COMMENTARYfebruary 7, 2009 EPW Economic & Political Weekly8Reviving the Economy: Problems and ProspectsA VaidyanathanMeasures to relax the fiscal constraint to permit a significant increase in investment necessary to arrest and reverse the current deceleration of growth without sacrificing programmes for improving social services and providing social protection have become more compelling and urgent than ever. This calls for a strong restraint in acceding to numerous demands for tax reliefs, special assistance and “bailouts” from different groups claiming to be affected by the crisis. Such relief must be discriminating, temporary and kept to the minimum. The focus of fiscal policy must be on reviewing policies and making such changes as will protect the interests of growth over the longer term.The government is pursuing a two-pronged effort consisting of an aggressive monetary policy com-bined with an increase in public spending to cope with the after-effects of the finan-cial meltdown and economic slowdown. A number of measures have been taken to increase liquidity and to stimulate expan-sion of bank credit and to induct them to increase the volume of lending. Terms on which financial institutions can borrow from the Reserve Bank of India (RBI) have been greatly liberalised inthe hope that this will bring down interest rates and help revive sagging demand for durable goods, real estate and more gen-erally investment. On the fiscal side, the centre has announced a series of tax reliefs both across the board and for specific sectors, and increased public spending to stimulate the economy. The presumption is that these are essential to ensure that the current slowdown in growth is arrestedand that it is soon brought back close to the levels of the last decade. The risk that this combination of policies will fuel inflation is considered to be less a matter of concern given the progressive deceleration in infla-tion and at any rate worth taking in the interests of protecting growth. The ration-ale of these presumptions and their valid-ity deserve closer examination.Monetary PolicyThe rate of increase in overall money sup-ply during the current year has been less than during the last year, largely reflect-ing the decline in foreign exchange reserves. Despite a significant deteriora-tion in the centre’s finances, measures taken by the RBI since September 2008 have led to a substantially increase in the volume of resources available to banks for providing commercial credit. During the current fiscal year taken as a whole, and also since September, the volume of outstanding non-food credit has in fact increased at a somewhat higher rate than the corresponding period of last year. This has not had much of an impact in check-ing the slackening, not to speak of revival, of real economic activity. Complaints of credit shortage and unwillingness of banks to lend even to reputed businesses persist.Credit CrunchWhile growth in the overall supply of bank credit to the private sector has not slack-ened, there is indeed a squeeze on the over-all availability of finance. Domestic mobili-sation from non-bank sources (through fresh capital issues in the primary market, private placements, foreign direct invest-ment and external borrowing) has declined significantly. Internal resource generation of enterprises has also come down in the last six months. All this is hardly surprising given the steep fall and continued volatility in the domestic share market prices, the adverse effects of slower growth in both domestic and foreign demand on profitabil-ity. Uncertainties about growth prospects in the short and medium term, the worldwide turbulence in financial markets and the recessionary trends in the high income countries have drastically reduced availa-bility of funds from foreign sources (com-mercial borrowing, American Depository Receipts and Global Depository Receipts). Expansion of domestic bank credit has not been large enough to offset the reduction in non-bank and external sources of credit. Growth in overall availability of financial resources is therefore considerably less than in the last few years. This is one rea-son for persistent complaints that shortage of credit is impeding the economy. Hesitation on the part of banks to increase lending is also a contributory fac-tor. Banks have not expanded credit dis-bursements to the full extent of the addi-tional funds they could avail of by borrow-ing from the RBI. The relatively large vol-ume of reverse-repo transactions is indica-tive of the hesitation of banks to lend. Their reluctance is understandable in the context of heightened economic uncer-tainty resulting from extraordinary rise in the price level, turbulence and volatility in financial and key commodity markets at A Vaidyanathan (a.vaidyanathan053@gmail.com), a well-known economist, has been a long-standing contributor to EPW and is currently on the board of the Reserve Bank of India.

