The former member of the Prime Minister’s Economic Advisory Council says a stimulus package without reforms will only achieve ‘stagflation’.

 

Official estimates from last week show that India’s Gross Domestic Product growth has slowed from 7% in just four quarters to 4.5%. On Thursday, the Reserve Bank of India lowered its annual growth forecast to 5%. India’s economy is in trouble.

 

Earlier this year, Dr Rathin Roy, Director, National Institute of Public Finance and Policy, and a former member of the Prime Minister’s Economic Advisory Council, cautioned about a “silent fiscal crisis” in India, suggesting that the government’s tax revenues during the year were likely to fall quite short of what the budget had estimated.

 

In an interview with Puja Mehra, Roy argues that unless serious attention is paid urgently to the economy, India could end up like South Africa, Brazil or Thailand – countries that tried but failed to develop and remain stuck below their potential.

 

Excerpts from the interview:

 

After the July 5 Budget, you warned of a silent fiscal crisis.

 

After I said this, I was told that I was profoundly wrong.

 

Who said so?

 

Every response I got to what I had said, from those responsible in the government for our public finances. I hope I am delightedly able to announce on Budget day [February 1, 2020] they are right, and I was wrong. Rest I leave it for you to judge.

 

Tax revenue collections have grown much slower than the July 5 Budget had estimated. With slower GDP growth, collections will slow down further. Isn’t the fiscal situation too tight for increasing capital and other government expenditure?

 

How much of the deficit do you believe is off-budget?

 

According to the Comptroller and Auditor General of India, a lot of it is.

 

[Note: The 2019-20 Budget put its estimate for the year’s fiscal deficit, that is the gap between the government’s revenues and expenditure, at 3.3% of India’s GDP. The CAG has earlier argued that the actual fiscal deficit for the year 2016-17 was much higher than what Budget documents for that year had recorded, as the government was able to push its deficit off its balance sheet to the books of public sector enterprises such as the Power Finance Corporation.]

 

My very conservative estimate is that we are already running a fiscal deficit of about 4.3-4.4%. Almost 70% of which is for administrative expenditure. From where is this capital expenditure push economists keep asking for going to come from?

 

Many economists insist a fiscal stimulus is the only way out of the slowdown.

 

I am surprised when people say government should do capex or counter-cyclical spending to solve the demand problem.

 

If you want to put money in people’s pocket, the best thing is to increase revenue expenditure by giving people money in their pockets. If done through fiscal policy, the government will have to borrow to do it. You will be paying in real terms to those you borrow from if the interest rate is higher than the rate of inflation, as it is now.

 

Who do you borrow from? Fortunately, despite some people’s best efforts, we do not yet borrow from foreigners for sovereign debt. So, the returns don’t go to foreigners. But we do borrow from deposit holders. By definition, the richer you are the bigger deposit holder or bond holder or LIC holder you are.

 

So, when you are borrowing to put money in people’s pockets, you are paying for that borrowing by making people who are rich richer.

 

What do you suggest?

 

Serious structural reforms. The medicine we need to give is not cyclical medicine. It is attention to the structural reasons for why a growing economy is in recession.

 

The aggregate demand problem is not macroeconomic. It is merely a reflection of the series of causal events which cause demand to be constrained. If you produce things that Indians earning minimum wages can afford, aggregate demand will increase.

 

What do you do suggest instead then?

 

You either improve productivity so that people are able to consume at the minimum wage or you increase the wage. That’s called an incomes policy. Keynes, and many post-Keynesians, for years took for granted that an important objective of macroeconomic policy is an income policy. Where you worry when wage share falls. Where you worry when the prices of things that all people consume is unaffordable for those people who should be able to afford and consume it at the minimum wage.

 

We need to start thinking in a more structural way about who is producing for whom and who is able to consume affordably.

 

Are you making a case for state intervention?

 

In a market economy, if relative prices are not working in line with the laws of demand and supply, then the state should not hesitate in intervening.

 

Are you ruling out fiscal and/or monetary stimulus?

 

We have a window of four to six quarters in which we can use monetary, fiscal and credit policies to keep the growth rate above 5% by boosting demand. And introduce incomes and industrial policies to address structural constraints. As the benefits of these policies begin to kick in, the monetary and fiscal policies could be moderated for a higher and more sustainable growth rate.

 

The Reserve Bank of India can increase high-powered money. In other words, quickly increase the amount of cash in the economy. Then banks, especially the public sector banks, can use that together with interest rate policy to provide easy credit. A larger supply of credit should lead to cheaper credit. This will have to be supported by the reduction of the administered price of credit, which is the RBI’s repo rate.

 

Fiscal policy is to play a supportive role which will come from intelligent choice of what to spend on.

 

But if only fiscal and monetary measures taken, and the structural measures get neglected, then the threat of inflation is real. The inevitable result of that will be stagflation.

