Budget 2009: Tax, Borrow, Spend

The Congress Party was re-elected in May on a promise of economic populism that the country can't afford. On 6th July the government delivered on that promise. This is bad news for India, and especially for its poorest citizens. The budget outlines three priorities: 9% economic growth, "inclusive development" and better public services. It would achieve these outcomes by boosting spending by 36% to 10.2 trillion rupees ($211 billion), mostly on handouts and infrastructure. No major public-sector rationalization or private-sector liberalization were announced.

This is in effect a revival of India's socialist past and a rejection of the 1990s reforms that gave India the best kind of "inclusiveness": economic growth. The Govt thinks that creating more 'yojanas'(schemes) and throwing money at them will eliminate poverty. Infact statistics show the exact opposite. More people were lifted out of poverty in the last 18 years(1991 to 2009) than in the previous 44 years(1947 to 1990).

Going back to 70's economic formula - government spending, large deficits and high interest rates will stifle economic growth and increase poverty. The 9% growth achieved in the last 4 years(2004-2008) was due to India's private sector. Mr. Mukherjee seems to understand some of these ideas, at least in principle. Yesterday he said private investment was "the principal growth driver" of India's boom years. Yet he did nothing to ease private industry's tax burden, cut regulatory red tape or liberalize the country's restrictive foreign direct investment regime. He also praised Indira Gandhi's 1969 bank nationalization as "wise and visionary" and "an inspiration".

The 9% growth achieved in the last 4 years was powered by foreign capital inflows(FDI, FII, Private equity, Venture Capital). These flows have slowed due the credit crisis. The main reason why Indian industry is dependent on foreign money is that the Government swallows a large portion of the domestic savings to finance its fiscal deficit. Things on this front do not look encouraging. In the financial year 2007-08 (i.e. between April 1, 2007 and March 31, 2008) the government spent Rs 1,26,912 crore more than what it earned. For the financial year 2009-10 (i.e. between April 1, 2009 and March 31, 2010), the government plans to spend a whopping Rs 4,00,996 crore more than what it earns.

When the government spends more than what it earns, it borrows by issuing financial securities known as treasury bills and bonds or government securities. So in the year 2007-08 the government borrowed Rs 1,26,912 crore to service its deficit. And in the year 2009-10, it will have to borrow Rs 4,00,996 crore to fund its deficit. Large Government borrowings are already leading to an increase in interest rates. The yield on the 10 year Gilt is already at 7% and could rise to 7.5%. The increase in the cost of borrowing could dampen investment and consumer demand.

Pranab Mukherjee's Budget wallows in the optimism that "something will turn up" and restore the Indian economy to high growth while miraculously restoring a sense of balance to the mounting fiscal deficit. Apart from making some ritual genuflections to fiscal responsibility -- he remarked that it was important to return to fiscal deficit targets "at the earliest possible opportunity" and that "reforms were required" to curb the fiscal shortfall -- he offered nothing concrete. The very real risk of a sub-par monsoon this year could upset all hopes of a sustained recovery.

If Pranabda is counting on a developmental Deus ex machina to save the day, I would bet against him.

The Bandra-Worli Sea-Link is now The Rajiv Gandhi Setu Bridge

The Bandra-Worli Sea Link opened for the public at midnight on 30th June 2009 (finally!!). The fact that the project is an engineering marvel is well known but what about the name of the project? As is always the case in India, when any sufficiently large infrastructure project (ports, airports, fly-overs, bridges etc.) is ready to be inaugurated there is a huge debate over the name of the project.

The Congress wants everything to named either Gandhi or Nehru. The BJP wants any of the other leaders involved in the freedom struggle. Local politicians demand that leaders from the region in which the project is located be chosen. The public is largely indifferent to the name; they are more interested in the benefit that will accrue to them from the project.

For example the Bandra-Worli Sea Link has been named "The Rajiv Gandhi Setu Bridge". This has (predictably) led to a huge controversy. This is something that has happened in the past and considering the political scenario will continue to happen in the future.

Why should projects be named after political leaders?. The right to name a project should be auctioned. It will be like an advertising contract just like the title sponsor for any major sporting event. (Barclays Premier League, DLF Indian Premier League etc). This will kill two birds with one stone. The political controversy over the name will be eliminated and money will be generated from the contract. The contract can be devised as a long term (say 5 years) advertising deal. The winner bidder will get prominent slots around the project area. The winning bidder will be able to use photographs of the project in other advertising campaigns(TV, Web, Print).

Infrastructure projects are expensive to build and maintain. The Maharashtra State Road Development Corporation (MSRDC) still has unpaid bills worth Rs 480 crore towards the construction of the Sea-Link. The money raised from such deals will definately prove useful.