COMMENTARYEconomic & Political Weekly EPW february 7, 20099home and abroad, the palpable adverse effects of slower growth in both domestic and foreign demand on profitability and consequent apprehensions of increased defaults on their loans. These concerns are heightened by the fact that growth of sectors (like information technology (IT), travel and tourism, real estate, motor vehicles, domestic airlines and some financial institutions outside the banking sector) which have driven the exception-ally high growth during recent years, are already confronted by sharp slowdown in demand. Some are in serious difficulties due to pile up of unsold inventories, incom-plete projects and prospect of huge losses. This has led to a huge demand for increasing liquidity, lowering of interest rates and bailouts by the government from a wide range of sectors to tide over press-ing financial problems. At the same time the slowing down of growth also means slower growth in requirements of short-term credit for working capital and long-term credit on account of cutbacks in fresh investments. Not enough is known about the impact of overall shortage of credit in different sectors. Reduction in mobilisa-tion through fresh capital issues and exter-nal borrowings has affected mainly the corporate sector which has relied heavily on these sources. It is also likely that the increase in commercial bank credit has not contributed significantly to easing the difficulties faced by small and medium enterprises which in any case depend mostly on non-bank sources for credit. Pressure for Lower Interest RatesMonetary policy since September last has focused on increasing liquidity and resources available to the banking system and at the same time bring down interest rates. The progressive and steep reduction in repo rates has, after some hiccups, brought down call money rates and stab-lilised them within a target band. But they have not been successful in bringing down either deposit or lending rates. Banks have been reluctant to reduce lending rates (they have begun to do so in small measure in the past fortnight) despite considerable pressure from government. Their margins are under pressure and the prospect of increased defaults can intensify the pressure. The reduction in prudential norms for risk provisions will not make much of a differ-ence to the cost of funds or to their opera-tional costs. Adjusting prudential norms and otherwise weakening the regulatory regime is clearly not conducive to healthy functioning of the financial system. If any-thing, recent experience suggests the need for stricter, tighter supervision and regula-tion. Lending rates can be reduced only by scaling down deposit rates. Whether the banks can reduce them significantly on their own without risking loss of deposits is therefore a major issue. So is the impact of lower interest rates on savings overall and especially on willingness to invest in finan-cial assets. These aspects and more impor-tant, the effect of lower interest rates on household savings, need far more discus-sion than they have received so far.Proponents of lower interest rates, both in the corporate sector and among a wide section of economists, argue that lower interest rates will arrest the current slow-down in growth by stimulating aggregate demand and help revive the growth momentum by inducing larger invest-ments. In countries like theUS, Europe and Japan, where a large proportion of consumption consists of housing and dura-bles, and which are acquired on instal-ment basis, a reduction in interest rates can provide a significant stimulus to aggregate demand. It is worth noting how-ever that the steep cuts in interest rates in these countries (to near zero levels in some) have so far failed to achieve this. The balance of the current debate on ways to deal with the severe and deepening recession in these countries has shifted from aggressive monetary policy to increase public spending in sectors and regions that will provide jobs and incomes to those worst affected by the recession, encouraging investments to improve the quality of infrastructure and exploit tech-nologies that are conducive to sustainable use of natural resources. In India lobbying for lower interest on such loans is most vociferous from produc-ers of durables and from real estate and housing companies. Reducing the cost of consumer credit is unlikely to make a sig-nificant difference to aggregate demand because they constitute a relatively small proportion of total spending. A general reduction in interest rates could improve their current profit and loss accounts (and also of enterprises in general). But it will not by itself make a significant difference to the returns to fresh investment even in these sectors, much less in others. The rapid growth of demand for these products of these industries during the past decade and a half is driven by a com-bination of exceptionally high growth of employment and income in sectors – IT, business process outsourcing (BPO), busi-ness and financial services, hotels and other upmarket services – where average incomes are very high. Optimism about the prospects of sustained high growth in these sectors and in overall GDP as well as the wealth effect of booming asset prices