"“The Budget and the economy”, `Economic and Political Weekly’, March 2002.

Prologue: What the FM saidAs this piece will be first read at least a full three weeks after the Budget for 2002-3 was presented, I shall spend very little time on its details per se for these have been well noted, and very likely digested. I shall instead scan it for rationale. In particular, I shall check on how its architect has addressed the current state of the economy. The concern of this short piece is this state and of the ability of the Budget to alter it. Essentially, I see the economy sputtering – to use the apposite expression of a former finance minister now safely out of office – ten years since the onset of reforms. This situation I refer to as `fatigue in a time of reform’. I must clarify at the outset that as I recognise this to be the case, I remain sceptical of the capability to rejuvenate the economy often attributed to (another round of) reforms. Hence, my characterisation of the Budget’s proposals as ‘reforms at a time of fatigue’. However, unlike some critics I do not see the dismal performance of the economy as intrinsically linked to the reforms. Rather I see it as the outcome of macro-economic policies endogenous to a fiscal crisis of the Indian state.            It is useful to commence with Mr. Sinha’s concluding remarks in his Speech which amount to his summing-up of the Budget. He had remarked: " …. this is a budget for consolidating, widening and deepening the reform process. This is a budget devoted to development." (paragraph 191, ‘Budget Speech’, New Delhi: Ministry of Finance) Altogether this gives the impression of a man in less than an hurry, actually quite a brave stance for a politician with a five-year term. However, it needs then be asked if the policies being pursued are necessarily good in a longer term, even if we may grant that their short-term impact is unlikely to be beneficial. My own verdict is that the budget is really a collection of measures, disconnected maybe but not necessarily badly conceived. However, it does not amount to a serious stab at launching the economy onto a higher growth path, which is what the so-called ‘second generation reforms’ that the FM has harped upon in the past half year or so are meant to do. To prepare the reader for my argument, I first discuss the current state of the economy.Backdrop: Fatigue in a time of reform‘Fatigue’ appears to me to be the appropriate characterisation of the current state of the economy, especially its industrial sector. Moreover this is not a particularly recent development. It is the culmination of a slowdown that commenced in 1995-96 when the annual growth rate of industrial production had peaked at close to 14 percent. Since then the rate of growth of industry has decelerated, dragging with it the economy-wide growth in GDP. Actually, since the second half of the nineties, the economy may well have grown at a slower rate annually than in the pre-reform period of the eighties. The growth process of the nineties may then be described as follows: after a rush to invest following the delicensing of capacity-creation, supply response has been poor. The market appears not to have grown after the initial pent-up demand, especially for consumer durables, had been met by fresh capacity. Nothing describes the current state of the reforms than this investment famine in the private sector of industry, the area of the economy most directly targetted.            At the macroeconomic level there are two factors that account for the slowing of aggregate demand, they are a slowing of public investment and the shift in the terms of trade in favour of agriculture. Since 1991 we have seen a decline in public investment as a share of GDP and a rise in the relative price of agriculture. This marks a reversal of the situation in the 1980s, when public investment was higher throughout and the agricultural price was lower in relation to industry. The role of public investment in maintaining the level of aggregate demand in a market economy is well accepted by all but the most naively ideological. No more immediate evidence is needed than the alacrity with which the political establishment in the United States rushed through a stimulus package for 200 billion dollars within weeks of September 11, no matter that some astute commentators see this as a ploy to reward Bush supporters with lower taxes. However, public investment has a bad image in India after decades of degeneracy in the public sector. This is unfortunate, for we are throwing the baby out with the bath water. Ideology is a poor substitute for arguments, as we are forced to recognise in most debates on the economy in this country today. However, while public investment at least makes a rudimentary appearance in these discussions of the economy the agricultural terms of trade seldom does. Even as it is ignored, though, the role of the terms of trade in determining short-term outcome may not have lessened to any substantial degree since 1991. Especially, where the shift in the terms of trade may have been led by a rising price of foodgrain. For this could constrain the expansion of the market for industrial goods.            