Weak stimulus

The real problem with the Central fiscal package is not so much what it contains but what it leaves out.

ACROSS the world, countercyclical fiscal policy is back in fashion. It has been only too evident that monetary and financial measures to save banks and other financial institutions, however necessary they may be, are simply not enough to prevent real economies from sliding into recession. Already the largest economic groupings the United States and the Eurozone have officially declared that they have been in recession for some time now. The growth slowdown has affected other countries quite sharply, including those such as China that were earlier hoped to have decoupled from the West. The slowing down or even decline of economic activity has had an immediate impact on employment, with significant job losses being reported from almost all economies.

So the case for aggressive fiscal expansion for economic recovery has not been stronger for quite some time. Some governments are responding. President-elect Barack Obama has promised a huge fiscal package in the U.S.; China has announced a large fiscal package driven by substantial increases in public expenditure, which is already being implemented.

The case for a strong fiscal stimulus in India has also been evident for some months now, as the adverse impact of the global economic slowdown combines with domestic forces that had already depressed mass demand. It is estimated that more than a million jobs have already been lost in the small exporting units and in the construction sector, and other non-agricultural employment is not growing. Meanwhile, the agrarian crisis is worsening as cultivators are hit by the fall in the prices of cash crops.

Of course, the impact of the current economic crisis has been most evident in the financial sector and, thus far, that is what the government has focussed on. Attempts to ease the credit crunch included measures to infuse more liquidity into the system by reducing the Cash Reserve Ratio and the Statutory Liquidity Ratio. The Reserve Bank of India also sought to reduce interest rates by bringing down repo and reverse repo rates, and to provide some relief to non-bank financial institutions, particularly insurance companies. These confidence-building measures were necessary not only because of the ripple effects of the global financial crisis, but also because the Indian banking system had several of the fragilities that undermined the U.S. banks, albeit in a less severe form.

But in a situation of liquidity trap, monetary measures prove to be lacking, and until now this is what has happened in the Indian economy as well. Banks are willing to lend only to the most credit-worthy potential borrowers, but such borrowers are unwilling to borrow because of the prevailing uncertainties and the expectation of a slowdown. Meanwhile, all other enterprises, even those that desperately require working capital to stay afloat, find it increasingly difficult to access bank credit even as they face more stringent demand conditions.

In such a situation, reducing interest rates does not solve the basic problem of tightened credit provision, although it may marginally reduce costs for those who are able to access bank credit. In any case, some of the measures seemed to be more designed to drive up the stock market than to revive the real economy, underlining the governments unfortunate obsession with stock market indicators relative to real economic problems.

Indeed, given all of this, it has been a bit of a mystery why the Central government has taken so long to announce a much-needed and much-awaited fiscal stimulus. Until a few weeks ago, the Prime Minister and the Finance Minister even tried to avoid the issue by declaring that they had anticipated the global downturn by including a large fiscal deficit in the annual Budget, when in fact that was no more than the result of some pre-election sops offered out of political exigency. All this led some people to suspect that no new fiscal package would be forthcoming, despite the obvious need for it. While this is patently absurd, from both economic and political perspectives, it is not impossible given the absurdities that the straitjacket of neoliberal economic thinking can generate.

On December 7, the Central government did finally announce a fiscal package to complement the previous monetary policy measures. Given the context, the need is for bold measures, which could also then be used to redirect economic strategy in a way that would benefit ordinary people. But the package that has been announced fulfils neither of these goals.

That is because the promised fiscal expansion is a small one only up to Rs.20,000 crore of direct additional spending through the Planning Commission in unspecified areas. This is less than 4 per cent of the governments projected expenditure for the year, and only around 0.5 per cent of gross domestic product (GDP). Such a tiny fiscal input is simply too small to be really countercyclical. It is not even enough to change the expectations of private agents to get them to start investing and spending more.

This direct spending is combined with a tax cut measure on domestic duties the ad valorem Cenvat (Central value added tax) rate is to be reduced by 4 percentage points. This will have an impact in terms of supporting economic activity only if producers respond by cutting prices and such price cuts generate demand responses. But neither is inevitable. For example, the recent cut in the price of aviation fuel was not passed on to consumers by the airline companies, and even now only one carrier has promised to reduce the aviation fuel surcharge. So that particular measure simply became an additional subsidy to shore up profits of airline companies.