reinforced the bullish expectations of both consumers and producers. But these presumptions have received a rude jolt since September 2008. The world-wide recession has slowed down the growth of export-oriented sectors and dampened expectations of their future prospects. Much the same has happened in hyper-growth, notably of activities depend-ent mainly on domestic demand – com-mercial real estate, housing, motor vehicles and fast moving consumer goods. It is very unlikely that they will get back to high double-digit growth. Projections for the current year have already been drastically scaled down.While the domestic financial system is in much better shape, thanks to farsighted actions of the monetary author-ity, the external environment is far from favourable for exports or for accessing foreign resources. The Fiscal Stimulus PackageThe policy of economic liberalisation and globalisation followed for the past two decades has contributed to the remarkable improvement in the country’s overall growth performance. But it has also accen-tuated inequalities, and there is much concern over the poor state of infrastruc-ture, and low levels of human develop-ment indicators, and high incidence of poverty, under-nutrition and unemploy-ment. The strategy of spending large amounts of money on social amenities, rural development and poverty alleviation has not been effective in resolving these problems. Significant improvements in fiscal management – in raising revenues,

COMMENTARYfebruary 7, 2009 EPW Economic & Political Weekly10controlling expenditures and scaling down the fiscal deficit – have become undone in the course of the last few months. The fiscal deficit – now projected to reach 8% of GDP – has spun out of control due to a combination of a pheno-menal rise in non-development expendi-ture (on subsidies, public sector salaries, farm loan waiver) and fiscal concessions leaving little room for increased develop-ment spending to counter the deceleration in growth.Under these conditions, the govern-ment’s ability to use increased public spending to stimulate the economy is severely constrained. The “stimulus pack-age” announced by the centre in the last few months adds up to nearly Rs 3,00,000 crore. But nearly half of it consists of issue of bonds to meet pending commitments to meet losses incurred by oil and fertiliser companies, raising the limit on state govern-ments raising market loans, allowing the India Infrastructure Finance Company Ltd (IIFCL) to raise loans through tax-free bonds for investment in infrastructure, and cre-ating special windows for cash strapped non-banking finance companies (NBFCs) and mutual funds. Of these only enhanced borrowings of state governmentsand IIFCL will stimulate demand to the extent they are actually utilised for investment. The supplementary budgets provide for some Rs 1,50,000 crore of additional expenditure during the current year. Muchthelarger part of this amount is meant to meet sub-sidy payments for food, oil and fertilisers and the costs of the farm loan waiver. Increased plan outlays for the National Rural Exployment Guarantee Scheme (NREGS) and education are meant more to protect the vulnerable groups from the eco-nomic slowdown and for improving the quality of human resources than for imme-diate gains in growth. Additional invest-ments that ease the infrastructure con-straint could facilitate growth in the near term and could stimulate demand for capi-tal goods. But that depends on whether the allocations are actually spent and spent effectively to speed up implementation. In any case the additional expenditure on these activities taken together is far too small to make a significant difference to demand in sectors (like consumer goods, real estate and automobiles) experiencing deceleration of demand. The magnitude and pattern of demand stimulus that the across-the-board reduction in the Cenvat and other selective tax reliefs (estimated to cost Rs 50,000 crore in revenue loss) will induce remains to be seen. Package InadequateThe “stimulus package” is unlikely to have much of an effect either in stimulating demand in the near future or in increasing the potential for reviving growth over the medium term of growth in productive capacity. The resulting increase in fiscal deficit much beyond the limits is now justified as necessary to cope with the cri-sis and that, with the inflation rate com-ing down rapidly to near acceptable levels, the risk that it will aggravate inflation is considered minimal and containable within reasonable limits. It should be noted, how-ever, that fall in inflation rate is based on the wholesale price index (WPI) and largely reflects the decline in fuel and metal prices. Prices of food and other essential commod-ities of mass consumption have not eased as much. The consumer price indices, in fact, are increasing at a considerably higher rate than WPI. Over the years the WPI and the consumer price index (CPI) do not always move at the same rate or in the same direction. In fact, over the last 35 to 40 years, the CPI has increased faster than the WPI half the time, and the other way around in the other half. Over the longer term, the behaviour of the general price level depends not only on monetary and fiscal policy, but on the