I am at pains to emphasise though that I do not believe that either declining public investment or a shifting terms of trade is a direct consequence of the set of reforms consciously adopted by successive governments since 1991. First, public investment has been crowded out precisely by rising subsidy payments – on food and fertiliser – which far from having been cut as part of `neo-liberal’ policy, have mostly swollen in real terms. Here we see truly endogenous macro-economic policy with public investment being squeezed out by a government trying to contain the fiscal deficit in the face of its own populism. The shifting terms of trade may also have been engineered by the government which has, during the nineties, raised both the procurement price of foodgrains and the minimum support price of cash crops over and above the inflation rate. Of course some downward pressure on industrial prices, resulting in a shift in the terms of trade, may also have come from a lowering of the tariff rate for industrial products, a mechanism envisaged years ago by Little, Scitovsky and Scott. Whatever may constitute the true diagnosis, the fact remains that the economy has lost the dynamism that it had gathered soon after the initiation of reforms in 1991. It should, however, be clear that precisely because the reforms per se may not have contributed to the slowdown, a fresh bout of reforms, termed the ‘second generation’, may not be able to revive the economy all that easily.The ministry: Reforms a time of fatigueThe title of this section carries my assessment of what this Budget does, carrying implicitly too my assessment of its potency. The line of thinking contained in the budget appears to be that the time is now ripe for what is being referred to as the second generation reforms. Prominent among these is labour reform which has not figured in the budget for it had figured only a little earlier. I refer to it nevertheless, for it is of the genre of reforms that Mr. Sinha has showcased in the budget, which in my view may also be expected to yield only similarly dubious results. On this, a serious look at India’s labour laws is not at all unwarranted, it being conceivable that restrictions on exit may have constrained private (and even public sector) investment. However, to bank upon reform of the labour law along with other elements of second-generation reforms to permanently raise the rate of growth appears to be fanciful. Like all supply-side policies it seriously underestimates the role of demand in sustaining a growth process. It does not take much to recognise that growth requires to be bolstered by both demand and supply factors. To two of the principal supply-side measures given attention in the Budget I now turn. The first of these relates to the agricultural sector. The other to external capital flows.            Under the banner `freedom to the farmer’, the Budget has proposed some measures that amount to further de-control and deregulation of the agricultural sector. It is proposed to remove restrictions on the movement of agricultural products across the country and to move towards the decanalisation of exports. A resolute move towards a common market in all its manifestations within the country is entirely to be welcomed. Also, it is not clear whether such measures as the Essential Commodities Act, a legacy of the British Raj albeit in a fresh avatar, has served anything more than its misuse in independent India. However, if the purpose of the package of measures in agriculture is to spur agricultural growth we may want to ponder the proposition a bit. As I have already stated, the nineties have witnessed a steady improvement in the terms of trade of the agricultural sector. This has not resulted in a faster rate of growth when compared to the eighties when the terms of trade were not particularly favourable to agriculture. Nevertheless, agricultural growth then was not only higher than what has been achieved in the nineties, it also compares favourably with growth rates achieved in earlier phases, a feature insufficiently recognised in commentary. As for the factors underlying the robust agricultural growth in the eighties, it may be mentioned that the growth of public capital formation in agriculture was high then, having declined since. This does point to likely role of price incentives, such ass implicit in the relaxation of zoning laws, as opposed to other supply-side factors such as investment in the land-improvement factor, a major contribution of public capital formation. If growth was to have taken off in agriculture in the nineties there has been sufficient provocation from favourable price movement already. Now, it is the extension of public infrastructure that is likely to tip the balance. An assessment of the Budget’s contribution to this would require access to a finer classification of its expenditure proposals than I currently possess.            Next, in the Budget come the measures extending capital account convertibility. Principally, what has been done is to facilitate the repatriation of income earned on investments in India by NRIs. Not quite linked to capital account convertibility is the revocation of limits on foreign direct investment (FDI) except in specified sectors.While a savvy reading of their provenance would suggest that these measures reflect the gathering clout of NRIs with respect to Indian economic policy, a more academic reading may be that all these measures with respect to capital flows are based on the sound principle that there is unlikely to be entry into a field from which there can be no exit, hence the increasingly generous provision for repatriation of earnings.            