Misplaced optimism

Print edition : September 20, 1997

The policy regime that is responsible for improvements with respect to the fiscal deficit and foreign exchange reserves and the easing of short-term interest rates has also triggered industrial recession.

THERE are signs of a change in the official assessment of the state of India's economy. This change can be sensed in the Reserve Bank of India's Annual Report for 1996-97, which provides an update on the Finance Ministry's Economic Survey released at Budget time. As compared with the buoyant assessment held till recently that economic reform had placed India on a new, more dynamic growth trajectory, the judgment now veers to one that expresses satisfaction with certain performance indicators, while viewing with concern certain other developments on the economic front.

As is to be expected of an official document, the Annual Report begins with a listing of the achievements made in 1996-97. Interest rates have fallen, especially at the short end of the market; money supply growth was under control and inflation was moderate; a reduction in the current account deficit together with an increase in foreign capital inflows took foreign exchange reserves to a relatively high level; "there was some strengthening of the process of fiscal consolidation with further reduction in the Central Government's gross fiscal deficit to an estimated level of around 5.0 per cent of GDP"; and finally, growth was estimated at around 6.8 per cent, largely because of a "smart recovery" in agriculture.

While stating that these features together with the "trend growth over the last three years has brought about a significant upward shift in the perception relating to the long-term growth prospects of the economy," the Annual Report shifts its attention to "areas of concern which needed concerted policy actions." These areas include the slowing of industrial growth from its "robust" levels in previous years; the widening of interest rate spreads because of a downward stickiness of long-term lending rates; the reduced offtake of credit by the commercial sector; and the exchange rate and monetary management problems being created by the large inflows of foreign capital. The most serious consequence of the last of these was the nominal and real appreciation of the rupee in 1996-97 despite large dollar purchases by the RBI, which substantially increased its foreign currency assets and rendered the management of money supply difficult. This appreciation, the RBI feels, had "a possible impact on export performance, especially so in an environment of depressed global demand."

IN any effort to work out the balance sheet for economic performance during a year, a combination of credits and debits are only to be expected. Further, being an official document, the RBI's Annual Report can be expected to treat the credit items as the basis for long-term optimism, while the debit items, though providing cause for concern, are flagged as areas that must engage the attention of policy-makers. Implicit in this treatment is a presumption that the positive developments are independent of the negative outcomes, and that the former are the result of liberalisation policies, while the latter point to areas that have been inadequately addressed by policy makers. This need not be true since it is quite possible that the same policies that result in developments seen as positive could themselves be triggering less favourable outcomes elsewhere. And if the instruments realising "benefits" are also generating adverse consequences elsewhere in the economy, both the net assessment of performance and the prognosis is likely to be less optimistic.

Consider, for example, the paradoxical trends in interest rates. The RBI's all-out effort to increase liquidity and reduce the bank rate have ensured the softening of short-term interest rates, but the long-term interest rate, which reflects the cost of capital for investment purposes, remains sticky. The banking system clearly expects that the long-term rate will remain at high levels. This cannot be attributed to simple "market phenomena" such as the fact that the demand for credit far exceeds the willingness of the banking system to provide the same. With the demand for credit from the commercial sector still sluggish, the explanation lies in some tendency inherent in the policy regime to prop up long-term rates.

One convincing explanation begins with the fact that that monetary reform seeks to set a ceiling on the Government's borrowing from the central bank to finance its fiscal deficit, and thereby forces the Government to borrow from other sources. This has resulted in the fact that the Government's demand for credit from the "open market", which is mainly the banking system, is far greater than that which would be automatically financed by the need of the banking system to hold government securities in order to meet the requirement set by the statutory liquidity ratio (SLR). In fact, in recent times, it is clear that the banking system holds far more Government securities than is statutorily required. This could only happen if, after discounting for risk, gilt-edged government securities offer a reasonable rate of return. The obverse of this should be that, forced by monetary reform to finance its deficit by borrowing from the open market, the Government has chosen to offer better yields on its securities, to entice banks, which, at the margin, are not statutorily forced to hold more such paper.

This higher risk-discounted rate of interest on government securities sets a floor for long-term interest rates, which now are expected to be high, independent of the availability of credit relative to demand and independent of the level of short-term interest rates. Thus the "stickiness" of long-term interest rates is a policy-induced rather than a market driven phenomenon. The nature of fiscal consolidation is one that raises domestic long-term rates.

This is not the only consequence of fiscal consolidation. That process has involved a reduction in expenditure rather than an increase in revenues to reduce the fiscal deficit of the Central Government. The RBI lauds the Government on the achievement in this area: "The year 1996-97 witnessed a further improvement in the process of fiscal consolidation. According to the revised estimates of 1996-97, all the major deficit indicators for the Central Government showed improvements during the year, with the Central Government's fiscal deficit contained around the budgeted level of 5 per cent of GDP. This represented a decline of 0.5 percentage point over 1995-96 and 2.4 percentage points over the level of 7.4 per cent in 1993-94."

