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Power of Finance

ECONOMIC AND POLITICAL WEEKLY Power of Finance At a time when the

December 16, 2006 ECONOMIC AND POLITICAL WEEKLY
Power of Finance At a time when the “India growth story” is being celebrated to great international acclaim, it is appropriate that we critically reflect on the content of the astonishing pace of expansion over the past three years. The performance of the Indian economy on the growth front since the second quarter of 2003-04 would be the envy of any of its contemporaries. In the 13 quarters since July-September 2003, growth has dipped below 7 per cent only once and in 11 quarters it has been 7.5 per cent and more. It would be quibbling to deny that the Indian economy has moved on to a higher growth path – for now. (Does it even have to be noted that this “scorching pace of growth” continues to bypass agriculture or that it still mainly benefits a sliver of Indian society?) Yet, even as policy-makers and their cheerleaders bask in the applause, it is intriguing that we do not yet have a clear and comprehensive understanding of what is now driving the economy. A strong export performance, a high rate of investment, low interest costs and a benchmarking against global standards in a few sectors are some of the explanations that have been provided. They are perhaps relevant factors, but what is surprising is that the very important (and worrisome) contribution of what can very broadly be called “finance” is rarely acknowledged. Since 1997, when P Chidambaram, as union finance minister in the United Front government, first abolished taxation of dividends, a vast number of incentives have been offered to finance. The policy has experienced some twists and turns, but P Chidambaram, as finance minister in the United Progressive Alliance government, has from 2004 onwards firmly put in place a regime of zero taxation of long-term capital gains for holders of shares and zero taxation as well of dividend income. (For holders of assets, the abolition of capital gains tax has not been neutralised by the introduction of the turnover tax.) The result is that the returns on finance, the avenues for deploying finance and the scope for promoting new financial products have all increased enormously. These have had myriad major effects on the rest of the economy. The statistics on sectoral growth since the early 2000s show that while services have made the largest contribution to economic growth, within this sector, “finance, insurance, real estate and business services” have been growing rapidly. But such statistics do not tell us what lies behind this expansion and what other effects finance now has on the economy. The first and biggest impact of the extraordinarily short-sighted tax policy favouring financial assets is in making India extremely attractive to foreign institutional investment (FII). It is no coincidence that the resurgence in FII flows in the early 2000s coincided with the changes in taxation in 2003. It is now accepted that it is these inflows that are behind the dizzying climb, again since 2003, in the stock markets. The second and equally important outcome of the surge in FII inflows has been the resultant explosion of liquidity. This has enabled the banks to go on a lending spree in the retail consumer and housing markets. (Credit to these markets is now growing at annual rates of 47 and 53 per cent, respectively.) Such credit expansion has in good measure contributed as well to the acceleration in the manufacturing and construction sectors. Third, the FII-driven growth in liquidity has facilitated the development of a whole range of financial products and services, which, in turn, have contributed to the increasing importance of this sector. It does not require mentioning that finance is not the only engine driving India’s economy today. The manifold growth of information technology and related services, the sustained increase in export of manufactures and, within services, the boom in telecom, have each contributed to the process. However, a dangerous approach in policy-making is either to ignore the rising power of finance or to even encourage its further growth (as in attracting FII funds). An “India growth story” that is built on such foundations is neither sustainable nor desirable. It feeds an “irrational exuberance” beyond the stock markets such as, first, in the bandwagon to set up the special economic zones and, now, retail shopping chains around the country. It also makes the economy

extremely susceptible to global changes in risk perceptions. Over the past two years, India has been the recipient of the largest bloc of FII flows to the emerging economies, indicating the extent of its external dependence – and vulnerability to changes in risk perception.

There are now concerns about a possible over-heating, as revealed in rising inflation, a widening current account deficit and the unending wild party on the stock markets. The Reserve Bank of India’s recent decision to hike the cash reserve ratio is the first step to cool the economy. But there is a larger and more fundamental danger lurking behind the “India growth story” that we are ignoring at our peril. EPW

Economic and Political Weekly December 16, 2006

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