The following is an excerpt from my project on the inherrent paradoxes in the
Indian economy. It is an independent work which does not exist in any other
form elsewhere. Hope it it is appreciated.
Abhishek
The Great Indian Paradox
The July 1991 revolution was as momentous for India as the 1979 Deng Xiaoping
engineered reformist movement in China. A post-independence interventionist
approach based on Nehruvian socialism was systematically dismantled. An edifice
based on domestic protection of industries, government directed credit
programmes, reservation for small- scale industries (SSIs), import substitution
and primarily public nature of investment was done away with.
The Actual Paradox
Paradox 1: High Fiscal Deficit and Soft Interest Rates
India's large fiscal imbalances, exceeding 10 per cent of the Gross Domestic
Product and the public debt representing almost four and a half years of
revenue, are �reasons to worry� though its credit rating is better than that of
many emerging markets. �India�s fiscal problem has deep roots in its federal
fiscal system, where multiple players find it difficult to coordinate
adjustment�, according to a paper, prepared by Ricardo Hausmann, Professor of
Economic Development at Harvard University and Catriona Purfield of IMF�s Asia
and Pacific Department. �The size and closed nature of the economy, aided by
its deep domestic capital market and large captive pool of domestic savings,
has disguised the cost of fiscal laxity and complicated the building of a
consensus on reform,� it said.
In a under-developed economy emerging from recession with a relatively
primitive private corporate sector a fiscal deficit can prove beneficial. If
the fiscal deficit is primarily the result of increase in Public Capital
Formation then the capital stock in the country increases. Simultaneously, the
aggregate absorption in the economy goes up. Firms use the excess capacity to
respond to increased domestic demand. However the rise in domestic absorption
leads to increase in imports and widening of the trade deficit. Increased
absorption also leads to higher disposable income, private consumption and
investment. The trade deficit is financed by a capital account surplus as a
result of higher differential rates of interest. These capital inflows lead to
further growth of productive capacity and boost employment. Per capita incomes
rise leading to higher tax receipts. Over time private investment picks up and
fiscal deficit is neutralised because of improved tax collections. Thus a
virtuous cycle of growth, investment and budget surpluses sets in which moves
the economy out of recession. While inflation may prove to be a dampener, in
the long run the impact on domestic prices will be minimal because of increased
returns from investment unlike the case if fiscal deficit is mainly comprised
of rise in Government Consumption .
However, a moderate fiscal deficit and a sustainable current
account deficit are necessary in order to maintain the capital inflows. If the
twin deficits blow out of proportion, expectations of imminent depreciation set
in and sudden flight of foreign capital follows. Private Investment has been
declining over the last few years Real interest rates have also witnessed a
significant decline over the last few years. The following is a possible
explanation for the declining private investment in the economy.
In the aftermath of 1990-01 BOP crisis, the Narsimhan Committee-I (1992)
recommended further strengthening of the financial sector (especially the
banking sector) in order to absorb the influx of foreign capital and create a
conducive medium for massive investment. In this regard, the RBI asked banks to
improve the quality of their loan portfolio, build capital adequacy and to
incorporate credit evaluation procedures. As a result, banks became more
conservative in extending loans for productive purposes. Thus expansion of
domestic credit and private investment suffered. Real2 gross domestic capital
formation (RGDCF) by the private corporate sector as a proportion of real GDP
has been declining from its peak value of 9.9% in 1994-95 and is provisionally
estimated at 4.9% in 2000-01, and quick estimates for 2001-02 put it at 4.8%.
RGDCF in the public sector has declined to around 6.4% of GDP in 2000-01 from
its peak of 8.7% in 1994-95.
But the recent improved performance of the private corporation
sector in India and higher corporate profits have led to a sharp increase in
private investment. Unless the fiscal deficit is reined in drastically, there
will be more competition for access to domestic savings. If domestic savings
rates remain static, a deregulated interest rate environment might cause a
massive jump in interest rates. This will compound the fiscal problems of the
government, increase instability of indebted companies and push the economy
into recession. So far though the symptoms of a fiscal malaise have been masked
by restrictions on capital convertibility, high tariffs and export promotion
measures. The above statement illustrates the first paradox, that of a high
fiscal deficit and falling interest rates.
Paradox 2: Failure to convert high Savings into Investment
While private corporate and household savings have been quite
impressive over the last few years, the domestic savings rate has been
consistently lingering at 24-25% of GDP between 1994-95 and 2001-02. Compare
this to savings rates of nearly 35% in East Asia and 40% in China and we a
general idea of how growth can be propelled by maintaining consistently high
savings and investment rates. Simultaneously gross domestic investment rate has
declined from a high of 27.4% in 1996-97 to 23.2% in 1999-00. The state of
public finances is the most obvious culprit.
The huge fiscal deficit has severely restricted the domestic savings rate which
otherwise could have been quite healthy. Therefore the figures for 2000-01 and
2001-02 are more reliable and the previous argument about huge public
dissavings stands. Thus the second paradox is presented where a capital
deficient capital like India exports capital in the form of foreign exchange
reserves due to its inability to generate an investment climate.