THIS trend decline, driven largely by the curtailment of expenditures, is bound to reduce investment and consumption demand in the economy. Any such reduction would soon show itself in the form of a deceleration in industrial growth, unless of course the net exports of manufactures rises and India's trading partners provide an alternative market. Not only was industrial growth during 1996-97 subdued relative to the previous year, but there were clear signs of deceleration after November 1996; the rate of industrial growth, which stood at 9.6 per cent during the first half of 1996-97, slipped to 6.6 per cent for the year as a whole. This deceleration affected the manufacturing sector as well, with the rate of growth of the manufacturing sector decelerating to 7.9 per cent during the year from 13.1 per cent recorded during the previous year. Sixteen out of 17 manufacturing subgroups recorded either a decline in production or a deceleration in growth.

It is indeed true that the process of so-called fiscal consolidation has been pursued since the beginning of the reform in 1991. However, success in this direction has been uneven over the years. This has meant that the impact of the process of fiscal consolidation on industrial growth was not adverse in all years. Further, liberalisation initially resulted in a surge of pent-up demand for a number of manufactured products made available in the domestic market through the assembly of imported knocked-down kits. Together these factors helped sustain a high rate of industrial growth. But with the "once-and-for-all" market created by pent-up demand having been exhausted, growth has come to depend on an increase in the size of the market available to domestic manufacture. It is precisely at that time that the Government has proved more successful in reining in the fiscal deficit. Since this adversely affects the rate of growth of domestic demand and since exports have not just failed to pick up but have actually recorded sharply falling rates of growth, the emergence of recessionary tendencies was inevitable.

It could of course be argued that even if the sluggishness of domestic demand is policy-induced, export growth is given exogenously. This is partly true, since the deceleration in export growth occurs in the context of a slow down in the growth of world trade. But even the RBI admits as plausible, a second cause, namely, the appreciation of the nominal and trade-and-inflation-adjusted value of the Indian rupee, which increases the dollar value and reduces the competitiveness of Indian exports at given rupee prices. The appreciation of the rupee is not the result of sharp improvements on the current account of the balance of payments, but really the fallout of the large inflows of foreign exchange in the form of portfolio (debt and equity) capital in the wake of financial sector liberalisation. The RBI has sought to neutralise the effects of these inflows on the value of the rupee by making huge purchases of foreign exchange, which have taken India's foreign currency reserves to record levels. But that effort has not been adequate to completely stall appreciation

THE Annual Report of the central bank refers to the large inflows of foreign capital and the rise in foreign currency reserves as positive indicators of post-reform economic performance. However, if it is true that the appreciation of the rupee following such inflows has contributed significantly to the virtual collapse of exports in recent months, it is clear that liberalisation has affected industrial growth adversely in two ways. Since it involves the pursuit of fiscal consolidation, it restricts one of the stimuli for the growth of the domestic market. And since it involves financial openness, which underlies the recent appreciation of the rupee, it limits the rate of growth of exports.

The resulting industrial recession implies that the offtake of commercial credit remains sluggish despite concerted efforts by the central bank to pump additional liquidity into the system. But increased liquidity and low commercial offtake does not ease the long-term interest rate because the process of fiscal consolidation forces the Government to set a relatively high floor for long-term rates in the form of the yields on its securities. The policies that delivered the "credits" in the RBI's balance sheet for the economy are also responsible for many of the debit items.

Fortunately, the industrial recession did not dominate the growth performance of the economy because of an unanticipated surge in agricultural production. In 1996-97 the index of agricultural production rose by 5.2 per cent as against a marginal fall of 0.4 per cent the previous year. "Foodgrains output, after having declined in 1995-96, is estimated to have scaled a new peak at 198.2 million tonnes, surpassing the previous peak of 191.5 million tonnes attained during 1994-95." These developments have little to do with the policy changes associated with liberalisation. Rather, as the Report admits, Indian agriculture is still vulnerable to "shocks" and its 1996-97 performance is largely attributable to the favourable temporal and spatial distribution of the South-West monsoon.

The performance of agriculture not only helped reduce the impact of the industrial recession on GDP growth but, in combination with the easy foreign exchange situation, which permits better supply management through imports, helped keep the rate of inflation down, which is the other positive entry in the economy's performance record for 1996-97.

There are, therefore, two different strands in the overall performance record. One, which is attributable to the policies associated with liberalisation, which involves a set of developments that contribute to or aggravate the industrial recession, the sluggishness of exports, and the stickiness of long-term interest rates. The other, which is partly a reflection of the internal dynamic of the economy and partly of fortuitous factors such as a favourable monsoon, delivers a record harvest, a reasonable rate of growth of GDP and a low rate of inflation.

The Annual Report captures both these strands in its discussion of sectoral trends. But when putting them together in an overall balance sheet to generate the bottom line, it attributes the positive features to liberalisation and classifies the negative ones as being areas of concern that call for concerted policy action. In doing so it misses out two crucial lessons from recent economic developments: first, that policy in the form of liberalisation explains many negative features of performance; and secondly, that as liberalisation proceeds, government intervention is less effective, as the RBI's own experience with exchange rate management illustrates.

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