Over to industry, RBI

Chidambaram has left no one in doubt that the governments focus now is entirely upon reviving economic growth.

After a succession of populist budgets from the former finance minister, Chidambaram’s budget for the coming year has come as welcome douche of cold water on an overheated face. Immediately after he concluded his budget speech, a distinguished panel of commentators was asked on a television channel, whether Chidambaram had succeeded in balancing the need to revive the economy with the need to keep voters happy for next year’s election.

 For almost the first time in years this question sounded irrelevant. For, Chidambaram has left no one in any doubt that the government’s focus now is entirely upon reviving economic growth. ‘Our economy’, he stated candidly, ‘is challenged’. The goal of his government was to achieve ‘higher growth leading to inclusive and sustainable development’. Growth in short, had to come first. What is more, election or no election, trading in a measure of growth for equity, an idea that  left wing economists have flirted with since the 1960s, was definitely out.  

The most reassuring  feature of his presentation was the pains he took to explain why his government could not afford to offer any more tax sops. Both India’s fiscal and foreign exchange (current account) deficits, he explained, were very nearly out of control. This meant that everyone in India would have to tighten their belts. The cuts in subsidies that the Centre enacted in September last year had enabled him bring the fiscal deficit down to 5.2 per cent and would bring it down further next year.

But a more immediate problem was the widening gap between annual foreign exchange earnings and expenditures that was being met by external borrowing. India’s private debt abroad  was coming close to becoming unsustainable. Coping with this required not only continued austerity but also a sharp increase in investment to remove the bottlenecks in infrastructure and revive growth.

Given this unequivocal statement of goals, the actual provisions of the budget contained few surprises. There was no change in the income tax floor to provide relief to the middle class, but there was a slew of taxes on the very rich, and on conspicuous consumption, to assure the poor and the middle class that they were not being left alone to bear the burden of austerity. 

The budget is equally forthright in its encouragement of investment, especially in infrastructure projects. It has enlarged provisions for infrastructure finance, offered private investors the shortcut of partnership with coal India to circumvent numerous roadblocks to  coal mining, and invited tenders for building 3,000 km of new roads.

By far its most effective provision is the offer of a 15 per cent investment allowance to all companies that invest more than Rs 100 crore in plant and machinery, provided they do so within the next five years. This is bound to kickstart investment in large projects.
 
Power to propose

These well thought out provisions and initiatives can, however, only bring the horse to water: they cannot force it to drink. Industry will only begin to invest again when demand firms up and the  cost of raising capital for investment declines.

Both will only happen when interest rates come down. But the power to take that decision has been ceded, too tamely (and too completely in this writer’s opinion), to the Reserve Bank of India.

Today, therefore, the  government of India, which is answerable to the people of India, only has the power to propose. The power to dispose lies with the RBI. A polite way to describe how the RBI has used this power is to call capricious. It first began to raise interest rates in January 2007, claiming that the economy was ‘overheating’ because of three years of high growth and rising budget deficits.

From then on till the end of 2011, with only a brief lull during the first few months of the  global recession, it refused to acknowledge that Indian inflation was not being caused by the pull of excess demand (which high interest rates can alleviate) but by shortages in supply caused by galloping Chinese demand for raw materials and domestic shortages in the supply of non-cereal agricultural produce (which it cannot).

Only when the industrial slowdown and decline in investment became too serious to ignore did it concede that inflation was being caused mainly by supply constraints. But it quickly shifted its ground and began to demand that government should first bring its expenditure under control and start bringing down the fiscal deficit, before it would lower interest rates.

This argument was much better grounded in economic theory than its first,  but in September, when the government cut Central oil and state power subsidies by Rs 1,00,000 crore in a full year, instead of immediately lowering interest rates sharply to stimulate investment and counteract a further fall in consumer demand, the  RBI surprised and appalled most people by quickly jumping back to its first argument, pointed to a slight, and as it turned out temporary, rise in the inflation rate, to postpone rate cuts once more.

Today, the Central government has fulfilled every single part of its bargain with the RBI: the fiscal deficit is down to 5.2 per cent and set to fall further. Inflation measured by the wholesale price index is also down from 9.9 per cent in January 2011 to 6.6 per cent today.

Industry, in the meantime is on the verge of collapse and hundreds of private firms that had borrowed and issuing  convertible debentures at low interest rates abroad to keep going are contemplating a default on their private foreign debt.

If the RBI again errs on the side of extreme caution in this month’s policy review and makes only a token reduction in its interest rates, it will kill the Indian economy and, for good measure, the UPA’s remaining chance of victory at the polls next year.