It is not clear whether the Cenvat reduction will meet the same fate, reducing government revenues without generating more economic activity. But already some companies have declared that they cannot be expected to pass on these tax cuts when their own accounts are still in the red. It is well known that in times of economic uncertainty, tax cuts are much less effective in stimulating activity than direct government expenditure.

The measures directed towards housing, combined with the encouragement of retail credit expansion by the banks to keep middle-class consumption high, suggest that the government has not really learnt any lessons from the current crisis. It is important to expand the Indira Awas Yojana that provides housing for those below the poverty line, but the money for it is supposed to come out of the Rs.20,000-crore package rather than being additional to it. Meanwhile, once again the financial system is being pushed towards supplying retail credit in the form of housing and personal loans in an attempt to reply the same bubble that is now coming unstuck. This is an illogical way to proceed if the desire is to put the economy on a sustainable growth path rather than subject to boom-and-bust episodes.

The aim of reviving infrastructure investment has been addressed by promising to allow the public-sector India Infrastructure Finance Company to float Rs.10,000 crore worth of tax-free bonds and leverage the money to borrow further in order to provide finance to those private participants in the public private partnership (PPP) projects who have developed cold feet. This may or may not work but in any case the effects will be felt only after some time, and certainly will not be as fast as direct public investment would have been. This indirect route reflects the urge of the Central government to keep such expenditure off-Budget, in a flimsy attempt to dress up its own accounts even though the need for expansionary fiscal stance is obvious.

The other measures are really rather modest in scope and niggardly in content. The only substantial measure directed to highly employment-intensive units in exporting sectors such as textiles, garments and leather is a small reduction in the interest rate on export credit. In addition, there are some small tax concessions and a tiny (Rs.350 crore) addition to export-incentive schemes. These are hardly likely to counteract the effect of big losses of export orders as the major markets start shrinking. What was required was a more serious and systematic attempt to allow these industries to keep producing at technologically efficient levels and shift demand to other markets.

Some of the proposed measures make very little sense for example, the elimination of export duty on iron ore fines and reduction of export tax on iron ore. There is really no reason why India should want to incentivise the export of iron ore rather than encourage the domestic processing of it into steel. However, the real problem with this fiscal stimulus package is not so much what it contains but what it leaves out. Clearly, small is not beautiful in this case, and the overall size of the package is too small to have much an effect. Additionally, some of the most critical areas of public spending have been neglected, especially State governments.

State governments have already started feeling the resource constraint as their tax revenues are affected by the economic downturn. They are responsible for most of the public services that directly affect the people, such as those relating to agriculture and rural development, health, sanitation and education. Yet there is nothing proposed to alleviate the fiscal crunch of State governments, which face a hard budget constraint. The overall living conditions of the citizenry are likely to be affected. The Centre could so easily have announced some measures to provide fiscal relief to the States to help them cope with the adverse effects of the downturn. Such measures could include reducing interest rates, providing more Central funds and, most of all, relaxing fiscal responsibility norms that are inappropriate for the current situation and which the Centre itself has already discarded.

Similarly, the food crisis has been forgotten in all the excitement about the financial crisis. Food insecurity remains widespread and may even be spreading, given the significant rise in prices over the past two years. While overall inflation has been easing, food inflation in India continues despite large foodgrain stocks. And the real incomes of workers and cash-crop cultivators have not kept pace with this. Poor or inadequate nutrition is already a big problem, which will deteriorate as the downturn worsens. This is a time to allocate much more money on expanding, universalising and improving the functioning of the Public Distribution System. This would at least partly alleviate the problems of those who are already at the margins of survival as well as those who could be tipped over into poverty by the recent economic processes. And there is a major need to address the financial problems of cultivators, who produce food and other essential agricultural items. Yet, there is no mention of any such attempts in the package.

When the economic conditions clearly call for bold and definitive measures and when the political situation is also one in which aggressive state action should be expected, why do we get such a half-hearted and unconvincing package? Is it that the Central government itself is not fully convinced of the need for clear Keynesian measures?

Or has it fooled itself into believing its own hype that the economic crisis is not so severe and will not deteriorate further? Whatever be the reasons, it is clear that this inadequate package is not enough to prevent the downturn and cause further unnecessary suffering to millions of Indians.