Paradox 3: Current and Capital Account Surplus
The persistent imbalance between public dissavings and investment
has proven to be a primary source of increase in the current account and trade
deficit. The increase in the private sector financial surplus has only
partially offset the increase in the trade deficit.. Thus the trade deficit of
India is actually negative. We have maintained a current account surplus in
recent years as a result of high remittances and trade in invisibles (these
include income accruing to domestic residents due to influx of BPOs and other
MNCs, booming IT exports etc.) A significant chunk of the current account
surplus is due to exports of the services sector. A closer look at what
comprises India�s Balance of payments reveals startling figures.
Table 2:- Balance of Payments (in $ billion)
2000-01
2002-03
2003-04
Exports, goods
45.5
53.8
64.7
Imports, goods
57.9
64.5
80.2
Trade deficit
12.5
10.7
15.5
Exports, services
16.3
20.7
24.9
Of which, software
6.3
9.6
12.2
Other miscellaneous services
3.5
4.7
4.7
Remittances
13.1
17.2
23.2
Invisibles surplus
9.8
17
26
Current account
-2.7
6.3
10.6
Gross FDI
4.1
5.2
4.9
Net Portfolio inflow
2.6
0.9
11.4
Rise in forex
5.8
17
31.4
Source: The Economic Times
The following observations are note-worthy:
� The trade deficit is significantly large and growing.
� The Current account, which was initially negative on account of the
current account deficit turned positive due to massive growth of remittances
like never before. So far, no reasonable explanation has been provided to
explain the sudden jump in remittances from 17.2 in 2002-03 to 23.2 in 2003-04.
The number of H1-B visas for Indians has reduced and remittances do not earn
any interest. As such, this observation is quite difficult to account for.
� There has been a massive growth in exports of services. However, about
50% of it is due to IT exports. What are these other miscellaneous services
which amount to over $ 4 billion?
� FDI in India is quite stagnant. Most of our capital surplus is on
account of the FII inflows and portfolio investment. The contrast between FII
inflows between 2002-03 and 2003-04 shows how volatile and speculative this
particular component is. This should be a major cause of concern for Indian
policy makers.
Thus, the argument about a high fiscal deficit leading to a larger trade
deficit and vice-versa is further reinforced. The over-exaggerated optimism
especially in the national media is extremely misplaced considering the
inexplicable composition of our current account surplus, fears of increasing
trade deficit and the speculative nature of capital inflows.
As stated earlier, the shift in composition of government expenditure towards
consumption ,and transfer and interest payments has led to decline in Public
Capital Formation. This has choked off non-inflationary financing of public
investment and growth. While the need of the hour is to reduce the fiscal and
trade deficits, it is quite an enormous task.
There are inherent structural factors that contribute to a large trade deficit
and prevent our exports from being internationally competitive. Some of the
problems faced are:
� Bottlenecks in production and exports due to limitations of
infrastructure. These include inadequacies in road, power and port facilities.
� Structural problems faced by SSIs
� Dwindling impact of the real exchange devaluation undertaken in the 90s
� Declining demand for Indian exports with trade partners.
� Dismantling a system based on artificial export promotion through
domestic protection and import tariffs.
� High fiscal deficit, which creates a price bias towards imports.
� Spiraling oil import bill due to higher international prices and
increased domestic demand.
A high fiscal deficit is also endemic to the Indian economy. An inefficient tax
system only ensures that 1.5% of the population is assessed for tax. Cutting
down on public investment will reduce the possibility of higher returns. Thus,
reining in the fiscal deficit is essentially about discovering newer avenues of
earning Government revenues. The causes for the third paradox is the most
difficult to ascertain. It would be conventional for a developing country like
India with a fiscal deficit and uncompetitive exports to suffer from a current
account deficit being financed by a capital account surplus. However, as seen
above the actual figures are quite different.
------------------------ Yahoo! Groups Sponsor --------------------~-->
In low income neighborhoods, 84% do not own computers.
At Network for Good, help bridge the Digital Divide!
http://us.click.yahoo.com/EA3HyD/3MnJAA/79vVAA/NJYolB/TM
--------------------------------------------------------------------~->
��������������������������������������������������������
This is ZESTEconomics. Post economics-related articles and event info to
[email protected]
If you got this mail as a forward, subscribe to ZESTEconomics by sending a
blank mail to [EMAIL PROTECTED] OR, if you have a Yahoo! ID, visit
http://groups.yahoo.com/group/ZESTEconomics/join
==theZESTcommunity======================================
[1] ZESTCurrent: http://groups.yahoo.com/group/ZESTCurrent/
[2] ZESTEconomics: http://groups.yahoo.com/group/ZESTEconomics/
[3] ZESTGlobal: http://groups.yahoo.com/group/ZESTGlobal/
[4] ZESTMedia: http://groups.yahoo.com/group/ZESTMedia/
[5] ZESTPoets: http://groups.yahoo.com/group/ZESTPoets/
[6] ZESTCaste: http://groups.yahoo.com/group/ZESTCaste/
[7] ZESTAlternative: http://groups.yahoo.com/group/ZESTAlternative/
[8] TalkZEST: http://groups.yahoo.com/group/TalkZEST/
Yahoo! Groups Links
<*> To visit your group on the web, go to:
http://groups.yahoo.com/group/ZESTEconomics/
<*> To unsubscribe from this group, send an email to:
[EMAIL PROTECTED]
<*> Your use of Yahoo! Groups is subject to:
http://docs.yahoo.com/info/terms/
