Blowing bubbles at the bust

Print edition : January 30, 2009

Borrowing in foreign exchange to finance expenditures in areas such as real estate is unlikely to yield foreign currency revenues that can be used to meet future repayment commitments. Here, a housing complex in Kolkata.-ARUNANGSU ROY CHOWDHURY

WITH the recent round of Assembly elections behind it, the government has chosen to unveil the promised second instalment of the economic package that it claims will stimulate a slowing economy. Given the global fashion these days, some media observers have wrongly described this as the Centres second fiscal stimulus package. The package is not fiscal but more monetary in nature, with little emphasis on increasing government spending. Such an increase in a context when tax collections are expected to be short of targets would require additional deficit financing or credit-financed spending by the Centre. Very clearly, unlike governments in many other countries, the United Progressive Alliance (UPA) in India has not shed the fiscal conservatism that is the centrepiece of its neoliberal economic ideology. It is reticent to increase the fiscal deficit even in the current circumstances of declining inflation and slowing growth.

In the event, the so-called stimulus package has three major components. The first set of measures is to be adopted by both the Reserve Bank of India (RBI) and the government and is aimed at reducing interest rates and increasing the access to credit of firms, State governments and individuals. The repo rate, or the rate of interest on the borrowing by banks from the RBI, has been reduced by one percentage point to 5.5 per cent. In addition, banks are being encouraged to lend to the private sector through a number of measures, including a reduction in the cash reserve ratio (CRR), or the cash balances they need to hold, by half a percentage point to 5 per cent of deposits; a reduction in the reverse repo rate, or the interest they can earn by lending to the RBI rather than the public, from 5 to 4 per cent; and a promised recapitalisation of banks with a government contribution of Rs.20,000 crore over two years so as to enhance their credit delivery capacity. Banks are also to be coaxed into lending, with guarantees on loans to small and micro enterprises, and achieving higher credit targets.

It is not just domestic financial institutions that domestic borrowers are expected to tap. Access to credit from foreign sources has also been enhanced by: (i) scrapping the interest rate ceiling on external commercial borrowings (ECBs) made through the approval route; (ii) allowing ECB for investment in commercial real estate in the form of integrated townships; (iii) permitting non-bank financial companies (NBFCs) dealing exclusively with infrastructure financing to access ECBs; and (iv) raising the ceiling on foreign institutional investor (FII) investment in rupee-denominated corporate bonds from $6 billion to $15 billion. If domestic credit is unavailable or expensive, borrow from abroad is the slogan.

The second set of measures incorporated in the package aims to get State governments and the India Infrastructure Finance Company Limited (IIFCL) to borrow to finance capital, especially infrastructure, expenditure. State governments would now be allowed to resort to additional market borrowing of 0.5 per cent of the Gross State Domestic Product (GSDP) or around Rs.30,000 crore to finance capital expenditure. In sum, while the Centre is unwilling to increase spending based on additional borrowing, it is willing to let States take that route and present it as part of a central package. The other component of public deficit-financed spending is to come from IIFCL, which having been permitted to raise Rs.10,000 crore through the issue of tax-free bonds by March 31, 2009, would now be allowed to raise an additional Rs.30,000 crore through similar bonds to finance infrastructure projects.

The third component of the package is directed at spurring the demand for automobiles. States are to be provided assistance up to June 30, 2009, under the Jawaharlal Nehru National Urban Renewal Mission (JNNURM) to buy buses for their urban transport systems. Buyers of commercial vehicles between January and March this year are being offered the benefit of accelerated depreciation of 50 per cent. And banks are now allowed to support NBFCs with credit for purchases of commercial vehicles.

Put these measures together and what we have is an element of compulsion on banks and financial institutions to lend and an invitation to different economic actors to borrow and spend. This includes borrowing in foreign exchange to finance expenditures in areas such as real estate, which are unlikely to yield foreign currency revenues that can be used to meet future repayment commitments.

This structure of the so-called stimulus package is shocking, to say the least, since it would only strengthen the kind of tendencies that generated the crisis in the developed countries in the first place. It is now widely accepted that the financial and real crisis in the United States and other Organisation for Economic Co-operation and Development (OECD) countries occurred because of an easy money and cheap credit regime introduced in a world of deregulated and rapidly proliferating finance. This provided the basis for a credit financed housing and consumption boom that was speculative in character and was self-propelling until such time as defaults began. That is, the speculative financial boom that went bust was not an independent and isolated phenomenon but contributed to and drew sustenance from a debt-financed real economy boom.

