saving would have implied a huge reduction in the size of the fiscal deficit, assuming that expenditures remained the same. Over the 1990s as a whole, the cumulative reduction in the deficit would have been more than Rs.100,000 crores, which is far more than what the government could possibly have mobilised through disinvestment.
 
This gap points in a number of directions. First, that the government would have been more successful in curbing the fiscal deficit if it had not done away with the practice of monetisation of part of the overall deficit. Second, if deficits had been maintained at actual levels along with monetisation, the expansionary effect of recent budgets would have been quite significant, with positive results on the growth and poverty alleviation fronts. And, finally, that if the Government had not merely stuck with monetisation but also dropped its obsession with the fiscal deficit, especially in recent times when food and foreign reserves have been aplenty, the 1990s would have in all probability been a decade of developmental advance.
 
Budget 2000 reflects the fact that the BJP-led Government has consciously chosen to forgo this opportunity by making "second generation" reforms its principal thrust. Central to that strategy is a further push to financial liberalisation. In hypocritical fashion, the Budget speaks of formalising the autonomy of the RBI, even while it ties the central bank's hands by liberalising the conditions for foreign capital inflows. Financial flows on the capital account into the country have been further liberalised by offering tax concessions to venture capital funds, raising the ceiling on equity holding by foreign institutional investors (FIIs) investing in firms in secondary markets to 40 per cent and promising to sell public equity in banks up to 67 per cent of the total, some of which would be picked up by foreign investors. So long as India remains the flavour of the time with foreign investors, this would only enhance the quantum of foreign capital inflows. In order to neutralise partly the impact this would have on the central bank's operations, the Government has chosen to ease the domestic capitalists' access to foreign exchange to undertake investments abroad.
 
The other route through which foreign exchange reserves would be run down is through the indiscriminate import that is likely to result from accelerated import liberalisation. Even while the BJP's capitulation to pressure from the United States to advance the dates for doing away with quantitative restrictions on the import of 1,429 items (714 to April 1, 2000 and another 715 to April 1, 2001) threatens to de-industrialise India and affect the livelihood of primary producers, the maximum rate of duty on agricultural products has been reduced fro m 40 per cent to 35 per cent. Allowing indiscriminate access to foreign exchange without imposing any conditions which tie such use to the earning of foreign exchange to meet future commitments is a sure way of paving the way for financial crises of the South-East Asian kind. The attack on domestic producers, namely, the import-competition route, occurs in a context where developmental expenditures are being squeezed. While the Budget claims to increase Plan outlays by 13 per cent over last year's budget estimates and 22 per cent over the actual spending in 1999-2000, Plan outlays in many crucial sectors, such as agriculture, rural development and irrigation, have been lowered. In addition, the actual spending on these important areas may turn out to be even lower. Thus, in both the previous fiscal years, the Central Government spent much less than it had budgeted for in almost all the crucial sectors of Plan outlay, such as agriculture, rural development, irrigation, energy, industry and minerals, thus depriving the economy of important sources of growth.
 
There have also been shortfalls in expenditure on social services. So, these critical areas of spending continue to be shortchanged. The slated 13 per cent increase in capital expenditure in this Budget at first appears to reverse this tendency. However, defence alone accounts for 80 per cent of the increase in total capital expenditure. One consequence of this "new militarism" characterising the BJP's tenure is that, in an effort to dampen U.S. criticism of this tendency, the Government is willing to make huge concessions on the economic front with regard to trade and foreign capital flows. The other consequence is that non-defence capital expenditure is budgeted to remain stagnant or decline in real terms. Further, in his effort to prove that despite this hike in defence outlays, overall expenditures and the fiscal deficit are to be controlled, the Finance Minister has chosen to attack food and fertilizer subsidies, besides capital expenditures unrelated to defence.
 
The orchestrated outcry on the unsustainable level of food and fertilizer subsidies appears to be almost a conspiracy. In fact, even if we consider only revenue expenditures other than interest payments, the share of food subsidies in expenditures has been more or less constant in recent years and the combined share of food and fertilizer subsidies has in fact been falling. Yet, the most striking "achievement" of this year's Budget is that at a time when the evidence points to a decade-long stagnation or even increase in the incidence of rural poverty, the prices of food distributed through the public distribution system (PDS) are to be hiked to realise a 12 per cent reduction in food subsidies. In order to sanitise this effort, Yashwant Sinha has presented the subsidy reduction as an effort to target subsidies at the needy, namely the population below the poverty line. That population, he argues, would now be eligible for double the quota available earlier.
 
What he left virtually unstated was the fact that this larger quota would be available at a much higher per unit price. Households below the poverty line would now have to bear with 68 per cent increases in the issue prices of wheat and rice. Even people above the poverty line, many of whom are also poor by a wider definition, would have to pay 23 per cent more for wheat and 30 per cent more for rice because they will now be charged the full economic cost. Not only does this mean that most pe ople who use the PDS will end up paying much more, but it also penalises the State governments that have been running a more broad-based and efficient PDS. This is because this price relates to the rate at which the Central government releases foodgrains to individual State governments, some of whom have been supplying it at a lower rate to consumers through the PDS.
 
The irony is that, while this measure will clearly hit ordinary people very hard, it may not lead to a decline in the food subsidy bill at all. This is because as prices rise, offtake from fair price shops tends to decline, and so the Food Corporation of India (FCI) is left holding even more stocks, with high carrying costs which add to its losses. This is indeed one reason why the level of stock-holding of foodgrains is already so high. As mentioned earlier, the availability of large foodstocks with the government calls for an effort to use the surplus foodstocks to part "finance" employment programmes that help strengthen the rural infrastructure. This would have helped improve agricultural growth performance as well as increase rural incomes and reduce poverty. The Finance Minister has, however, chosen to ignore this opportunity and persist with a strategy of reform that goes to the contrary. The financial component of such reform requires curbing borrowing from the RBI and cutting a range of expenditures as part of the effort to appease international finance, even if the consequence is a combination of policies which squeeze the poor and underm ine growth prospects. These are further indicators of the fact that under the BJP the overall interests of international finance have come to dominate economic policy-making in India. And it is that dominance which has put the Government in a state of pa ralysis with respect to triggering growth and reducing poverty. The interests the BJP-led Government seeks to serve and those it wishes to penalise are therefore clear.