The Hindu Business Line : Inflation, rising rates and financial repression

In the emerging situation, there could be a sharp upsurge in inflation or a sharp increase in interest rates or heavy financial repression. There is no way that we can get away from all these unpleasant consequences, says S. S. TARAPORE.

The Union Budget for 2009-10, has admittedly been formulated at a very difficult time when the global economy is in the throes of a crisis and the GDP growth rate has also slowed down. The Budget has substantially increased outlays on the economic and social sectors and the strong orientation towards reducing poverty ensures a more equitable distribution of income; this deserves unequivocal support.

Whenever there are large allocations for the social sectors, there is generally a hue and cry that there are leakages in the system and the government is resorting to populist measures. There is a clear need to take a more enlightened view. Inclusive growth is not merely a political slogan but a firm basis for sustained economic growth.

To the extent that there are leakages in the system, a portion of the allocations should be earmarked for vigorous monitoring to ensure that the allocated resources reach the target group. One needs yet another Nandan Nilekani, together with strong and visible political support, to devise a fool-proof system to ensure that leakages are completely plugged, or at least substantially reduced. This would be the single most important impetus to sustained growth.

It must be recognised that the investment pattern determines the output pattern and the output pattern determines the distribution of income. If the rapid alleviation of poverty and a just society are overriding priorities, then the tilt in the Union Budget to social sector expenditure cannot be faulted.

Getting deficits right

It is true that no Budget can wish away the fundamental economic problem of scarce means with alternative uses. Given this axiom, social sector expenditures should be the first charge on budgetary resources. It is grotesque to claim that the unmanageable gross deficit is attributable to these social sector expenditures.

The Centre’s fiscal deficit for 2009-10, as per the Budget estimate, is put at 6.8 per cent of GDP and the revenue deficit is estimated at 4.8 per cent of GDP. The enormity of the deficit is seen when juxtaposed with the 2007-08 revenue deficit of 1.1 per cent and the gross fiscal deficit of 2.7 per cent of GDP.

For 2009-10, if one adds to the Centre’s gross fiscal deficit of 6.8 per cent the State’s deficit of 4.0 per cent and the quasi fiscal deficit of a little over 3 per cent of GDP, the combined gross fiscal deficit could be in the region of a staggering 14 per cent of GDP. One concedes that this large fiscal deficit is a result of extenuating circumstances but, nonetheless, it is necessary to work out a strategy of dealing with such a stupendous deficit.

According to the Medium-Term Fiscal Policy Statement, the gross fiscal deficit as per the Rolling Targets as a percentage of GDP would be 5.5 per cent in 2010-11 and 4 per cent in 2011-12. Likewise, the revenue deficit target is 3 per cent for 2010-11 and 1.5 per cent in 2011-12.

Given the uncertainties and fluctuations in the real sector, the situation can be worse than charted out in the Medium-Term Fiscal Policy Statement. While not bemoaning the hopeless position of the fisc, it is necessary to devise a sustainable strategy for dealing with this most difficult situation.

As a first step, the Government should move over to a transparent presentation of the fiscal accounts. It is stultifying to claim that as there are inadequate resources to finance vital expenditures, these expenditures are treated as off-Budget and there is the odd animal called the “quasi-fiscal deficit”. It is time we give up the charade of a gross underestimation of the fiscal deficit and reveal the true extent of the malady.

The truth

While negative criticism should be avoided, it is essential to have a truthful picture of the enormity of the problem. It is unfortunate that there is obfuscation of basis principles of macro-economic management.

There are influential and well-respected policymakers and opinion makers who argue that high deficits result in higher GDP growth and that tax collections are higher, so such deficits are self-correcting. What is more alarming is the hair-splitting between monetisation and the RBI’s open market operations (OMO). The borrowing programme of the Centre is close to Rs 4,00,000 crore (net) or about Rs 4,50,000 crore (gross). This compares with only Rs 1,00,000 crore as per the Budget Estimate and Rs 2,62,000 crore as per the Revised Estimates.

It is argued that while direct monetisation is not permitted under the FRBM via RBI direct subscription to fresh government floatations, the RBI should use its OMO to pick up 50 per cent of the total government floatations. It hardly needs to be stressed that either way it amounts to a large increase in net RBI credit to government, large M3 expansion and strong inflationary pressures.

It is further claimed in policy formulation circles that there would be no crowding out of the commercial sector. To prevent crowding out, the highly expansionary fiscal policy will need to be accompanied by a highly expansionary monetary policy.

Unpleasant consequences

The late Dr I. G. Patel, when he was Governor, RBI would lament that: “In this beholden land of ours, people believe that the laws of money do not work.” With the burning of candle at the fiscal end and the monetary end, something has to give.

To add to these problems, the Government is wedded to the idea that interest rates should not be allowed to rise. Long experience with the policy of diktat should surely have taught us that if we have mutually conflicting objectives, there would be severe financial repression with its attendant problems.

If the Government needs more resources, however legitimate the need, the non-government sector will have to make do with less. Using unlimited created money to resolve this issue will merely result in inflation. There are erudite scholars, particularly in India, who with their superior knowledge claim that there is no link between money, income and prices.

Unfortunately, the harsh reality is that the fundamental laws of money do not give us the luxury of wishing away these laws. In the emerging situation, there could be a sharp upsurge in inflation or a sharp increase in interest rates or heavy financial repression. There is no way that we can get away from all these unpleasant consequences.

(The author is an economist. blfeedback@thehindu.co.in)

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