As a result, even though the crisis first appeared as a sub-prime housing loans problem, it soon snowballed into a full-fledged financial crisis that had severe recessionary implications for the real economy. Moreover, once the crisis occurred and needed to be addressed, it became clear that merely pumping liquidity into the system or reducing interest rates was inadequate to get the economy going again. The end of the financial boom was accompanied by a sharp contraction of private sector demand on the one hand and the threat of insolvencies on Wall Street and Main Street on the other. The government, therefore, had to step in to both rescue failing firms and fuel demand directly. This made a fiscal stimulus the focus of policy, leading to the current revival of Keynesianism in the U.S. and parts of Europe.

Seen in the light of that experience, the stimulus package put in place over two phases implicitly presumes that Indias case is different. The problem here, it is being suggested, is indeed one of inadequate liquidity, of costly credit and of an unwillingness to lend. And it is being presumed that efforts to address these issues directly would not put India in a situation where it, too, would be using a speculative bubble to drive a real economy recovery and paving the way for a financial meltdown that would abort or subvert that recovery.

There are, however, clear indications that such assumptions are unwarranted. To start with, even if not as yet in a debt-driven crisis, India is substantially dependent on private credit to sustain growth. The so-called economic reform, which included both fiscal reform that limited capital expenditure by the state and financial liberalisation that refocussed bank lending in favour of retail credit, did transform the trajectory of growth.

If, earlier, public spending was the principal stimulus for growth, this was substituted with debt-financed housing investment and private consumption. This required a relaxation of the terms on which, and the volumes in which, debt was available to households and the private sector.

In the event, the share of retail credit in the total advances of the banking system has increased substantially, and the direct and indirect exposure of banks to sensitive sectors such as the stock market and real estate has increased considerably. That is, Indias recent near nine per cent growth rate was also fuelled by debt, which has made this countrys financial system vulnerable to large-scale default.

Yet, what the government is attempting now is to coax, cajole and force banks into lending even more in the hope that there would be enough borrowers who would use that credit to revive flagging domestic demand and make up for sluggish exports. The objective appears to be to inflate further the embryonic credit bubble to prevent growth from slipping sharply.

In the process, it is not just banks, households and corporations that are being directed into a debt spiral; so are State governments, who have been permitted an additional Rs. 30,000 crore of borrowing. In a period when tax revenue collections are turning sluggish, when resource devolution from the Centre to the States is biased in favour of the Centre, and when an impending pay revision is likely to strain the States capacity, asking them to borrow and spend to help a recovery even when the Centre holds back is indeed bizarre. What is needed is the transfer of more resources from the Centre to the States, since spending is likely to be quicker at the State level, to help stall the slump and pave the way for recovery. But no such transfer is forthcoming since the Centre is holding back on its spending.

The Centres reluctance to spend has also resulted in a strange off-budget transaction in which it is willing to forego tax revenues to help IIFCL to mobilise up to Rs.40,000 crore, which will then be used to leverage and supplement private or public sector investment in infrastructure. It is by no means definite that such investment would be forthcoming in the midst of a downturn. On the other hand, there are obvious dangers of adding to private debt exposure in this fashion. It would have been far more advisable for the government to undertake the expenditure and meet it at least partly with the revenues it would have garnered through taxation when the recovery occurs.Finally, as noted above, the package not merely relies on infrastructural investment financed with domestic debt but encourages such spending financed with external commercial borrowing. This not merely adds to the debt spiral, but involves a currency mismatch inasmuch as infrastructure projects are unlikely to yield foreign exchange revenues that can be used to meet interest and amortisation commitments payable in foreign exchange. On the other hand, with global interest rates being much lower than domestic rates, firms may not adequately take into account exchange-rate risks and opt for foreign borrowing whenever available. This can lead to solvency problems if the rupee depreciates sharply and strain Indias foreign reserve position if the exodus of foreign capital continues.

What does this reliance on private debt-financed spending to trigger a recovery indicate? One of the lessons that came out of the global crisis was that if big financial firms were regulated lightly and permitted to discount risk when seeking profits, then the government would have to nationalise them because letting them fail (as happened with Lehman Brothers and did not with the American International Group, AIG) could have adverse systemic effects.

The implication was clear. Embracing deregulation and a minimal role for the state by relying on debt-financed private consumption and investment as part of a neoliberal strategy leads up to a crisis-induced retreat from neoliberalism, in the form of nationalisation and state-financed bailouts. Capitalism could possibly do better by discarding neoliberalism and providing a role for the state, many conservative commentators argue. This is, however, a lesson that is difficult to absorb for a UPA government that is steeped in neoliberal ideology. That, together with the fact that Indias crisis is still in the making, possibly explains the bizarre form that Indias official stimulus takes.

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