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Indian economy: Policies to support growth

Ashok K Lahiri

Part I: Signs of recovery visible

Reserves grew by an unprecedented $11.8 billion in 2001-02. We have low inflation, abundant capacity in many sectors, overflowing food stocks, and foreign exchange reserves equivalent to a little more than a year's worth of imports. In this situation, the temptation to "buy" growth, through a modest increase in inflation or a weakening of the balance of payments, can be strong. Why not loosen fiscal and monetary policies to stimulate growth?

The answer to this question, as far as the fiscal part is concerned, is in the negative. With the consolidated fiscal deficit of the Centre and the states running at around 9 per cent of GDP, fiscal policy is already too loose.

If pump-priming through the fiscal route - without any regard for on what and how the money is spent - could deliver growth, the post-1996 growth experience following the Fifth Central Pay Commission award would have been very different. There may be a case for enhanced public investments, but this has to go hand in hand with better public expenditure management and improved returns.

With over 50 per cent growth in central revenue receipts in the first two months of 2002-03, the current financial year has started on a strong note.

In 2001-02, central revenue receipts in six - including the first two - of the 12 months were lower than the corresponding figures of the previous year. Actual receipts in 2001-02 estimated at Rs 2,028.81 billion were considerably less than both the budget and revised estimates.

Improved revenue performance to finance public investment has to be a key component of the fiscal strategy for sustaining rapid growth. Buoyant revenues should open up fiscal space for enhancing outlays without increasing the deficit.

With a loose fiscal stance, monetary policy has been shouldering the multiple and perhaps "impossible" tasks of fostering growth through low interest rates and adequate credit, securing a comfortable balance of payments position, and maintaining low inflation. With monetary policy in such a tight spot, the scope for loosening the monetary stance also appears to be limited.

Money (M3) growth was higher than nominal GDP growth by as much as 32 per cent to 97 per cent in each of the four years since 1997-98. As a result, money holding per rupee of income, which was virtually constant at 52 paise until 1996-97, has increased rapidly to 64 paise by 2000-01. A sustained loosening of monetary policy entails inflationary risks.

The avowed RBI policy is to maintain orderly conditions in the foreign exchange markets while trying to meet the legitimate credit needs of trade and commerce consistent with price stability.

What the RBI has managed to achieve, however, is not only orderly market conditions but also a progressive strengthening of the external sector since 1995-96. The year 1995-96 saw a reserve loss of $1.2 billion, with a current account deficit of almost $6 billion. By 2000-01, the current account deficit declined to about $2½ billion.

There is little room for complacency on the external front, for our relatively strong balance of payments conceals a less than satisfactory export performance. After a lacklustre growth of around 5 per cent in each of the previous two years, exports had declined by over 5 per cent in US dollar terms in 1998-99.

A rebound in export growth in the following two years took exports to $44½ billion in 2000-01, double of the 1993-94 level. Exports declined, however, by over $500 million in 2001-02. There are signs of a revival of growth in the current year with exports growing at 18 per cent in April 2002.

Between 1993-94 and 2000-01, imports went up 2.2 times to $50½ billion, decidedly faster than the corresponding growth in exports. Imports practically remained constant in 2001-02, and experienced a marginal decline in April 2002 over the same period in the previous year. A steady narrowing of the trade deficit from $17.8 billion in 1999-2000 to $12.7 billion in 2001-02, and a sizeable increase in inflows from $13.1 billion to $14.1 billion under invisibles in the same period produced last year's current account surplus.

With the strengthening of the external sector and the growth of reserves, there have been allegations that the RBI is following a mercantilist policy. Do we need to have $58 billion in reserves?

The instinctive answer for many high growth advocates would be no. Yet, a closer look at the Indian situation supports a more cautionary approach. Reserves are a safety measure that boosts investor confidence. Our international reserves were a considerable source of comfort during the East Asian crisis in 1997. Even today, the Argentine crisis is far from over, and Brazil, Paraguay and Uruguay seem to have been affected. Closer home, in Turkey, political uncertainty has been compounded by a severe balance of payments problem. Our reserves continue to comfort against contagion in international financial markets.

But, do we really need import cover for over a year? The operative issues are the exchange market intervention strategy and the policy towards the rate of interest. Reserves change because the RBI intervenes in the foreign exchange market. If the RBI stops mopping up foreign exchange from the market, reserves will stop growing and an appreciation of the rupee will follow.

In terms of the real effective exchange rate - which measures the exchange rate of the rupee vis-à-vis a basket of currencies of other countries adjusted for the inflation -differentials - the rupee is currently only marginally more competitive relative to 1993 -94, the first year in the post-liberalisation era when our balance of payments moved from "agony to comfort". With our share of global exports still well below 1 per cent, it is doubtful that a real appreciation of the rupee is in the country's interest.

High domestic rates of interest depress investment, and also attract capital flows. With reserves at the current level, there is no compelling need to attract foreign capital. Should we reduce the rates of interest?

The rates of interest have already come down considerably since 2000-01. With inflation at 2-3 per cent per year and real growth of 6-7 per cent, it is doubtful if the rate of interest on sovereign paper can go much lower than the current 7½ per cent. The rates of interest applicable to private bonds and credit have not come down as much as the rates on government paper. This may be a reflection of the stiffening of the risk premium and a flight to quality.

Reduction of interest rates on private credit will require a reduction in the risk premium through better loan recovery and enforcement of security interests. The recent ordinance for loan recovery issued on June 21 should provide some relief. For increasing investment, there is currently greater need to improve lender confidence about the recoverability of loans than to further reduce the rate of interest on safe assets.

At this juncture, the room for revitalising growth through a traditional expansionary fiscal or monetary stance is rather limited. Embarking on such a course will entail extra risks on the fiscal sustainability and inflation front. Policies for revitalising growth will have to be designed with particular emphasis on supply side management, particularly productivity enhancement. A simplistic lower-interest-rates and higher-government-spending approach may do more harm than good.

(Concluded)

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