This is not as radical as it sounds. BEST buses and Railway trains are already covered with advertisements. Companies can pay the Indian Railways to have an entire train covered with their advertising. In many places companies maintain public gardens and in return they get advertising rights. It really is a win-win situation.

Will The US Dollar Decline In Value?

In theory, because of the huge amounts of dollars printed by the US Fed the US Dollar should weaken against all currencies. To some extent it has already happened. In the last 3-4 years as the US Trade and Fiscal deficits increased, the dollar did weaken.

From 2000 to 2007 the USD lost half its value with respect to the Euro. Refer the Euro-USD chart below:

This is exactly as per theory. But in the short run when investors seek to avoid risk they move into safe assets. So currencies like US Dollar, Swiss Franc appreciate in value. Similarly Gold gains when investors seek safety over returns. So in the last 6 months the dollar strengthened against other currencies.

In many respects India and US are remarkably similar. India has a huge fiscal deficit and is a net importer of goods. Last year India's Trade Deficit was over $100bn which as a percentage of GDP is worse than America !! This trade deficit was financed by foreign investors who bought Indian stocks and bond by the truckload. So, the rupee remained stable, when the stock market declined, the inflows dwindled and the rupee weakened.

India does not have Capital Account Convertibility. The Reserve Bank of India's official is to prevent sudden volatile movements in the currency markets. The RBI does not try to fight the trend; it tries to smooth out the volatility.

There was an article in the New York Times weekend edition about the US Dollar. Read the article here

Debt Monetization & Inflation

Mr Anonymous in response to my post "Asphyxiation By Forex" wished to know how Governments are going fund their fiscal deficits - Will they borrow the money or just print it?

The answer - bit of both actually. The technical term for Governments printing the money they need is 'Debt Monetization' or 'Quantitative Easing'. It works in the following manner: When the Government can’t find domestic or foreign buyers for its debt (usually because the interest rate is not high enough to attract lenders), the Central Bank buys this debt by printing new money. The government spends this money and in turn debases all the currency outstanding. Essentially the Central Bank "creates" money.

This is a sophistication of a process first used by the Roman empire. They would shave some gold off the edges of gold coins, remelt the shavings and mint them into more coins. The new coins would then be recirculated !!

Coming back to the present, the US Federal Reserve has "created" nearly $1.3 trillion dollars since October 2008. See the chart below:

Source: Wikimedia Commons

Is It Useful?

The size of a nation's economy is the total value of the spending on goods and services in the nation in a year.

The formula for GDP (Gross Domestic Product) is:

GDP = C + I + G + (Ex - Im)

where “C” equals spending by consumers,

“I” equals investment by businesses,

“G” equals government spending and

“(Ex - Im)” equals net exports, that is, the value of exports minus imports. Net exports may be negative.

The Global Economy is in the midst of a severe recession. Demand from consumers and businesses has dropped sharply. Economic theory suggests that the Government should increase spending to cushion the blow. By spending borrowed money Governments are trying to get the economy moving again.

Is there any risk?

The problem created by Quantitative Easing is that more the money in the economy less is its value. So it buys less over time. The prices of goods and services increase .leading to inflation. Inflation s a problem because it lowers the real value of wages and salaries and hurts people like retirees with a fixed source of income whose standard of life reduces due to inflation.

To sum up, Quantitative Easing is aimed at increasing the supply of money into the economy. Once the economy shows signs of recovery Central Banks will have to reduce the supply of money. If left unchecked the excess money can lead to high inflation, but managed well will soften the downturn.

Asphyxiation By Forex

India's phenomenal growth of the last five years was powered in large part by huge injections of cash and investment. Investment accounted for about 39% of the country's gross domestic product in the 2008 fiscal, up from 25% five years ago. At its peak, more than a third of investment came from abroad. At its peak, more than a third of investment came from abroad.

But in the last three months of last year, foreign loans and direct investment fell by nearly a third, to their lowest level in more than two years.

Source: Reserve Bank of India

The decline in foreign investment has taken a big toll on sectors like real estate, manufacturing and infrastructure. In the last quarter of 2008, the economy's growth rate plummeted to about 5.3%, the lowest in five years.

For 8-9% growth rate, private investment and low cost of capital is essential. The Government's Fiscal Deficit has ballooned to 10% of GDP. The Government is expected to borrow Rs 300000 crore this year compared to Rs 120000 few years ago. Such large borrowings will crowd-out the private sector and lead to an increase in interest rates.

Cutting subsidies, reducing the fiscal deficit and attracting foreign investment should be top of the 'To Do' list for the Government.