rate of overall GDP growth, changes in the distribu-tion of incomes, consumption patterns and to a large extent on trends in the prices of food and clothing, which in turn are influ-enced by the behaviour of agricultural pro-duction. Given that food and clothing con-stitute by far the largest share of total con-sumption of the large majority of the popu-lation, the trends in CPI are politically of greater importance in assessing core infla-tion. There is of course need for reviewing the current CPIs to one which is representa-tive of the overall population and reflects the current patterns of consumption. The current, rather sanguine, assess-ment of inflationary risk also presumes that the increase in the overall fiscal deficit of the centre and the states taken together may not be as large as that of the centre. This can happen only if actual spending by either or both turns out to be much less than the budgeted and approved levels. This may well be a realistic assumption for the current year, but not in the next year or over the medium term. The pressure on the fisc on account of recent tax reliefs, higher personnel costs consequent on the revision of salaries and benefits, pending commit-ments to cover losses incurred by oil and fertiliser companies and the cost of the farm loan waiver, and prospects of such losses continuing to increase because of the reluctance to adjust prices in the face of rising costs, are likely to increase further in the coming years. The capacity to increase public spending on development will also be constrained by the slowing down of overall growth, precisely at a time when increased public investments are essential to provide adequate economic infrastruc-ture to realise medium-term growth tar-gets, and to meet political commitments to expand and improve the quality of educa-tion and health services, rural employment programmes and provide social safety nets for vulnerable segments. The government has a proactive policy of wooing domestic and foreign private enterprises to invest in new projects in some key infrastructure sectors (electricity, oil, roads, ports, airports and higher edu-cation) through a variety of arrangements (wholly private, joint ventures, public-private partnerships, build, operate and transfer orBOT, etc) and offering a variety of “incentives”. This is justified on the grounds of superior efficiency of private sector in constructing and managing these ventures. More importantly, private invest-ments will not be forthcoming unless assured of an attractive return. This is sought to be done through a variety of inducements including provision of land at far below market prices, various fiscal concessions, right to determine and collect user fees in some cases, and guaranteed prices in others. The nature, magnitude and justification for these inducements are far from clear or transparent. In the case of electricity, for example, the public systems are already incurring huge losses on account of subsidised pricing compounded by widespread theft. These losses are borne by the government and are

COMMENTARYEconomic & Political Weekly EPW february 7, 200911among the major factors for the high fiscal deficit. The cost of even efficient new plants will be much higher than costs of existing facilities. While price guarantees may take care of the investors’ returns, losses incurred by utilities will continue to soar. Unless rates are increased, theft is curbed and dues are collected, the burden of subsi-dies on the budget is also bound to grow. Role of Fiscal Policy On the face of it, greater private invest-ment would also reduce the extent to which the public sector plan needs to finance them. This is clearly the case when new investments are financed from exter-nal sources, the prospects for which are and will continue for some time to be dim. But this is not necessarily the case when resources are raised domestically. Recent discussions have highlighted the complex interrelations between government fiscal and monetary policies on the one hand, and the availability and cost of resources for private sector through the financial system, on the other. The quantum of domestic financial resources available and the level of interest rates are determined by monetary policy, which is supposed to strike a balance between providing adequate liquidity for the functioning of the economy, keeping inflation within acceptable limits and ensuring stability of the financial system. Part of these resources are invested in government securities and used to finance government expenditures. Their magnitude depends partly on the scale of government expenditures, the extent to which they are met out of tax and non-tax revenues and how the deficit is financed. Recourse to borrowing from the central bank has to be restrained to keep inflation in check. Therefore larger fiscal deficits mean larger draft of government on resources of the financial system and less availability for lending for the rest of the economy. The prospect of a slowdown in growth of realGDP, reduction in foreign resource inflows and reduction in the country’s for-eign exchange reserves implies that the rate of money expansion consistent with a moderate inflation cannot be as high as in the last few years. Under