The Dog that did Not Bark at Night
Burgeoning fiscal deficits are supposed
to reflect themselves in unsustainable current account deficits. Indeed,
this is one explanation for India’s economic crisis of 1990/91-that
fiscal profligacy of the mid-1980s, while boosting growth for a while,
also led to an external collapse. But since the mid-1990s fiscal deficits
have been very high at around 10% of GDP and yet current account deficits
have been extraordinarily low at slightly over 1% of GDP. This puzzle-like
the curious incident of the dog that did nothing in the night-time as
unearthed by Sherlock Holmes in Silver Blaze– has escaped investigation.
Till now.
Montek Ahluwalia, in an insightful paper on India’s external vulnerability
which is to appear shortly in a festschrift (birthday volume) for Dr.
C. Rangarajan, writes that capital controls and the public sectors nature
of our banks explain the paradox. Restrictions on capital inflows and
outflows do not penalise fiscal irresponsibility and the willingness
of our public sector banks to absorb government debt make it possible
to sustain large deficits. He is right but these factors were also present
in the 1980s. So what changed in the 1990s?
A fundamental identity in national income accounting states that the
sum of the investment-savings gap in the government sector and in the
private sector equals the current account deficit. The gap in the government
account is roughly the fiscal deficit. Ahluwalia uses this identity
skillfully to show that if the fiscal deficit is high and the current
account deficit is low, it simply means that private sector is under-investing.
The current account deficit is made up of two elements–the trade deficit
which is imports minus exports of merchandise goods and “invisibles”
earnings which are mainly revenues from remittances from workers overseas,
net software exports and tourism. Invisibles earnings have boomed and
in the mid-1990s averaged over $ 10 billion annually, five times that
in the 1980s. Invisibles have depressed the current account deficit
in the 1990s. But Ahluwalia’s analysis is strangely cursory on this
aspect. And the trade deficit has been kept low by low growth in imports
reflecting investment stagnation.
Is the investment famine because of high interest rates? Ahluwalia certainly
thinks so but in the past investment has boomed even when interest rates
have been high. Is it because of high import duties? No, since low import
duties helps exports and in any case industry gets protection via the
exchange rate with a depreciating rupee making imports costlier. Is
it because of a demand constraint? How can that be, seeing the experience
of companies that have created new markets? Is it because of a lack
of a low exports-to-turnover ratio in industry? Ahluwalia thinks that
most large companies are still too inward-looking. This is, however,
changing and a number of Indian enterprises are becoming competitive
even in manufacturing.
At a very macro-level, gross domestic investment in the later half of
the 1990s averaged about $ 100 billion annually. An additional $ 25-30
billion needs to be invested every year at a very minimum over and above
what is inherent in the present growth trajectory. A bulk of the extra
investment must be in social and and physical infrastructure. Hence,
funds have to be mobilised largely within India.
The capital market can help somewhat-about $ 6 billion of public issues
are in the pipeline. But the main channel will be household savings
being converted into productive investment opportunities. Unfortunately,
this will not happen as long as banks are micro-administered by the
government and as long as a dangerously large proportion of government
expenditure is eaten away by interest payments, salaries and pensions,
subsidies and losses and defence. Financial sector reforms and deficit
control are, therefore, essential to trigger an investment boom which
is so badly needed.