 

Dr Manmohan Singh has warned of the threat of stagflation too. What is this threat?

 

What he is saying is that when countries enter into structural problems as India has, you can do things to raise the growth rate. But if you do not address the structural problem, ultimately the growth rate will stop rising but inflation will rise. A situation where you do not have high growth, but you have high inflation is called stagflation. Stagnant [growth] & inflation.

 

Think of a patient suffering from an illness needing antibiotics. I can get the fever down by giving paracetamol. But if I keep giving the paracetamol and don’t give the antibiotics, fever will be higher and higher, requiring higher and higher doses of paracetamol, finally resulting in immobility in the patient from the untreated disease.

 

The RBI has dropped the repo rate – the rate at which it lends to banks – but banks have not reduced lending rates as sharply. Why?

 

Because you cannot write an order on file asking banks to lend more. Banks have to be told very clearly that higher risk strike rate will be tolerated by the prudential and fiduciary system. Or target credit with government guarantees without the fear that the cost of the loan going bad will rebound on the financial institution extending the loan.

 

At the moment, neither is possible because banks are not term financial institutions. They have neither the capacity, nor the remit to lend for term finance. For a while they relied on the bagpiper tune of consumer credit. The NBFCs [non-banking financial companies] then stepped in but the governance conditions were inadequate in some of them and therefore, there is a crisis situation.

 

The RBI has failed to monitor, detect or address these. The buck for the overarching responsibility for the governance of the financial system stops with the RBI.

 

Therefore, the people responsible for lending at banks will not lend. They have an alternative which is very attractive to them, which is to invest in government paper and where possible to lend to public sector enterprises.

 

There is no shareholder value to be maximised from lending [by the state-owned banks]. There is no clear understanding on part of the shareholder [of the state-owned banks, that is, the government] as to why these banks exist and what they want to do with them. A process of banking reform has taken place without any white paper or roadmap guiding it.

 

To sum up, there is a huge directionless public banking sector with huge punitive costs for credit decisions that go wrong. In these circumstances, banks will not lend except at rates that allow them to cushion for risk.

 

What fiscal support would you suggest?

 

In times of fiscal stress, incremental spending should be done by fiscally sound parties. At this point, both in implementing fiscal discipline and maintaining low revenue deficit, that is the states.

 

If the Centre was to divest itself of its core responsibilities, its non-defence, non-Railways, non-internal security obligations – the three things that private sector can’t do – and outgo on interest payments on borrowings, it will be left with about a third of its spending. Anybody who thinks the private sector can run railways, just go and live in Britain.

 

One-third [of central government spending] can immediately be shut down and transferred to people’s pockets. Or, the responsibility for spending that can be put on state governments. The central government has no infrastructure or means to spend that money. All it is doing is cost-sharing with state governments [that is, schemes and programmes are conceived by the Centre, but the funding is shared by the Centre and the states].

 

Centre needs to adjust itself to let this shift to the states happen. Finance Commission could have been a golden opportunity to all it to be so, but I don’t think it is going to happen.

 

Second, the process of government spending is incredibly inefficient. It has large balances of surpluses sloshing around in the system, as the PFMS [Public Financial Management System, a Central Plan Scheme monitoring system, of the Department of Expenditure, Ministry of Finance], were the government to make it public, will show.

 

At the same time, central government is one of the worst defaulters in terms of paying its bills. Just by paying its bills on time, using its surplus balances and improving efficiency of its public spending, the central government can change things a lot and infuse aggregate demand. It’s not violation of contracts by one or two months. It’s much worse. It is not a healthy situation when the sovereign of the country is in sovereign default to its citizens. If this is not done, other things sound grandiose to me.

 

And, it is not the job of a committee of secretaries to oversee this. They are the source of the problem. This is the job of a Parliamentary watchdog or agency monitoring on a daily or weekly basis and reporting back to government if the government is paying its bills.

 

Do you have an estimate?

 

No. Let me add that none of this is doable if the budget remains stuck in the mid-twentieth century. India is the only significant country that budgets for one year at a time. From New Zealand to UK, medium-term budgeting is now the norm. Last three to four finance commissions have appealed to government to implement a more modern budgetary system. It has fallen on flat ears because political control on bureaucracy is weak. Bureaucrats do not like accountability that a medium-term framework imposes.

 

If all that you are saying does not get done, then what is the risk that India runs? How does the future then look like?

 

We will be South Africa.

 

Meaning?

 

In the history of development there are three big success stories that their development transformation successfully: Japan, China and South Korea. If you look at Brazil, South Africa, Egypt, Thailand, Turkey, these countries also tried to do the same things that China and South Korea tried to do. They too tried to move but stayed at low income. But they got stuck at different levels because they essentially failed to broaden the demand base whether they exported initially or not. They got stuck in an equilibrium which is well below their potential. That is what will happen to us, if we do not expand the incomes base.