these conditions, which are characteristic of the current and prospective situation, a large increase in private investment is likely to result in excess demand for funds relative to sup-ply and a rise in interest rates unless the fiscal deficit is brought down. Striking a viable and acceptable balance between measures to arrest and reverse the cur-rent deceleration in growth, controlling inflation, keeping the current account deficit within manageable limits and low-ering interest rates will be far more daunting and difficult than is recognised in current discussion.Measures to relax the fiscal constraint to permit a significant increase in investment necessary to arrest and reverse the cur-rent deceleration of growth without sacri-ficing programmes for improving social services and providing social protection have become more compelling and urgent than ever. This calls for a strong restraint in acceding to numerous demands for tax reliefs, special assistance and “bail outs” from different groups claiming to be affected by the crisis. Such relief must be discriminating, temporary and kept to the minimum. The focus of fiscal policy must be on reviewing policies and making such changes as will protect the interests of growth over the longer term.On the expenditure side, there is little scope for reducing outlays on salaries and interest. Substantial reduction in several of these subsidies is justified not only in the interests of efficiency and equity, but more importantly essential to release resources for development programmes. Unless this is done, it will not be possible to increase public investments in basic infrastructure on a scale needed to revive growth to even moderate, not to speak of double-digit growth. “Subsidies” provided by government reflect the difference between the pro-ceeds of goods and services provided by or through the public sector and the costs of producing and delivering them. Only a part of it is explicitly recorded in the budgets. Implicit and indirect subsidies are much larger. Altogether their combined magnitude – according to the latest and rather dated estimates relating to the mid-1990s – is around 14% of the country’s GDP, and were greater than the public sec-tor plan outlay and the gross fiscal deficit of the centre and the states. Their magni-tudes have continued to grow apace since. A large part is on account of free or highly subsidised supply of food, education and healthcare, basic amenities as well as expenditures for providing social protec-tion to the aged, disabled and widows. They reflect the state’s deliberate policy in pursuit of the Directive Principles set out in the Constitution and a political consensus about their priority. The scope of reduction is limited and any attempt to effect signifi-cant cuts cannot be justified. The issues here relate more to their coverage, target-ing and quality of the facilities provided. A second category consists of various direct and indirect subventions ostensibly meant to attract private investment in par-ticular regions, encourage the adoption and spread of particular kinds of improved technologies and inputs (like drip and sprinklerirrigation,windmills,solarenergy) and provide relief to specified groups/institutions (such as housing schemes for the poor; free electricity connection to poor rural households; midday meals for schoolchildren; interest and loan waivers on farm loans. low interest loans to agri-culture; handlooms, khadi and village industries; and numerous others). Their scope, scale and impact need to be properly documented to assess the scope for reduc-ing them based on a proper assessmentof their justification and effectiveness. Their overall magnitude is, however, likely to be relatively small compared to the losses borne by the budget on account of electricity, oil and oilproducts,water supply from public systems, and fertilisers. These cut hugely and increasingly into the budgetary resources of the government available for development and welfare. They encourage inefficient and wasteful use of scarce natural and foreign exchange resources thereby raising the costs of production in user activities and contri-buting to the growing threat of pollution, degradation and over-exploitation of land and water. Reducing these losses is there-fore desirable and necessary in the inter-ests of efficiency, resource conservation and sustainable development. Losses in these sectors are the result of inefficiency in production and distribution of their products; laxity in governance man-ifest in underassessment and poor recovery of dues and failure to check widespread ille-gal use of water and electricity; and the