However, the best disquisition on the promise of more liberal policy towards external capital flows must start from experience rather than economic theory. First, India’s experience with FDI, as opposed to portfolio flows, has been very poor since 1991 so that we may be led to enquire whether the changes in this Budget are so significant as to turn the tide. Second, the experience of China is of the essence in assessing India’s prospects of attracting foreign capital. Above all, the persistent reference to the much higher level of capital inflow into China as a predictor of higher inflow into India consequent upon more liberal policy misses the cause of the Chinese experience. There are two aspects to the Chinese experience that are germane to India. First, FDI in China is high because domestic investment is high there, at least a third higher as a share of GDP than in India. Indeed all the East Asian economies are high-investment economies, it being a part of their character as much as their, at least by-now, open trade regimes. Essentially, FDI is high in these economies because domestic investment is high, and not vice versa. Secondly, as in the other East Asian economies, domestic investment is high in China because public investment is high. Here, it bears emphasising that private investment, far from having allowed itself to be `crowded out’, appears to have responded favourably to what is clearly a buoyant investment climate due at least in part to high public investment. Finally, an aspect many appear to be unaware of is that the share of FDI in aggregate investment in China is not very high. That FDI in China is high in relation to FDI in India has led to hoary predictions of the fruits of re-writing the rule book on external capital flows. Here as elsewhere we need to remember that government needs to actually create physical assets rather than just to invite the private sector to build them on the basis of profit incentives. Expectation of private profits is as much related to public assets as they are to tax and other provisions that may directly affect the profit rate, for public assets – such as infrastructure – are most often essential for private economic activity to take place at all.                The overall tenor of the Finance Minister’s Speech was that he has been able to give the economy a boost within the constraints of fiscal prudence. I contest both these claims. First, the increase in budgetted capital expenditure (over the revised estimates for 2001-2002) is at 16.3 percent lower than the increase of 25.9 percent actually attained in 2001-2 over 2001-0. In a dynamic context then, the fiscal expansion in terms of capital spending is actually lower in the current budget than in the past year. Next, even as the increase in capital spending has slowed, the growth in revenue expenditure has accelerated. The relevant figures for the two periods over which we have just considered the growth in capital spending are 9.5 percent and 11.9 percent, respectively (all figures are calculations from `Budget at a Glance’, New Delhi: Ministry of Finance). There is absolutely no evidence of any serious fiscal correction having taken place, and if an indicator is needed we see that the Revenue Deficit for the coming year is projected to be even higher than what was budgetted for 2001-2. Tailpiece: And then there is the uncertaintyI presume it to be unexceptionable to say that the revival of the economy does depend much on private investment. While I would argue that a step up in public investment is a sine qua non for a revival of the private, the Finance Minister, judging from his Budget would appear to be arguing that it is not. Indeed he would argue that what private investment really requires are incentives to invest. While the budget does not have much by way of tax breaks for investing firms he would argue that by ‘extending’ the reforms he has provided a vital input. It is of course conceivable that neither I nor the Finance Minister has exhausted the reasons for lagging private investment. I have in mind a variable outside the economic sphere, political uncertainty. This is extremely difficult to quantify or to even get a firm handle on analytically. However, I need only point to the near exactness of the timing of the private investment slump in this country to suggest that the private sector places very little confidence upon this government. The collapse in investment is almost co-terminus with the first, short-lived, Vajpayee government of the mid-nineties. When the private sector gets a whiff of political uncertainty there is little that economic policy can achieve. Note that the inflation rate, the academic economist’s favorite index of (economic) uncertainty is a mere one percent, perhaps the lowest in several decades. Shrinking aggregate demand and a gathering political gloom frustrate a gormless government’s half-hearted interventions.