There are reformers in this world, and there are those who enjoy the fruits of reforms; seldom do the two coincide. India is one of those exceptional countries. Manmohan Singh and P. Chidambaram implemented the reforms in the early 1990s; today they are at the helm again. It is even more unusual because they did not immediately inherit the fruits of their reforms. Both were in the wilderness for years; it then looked as if their path-breaking policies had only benefited their political opponents, who had done nothing to deserve the fruits. So there is poetic justice in their return to power at the peak of the golden boom that reformed India is enjoying.
It is therefore not surprising that they feel rather elated and tend to rest on their oars; they deserve it. And it is understandable that when they think of what to do next, their ideas fall somewhat short of their best. If Chidambaram thinks of tripling loans to farmers, Manmohan Singh thinks of jobs for Muslims. If Chidambaram proposes tax cuts, Manmohan Singh proposes capital account convertibility. Chidambaram does not recognize that so called bank loans to agriculture already represent a substantial proportion of agricultural credit, but that they go largely to big farmers who do many things besides farming, and use those loans for many other purposes.
Manmohan Singh does not betray knowledge of the fact that the low proportion of Muslims in prized jobs has much to do with the smaller proportion of them acquiring education that is the gateway to those jobs, and indeed with fewer of them finishing school at all. Chidambaram wants to reduce taxes even though no one is complaining of high taxes, and has not considered what other uses the tax revenue he wants to forgo might be put to. Manmohan Singh does not say why he wants capital account convertibility — because Indian savers can then invest globally, or because foreign capital inflows would increase, or because cost of capital to Indian businesses would come down.
If he did, he would see that all these potential benefits are uncertain, conditional and not necessarily large. At one time, a Japanese friend taught me Go. He used to beat me in every game. After every win he would tell me, “Don’t make weak moves.” It is difficult to avoid the impression that the reformers of yore are making consistently weak moves.
I believe something better is now within the government’s reach: a revenue surplus. However desirable it might have been, it was unthinkable till now. The deficit was too large, and demands of spending ministries were too strident. But because of the ongoing boom, Central revenue is rising at an extraordinary rate. Even if Chidambaram did nothing, the revenue deficit would come down. If he put a slight brake on government expenditure, it would be possible to abolish the revenue deficit in two years, and from then on to run a surplus. Instead of forcing banks to hold a high proportion of their assets in government securities, it would then be possible to retire or buy off government debt from them. And the more the debt contracts, the greater will be the funds that banks can lend to businesses. Retirement of debt will bring down the share of interest payments, currently 60 per cent of government expenditure, and will enable the government to spend more on infrastructure.
A revenue surplus, being deflationary, will lead to an improvement in the current account. A stronger balance of payments will give Reserve Bank the choice of either accumulating foreign exchange reserves even faster, or of appreciating the rupee. As we have experienced in the past four years, reserve accumulation leads to a rise in money supply, greater liquidity, lower interest rates, higher business profits and greater industrial investment. Appreciation of the rupee would reduce the price of imports, bring down inflation and intensify competition in the domestic market. Real production and incomes would rise faster once the economy got through the initial deflationary impact — which in current conditions of buoyancy would be a good thing anyway.
One possible danger to our long-term growth has been the current account deficit; if foreign capital inflows stopped today, foreign exchange reserves would decline. That would reduce money supply, raise interest rates and reduce the growth rate. If reserves fell beyond a certain point, the Reserve Bank would panic, push up interest rates even further and deflate the economy. This danger can be avoided if a sufficient revenue surplus is achieved to rectify the payments deficit. All countries (other than the US) that grew rapidly over long periods had a current account surplus; if India achieves one, its growth would be much less vulnerable. A payments surplus does not preclude net capital inflows. China has a huge current account surplus and still receives large capital inflows. It chooses to accumulate reserves; we could choose any combination of reserve accumulation, exchange rate appreciation and import liberalization.
Those are the real effects of a revenue surplus. In addition, there will be a monetary effect. As the supply of government securities declines, a higher proportion of the rise in banks’ deposits will become available for financing productive investment. The government has no budget constraint, and can afford to borrow at any interest rate. Government borrowings define a floor to interest rates. When the revenue budget goes into surplus, government borrowings will become negative; the government will begin to buy off debt from banks and other institutions and retire it. Its borrowings will no longer place a floor under interest rates; interest rates can then fall to any level. A reduction in interest rates will lead to a rise in demand for all the expensive goods that are generally bought with borrowed funds — plant and machinery, and land and buildings. It will lead to a rise in investment, and hence in the growth rate of the economy.
The past three years have seen a fall in the government’s savings deficit, and a simultaneous rise in the domestic savings and investment ratios. Improvement of the revenue balance will have the same effect; and as domestic savings and investment increase, the growth rate also will rise.
Thus, achievement of a revenue surplus is the strongest growth-stimulating measure the government can take. From 8-9 per cent, it could push up growth to 10 per cent and above by spending less. If India is serious about catching up with China’s breathtaking growth, this is the most promising step the government can take towards that goal.
The fact that India has accelerated its growth despite high fiscal deficits has created the belief that fiscal balance does not affect growth — a belief that can be supported by running regressions on annual data. But such regressions exclude many other influences on growth as well as lagged effects, and are therefore unreliable. The macroeconomic effects of an improvement in fiscal balance are easy to work out in any model, and will give the same results in all — that it raises the growth rate. Now our celebrated reformers have a chance to see this work out in practice. It is an experiment they cannot afford to miss.