COMMENTARYfebruary 7, 2009 EPW Economic & Political Weekly12deliberate policy of government, dictated by considerations of short-sighted populism, of not adjusting prices in the face of rising costs. Reducing them requires action on all three fronts: Stricter standards of design, choice of technology and project construc-tion to reduce costs; review of fiscal and price control regimes to create strong incen-tives for improving efficiency in production; and proper assessment of dues for public utility services and their prompt collection; and acceptance of the principle of adjusting issue prices in the light of cost increases leaving the actual revisions to be decided periodically by independent regulatory authorities. The potential contribution of these measures to augmenting resources for development is large. How much of it is, in fact, realised depends, of course, on whether governments are willing to accept their importance and implement them seriously with a sense of urgency. Improving Efficiency The ultimate outcome in terms of growth of output, employment and well-being of the masses obviously does not depend only on the scale of financial outlays on development activities, but on how effec-tively they are used. It is common knowl-edge that there are serious deficiencies in the design of programmes, scrutiny and evaluation of schemes, in monitoring their implementation and ensuring accountability for performance. A large part of public sector development pro-grammes relating to agriculture, roads, electricity, social amenities and welfare fall within the domain of state govern-ments. But the design, financing and implementation mechanisms of several of them are decided centrally, leaving little flexibility for states to adapt them to local conditions and priorities. The plethora of overlapping subsidy-intensive schemes, fragmented implementation, virtual lack of credible accounting or audit leave much scope for waste and corruption at all levels. The cumulative effect of all this is to greatly reduce the effectiveness of public spending in achiev-ing their ostensible aims. Inefficiency in management of public sector enterprises and public systems is reflected in high costs, poor quality of services and huge losses to the exchequer. Redressing these deficiencies is therefore as important and urgent as finding more money to spend. The needed reforms are numerous and wide-ranging. The following are among the more crucial: entrust imple-mentation and continuing management of major projects to organisations autono-mous of the executive arm of government, establishment of credible independent reg-ulatory bodies, giving elected local govern-ment institutions the authority, responsibil-ity and funds to choose and implement programmes according their needs; strengthening the right to information and independent social audit of the perform-ance and impact of public programmes.Systemic reforms of such range and depth cannot be done without a concerted effort at educating public opinion and forg-ing a broad consensus among political par-ties and between the centre and the states. Compulsions of competitive electoral poli-tics make even the more perceptive and far-sighted political leaders unwilling to press for such reforms. More important perhaps is the fact that public sector plans and the public systems responsible for implementing them have evolved into an institutionalised system of corruption and dispensing patronage to supporters of parties in power. Practically all parties have contributed to this process and exploited it to their advantage. Any reform that erodes their privileges will face strong resistance. A concerted effort is necessary to create a wider appreciation among the public and the political class and about the seriousness of our current predicament and the urgent need for reforms to ensure prudent and effective use of public resources for reviving growth and to safeguard the interests of the masses. The campaigns on right to informa-tion, social audit of NREGS, and empower-ing panchayats show that civil society and the media could play an important role both in raising the general level of awareness of the issues involved and promote serious debate on concrete measures in selected strategically important areas. The process by which such a far-reaching reform as the introduction of Cenvat was accomplished shows that careful technical studies of pro-posed changes and their implications pre-pare the ground for facilitating the process of forging a political consensus between the centre and the states through the National Development Council. A similar approach needs to be initiated to deal with broader institutional reforms in government and public systems responsible for development. As the institution centrally responsible for long-term development policy, the Planning Commission needs to take a proactive initia-tive to launch this effort. Fifth 4-week Refresher Course in Public Economics for the South Asian RegionNIPFP proposes to organize a four-week refresher training programme in Public Economics for the South Asian Region, during 25.5.2009 to 20.6.2009. The participants would be college or university teachers, faculty in research institutions, normally under 45 years of age. Preference would be given to teachers teaching Public Economics/Public Finance. The teachers who have attended the programme in the past need not apply.The programme would be organized at the Institute premises. Participants would be reimbursed 2-AC train fares. All local hospitality would be provided by the Institute.Interested candidates may send their CV to the following address by April 1, 2009.Jai Mohan PanditSecretaryNational Institute of Public Finance and Policy18/2 Satsang Vihar MargSpecial Institutional Area [Near JNU]New Delhi - 110 067E-mail: jmpandit@nipfp.org.in Tel.26563688 Fax26852548